International Finance &amp Banking

IIMM/DH/02/2006/8154, International Finance & Banking
Q1. (a) What are the additional factors in International Finance Management as compared to domestic financial management Discuss? Answer:We all know, since the beginning in the 1980, there has been an explosion in the international investment through mutual funds, insurance products, bank derivatives, and other intermediaries by individual firms and through direct investments by institutions. On the other side of the picture, you must have realized that the capital raising is occurring at a rapid speed across the geological boundaries at the international arena. In the given scenario, financial sector especially the international financial and banking institution cannot be anything but go international. With the Indias entry into the world trade organization since 1st January 1995 and consequent upon a series of economic and banking reforms, initiated in India since 1991, barriers to international flow of goods, services and investments have been removed. In effect, therefore, Indian economy has been integrated with the global economy with highly interdependent components. Rapid advancement in science and technology especially supported by astronomical development and growth in telecommunication and information technology, has provided a cutting- edge and global leadership for India to participate in the international business. This, in turn, has stimulated a phenomenal growth in Indias proactive participation in international exchange of goods, services, technology and finance so as to knit national economies into a vast network of global economic partners. Financial people know in their bones that their profession goes back a long way. Its frequent association with the worlds oldest profession may simply be because it is almost as old. After all, the essential technology of finance is simple, requiring little more than arithmetic and minimal literacy, and the environment in which it applies is universal that is, any situation that involves money, property, or credit, all of which are commodities that have been in demand since humankinds earliest days. The basic principles of financial management viz., raising of funds on most economical terms and their effective utilization; are same, both for domestic as well as international concerns. However, an international concern (MNC) faces higher degree of risk as compared to domestic concern because it operates in more than one country and its operations involve multiple foreign currencies. Hence, foreign exchange risk management is an additional aspect in case of International Financial Management, which occupies a major attention of finance manager of a MNC. Beside MNCs, foreign exchange risk management is also important in case of international trade (i.e. export-import). Among the few differences between financial management of a multinational company (MNC) and domestic company (DC) is that the MNC has got operations around the world. This means they have to deal with an international group of customers, shareholders and suppliers. What this means is that they are exposed to exchange rate changes, issues about raising capital internationally, and also different accounting standards of reporting. In my opinion, the most important difference between an MNC and DC is the exchange rate. The MNC have to take consideration into exchange rate fluctuations, as it affects their sales and investment decisions (exchange rate changes will change their revenue from customers and also make investment decisions difficult, as they have to constantly convert back to their home country and see if the return is higher or if the investment is worth it). It also affects the way they report their financial statements, which is balance sheet or profit and loss. The MNC faces more difficulty in reporting this, as they have various standards to follow. (for example, how should they report the profit or loss for the year, in a foreign currency or home currency. Either way, it tells us different things about the MNC, as they can be making money in the home currency, but losing money in the foreign currency). Generally speaking, the financial management for an MNC has to deal with the larger external influence affecting the company, and a large part of books for Multinational Financial Management or International Financial Management deal with exchange rates. The field of international finance has witnessed explosive growth dynamic changes in recent time. Several forces such as the following have stimulated this transformation process: (1) Change in international monetary system from a fairly predictable system of exchange (2) Emergence of new institutions and markets, involving a greater need for international financial intermediation (3) A greater integration of the global financial system. Finance Function in a Global Context
The finance function in a typical non-financial firm consists of two main tasks, treasury on one hand and accounting and control on the other; needless to say, the treasurer and the controller do not function in watertight compartments. There is a continuous exchange of information and mutual consultations. In many firms a single person without any formal separation of two responsibilities may in fact, head both the tasks. In what way is the finance function different in a multinational context? The basic task of both the treasurer and the controller remain the same as in the case of a purely domestic firm, the difference is in terms of available choices and the attendant risks. These are the key differences: 1. The firm must deal with multiple currencies. It must make or receive payments for goods and services in currencies other than its home currency, raise financing in foreign currencies, carry financial assets and liabilities denominated in foreign currencies and so forth. Thus, it must acquire the expertise to deal in the forex market and learn to manage the uncertainty created by fluctuations in exchange rates. 2. A Treasurer looking for long- or short-term funding has a much richer menu of options to choose from when he or she is operating in a multinational context. Different markets, national or offshore, different instruments, different currencies and a much wider base of investors to tap. Thus, the funding decision -acquires additional dimensions, which market, which currency, which form of funding, etc. that are absent when the orientation is purely domestic. 3. Similarly, a treasurer looking for outlets to park surplus funds has a wider menu- of options in terms of markets, instruments and currencies. 4. Each cross-border funding and investment decision exposes the firm to two new risks, viz. exchange rate risk and political risk. The latter denotes the unforeseen impact on the firm, of events such as changes in foreign tax laws, laws pertaining to interest, dividend and other payments to non-residents, risks of nationalization -and expropriation. These are over and above all the other risks associated with -these decisions like interest rate risks and credit risks. 5. Cross-border financing and investment also obliges a firm to acquire relevant expertise pertaining to accounting practices, standards and tax laws applicable in -foreign jurisdictions. To summarize managing the finance function in a multinational context involves wider, opportunities; more varied risks, multiplicity of regulatory environments and, as a Consequence, increased complexity in decision-making. Taxonomy of Financial Markets Financial markets can be classified in various ways. The main division we will follow here is that between domestic or on shore markets on the one hand and off shore markets on the other. Domestic markets are the traditional national markets subject to regulatory jurisdiction of the countrys monetary and securities markets authorities trading assets denominated in the countrys currency. Thus, the market for government and corporate debt, bank loans, the stock market etc. in India is the Indian domestic market. Similar markets exist in most countries though many of them in developing and emerging market economies are quite underdeveloped. In many countries, nonresident entities are allowed to raise funds in the countrys domestic market which gives the market an international character. Thus, an Indian company (e.g. Reliance Industries) can issue bonds in the US bond market and a Japanese company can list itself on the London stock exchange. The main feature of these markets is that they are generally very closely monitored and regulated by the countrys central bank, finance ministry and securities authority like the Securities Exchange Commission in the US. Offshore or external markets are in which assets denominated in a particular currency are traded, but markets are located outside the geographical boundaries of the country of that currency. Thus, a bank located in London or Paris can accept a time deposit denominated in US dollars from another bank or corporation-an offshore dollar deposit. A bank located in Paris might extend a loan denominated in British pound sterling to an Australian firm-an offshore sterling loan. An Indian company might in London, bonds denominated in US dollars-an offshore US dollar. The main characteristic of these offshore markets is that they are not subject to many of the monitoring and regulatory provisions of the authorities of their country neither of residence nor of the country of the currency in which the asset is denominated. For instance, a bank in the US accepting a deposit would have to meet the reserve requirements laid down by the Federal Reserve and also meet the cost of deposit insurance. However, the London branch of the same bank accepting a dollar deposit is not subject to these requirements. An Indian company making a US dollar bond issue in the US would be subject to a number of disclosures, registration and other regulations laid down by the SEC; dollar bonds issued in London face no such restrictions and the firm may find this market more accessible. Since both investors and issuers are generally free to access both the domestic and offshore markets in a currency, it is to be expected that the two segments must be closely -tied together. In particular, interest rates in the two segments cannot differ significantly.
There will be some differences due to the fact that one segment is more rigorously regulated (as also protected against systemic disasters), but unless the authorities impose restrictions on funds flow across the two segments, the differences will be very small. The euro currency market or simply the euro market was the first truly offshore market to emerge during the early postwar years. It blossomed into a global financial marketplace by the end of the 1980s. A brief look at its evolution and structure will enable us to understand how offshore markets function. With the spread of such markets to locations outside Europe, and the arrival of the pan-European currency named euro, the designation euro currency markets became inappropriate and inconvenient. A US dollar deposit with a bank in London used to be called a euro dollar deposit. What do you call a deposit denominated in euro with a bank in Singapore? The designation euroEuro deposit would be rather cumbersome. A more appropriate and comprehensive designation is offshore markets. The important distinguishing features of international finance are discussed below: 1. Foreign exchange risk: An understanding of foreign exchange risk is essential for managers and investors in the modern day environment of unforeseen changes in foreign exchange rates. In a domestic economy this risk is generally ignored because a single national currency serves as the main medium of exchange within the country. When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates. The present International Monetary System set up is characterized by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests. In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy makers. At present, the exchange rates among some major currencies such as the US dollar, British pound, Japanese yen and the euro fluctuate in a totally unpredictable manner. Exchange rates have fluctuated since the 1970s after the fixed exchange rates were abandoned. Exchange rate variation affect the profitability of firms and all firms must understand foreign exchange risks in order to anticipate increased competition from imports or to value increased opportunities for exports. 2. Political Risk: Another risk that firms may encounter in international finance is political risk. Political risk ranges from the risk of loss (or gain) from unforeseen government actions or other events of a political character such as act of terrorism to outright expropriation of assets held by foreigners. MNCs must assess the political risk not only in countries where it is currently doing business but also where it expects to establish subsidiaries. The extreme form of political risk is when the sovereign country changes the rules of the game and the affected parties have no alternatives open to them. For example, in 1992, Enron Development Corporation, a subsidiary of a Houston based energy Company, signed a contract to build Indias longest power plant. Unfortunately, the politicians in Maharashtra who argued that India did not require the power plant canceled the project in 1995. The company had spent nearly $300 million on the project. The Enron episode highlights the problems involved in enforcing contracts in foreign countries. Thus, political risk associated with international operations is generally greater than that associated with domestic operations and is generally more complicated. 3. Expanded opportunity sets: When firms go global, they also tend to benefit from expanded opportunities, which are available now. They can raise funds in capital markets where cost of capital is the lowest. In addition, firms can also gain from greater economics of scale when they operate on a global basis. 4. Market imperfections: The final feature .of international finance that distinguishes it from domestic finance is that world markets today are highly imperfect. There are profound differences among nations laws, tax systems, business practices and general cultural environments. Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolio. Though there are risks and costs in coping with these market imperfections, they also offer managers of international firms abundant opportunities. Thus, the job of the manager of an MNC is both challenging and risky. The key to such management is to make the diversity and complexity of the environment work for the benefit of the firm. 5. Agency Problem: Financial executives in multinational corporations many times have to make decisions that conflict with the objective of maximising shareholders wealth. It has been observed that as foreign operations of a firm expand and diversify, managers of these foreign operations become more concerned with their respective subsidiary and are tempted to make decisions that maximize the value of their respective subsidiaries. These managers- tend to operate independently of the. MNC parent and view their subsidiary as single, separate units. The decisions that these managers take will not necessarily coincide with the overall objectives of the parent MNC.
MNCs use various strategies to prevent this conflict from occurring. One simple solution here is to reward the financial managers-according to their contribution to the MNC as a whole on a regular basis. Still another alternative may be to fire managers who do not take into account the goal of the parent company or probably give them less compensational rewards. The ultimate aim here is to motivate the financial managers to maximize the value of the overall MNC rather than the value of their respective subsidiaries.
Q1. (b) Define Derivatives ? Explain the features and types of derivatives. Answer:A derivative is a product whose value is derived from the value of underlying asset, index, or reference rate. The derivative does not have any physical existence but emerges out a contract between two parties. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmer may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction would take place through a forward or futures market. This market is the derivative market, and the prices of this market would be driven by the spot market price of wheat which is the underlying. The terms of contracts or products are often applied to denote the specific traded instruments. Derivatives are only secondary market securities and cannot help a firm in raising fund. In fact, derivatives arise only when the shares and debentures are already issued by the Company. The derivatives market is quite liquid and transactions can be effected easily. In recent years, derivatives have become increasingly important in the field of finance. Futures and options are now actively traded on many exchanges. Forward contracts, swaps and many other derivative instruments are regularly traded both in the exchanges and in the over the -counter markets. Derivatives are actually easy to understand and use, thanks to two men: Fischer Black and Myron Scholes. Together, these two developed the Black-Scholes Model back in 1973 - a mathematical model that allows investors to determine derivatives prices. With regard to options, the Black-Scholes Model allows you to determine how much an option is worth by plugging numbers into a formula that asks for specific inputs common to all derivatives. Among these factors are: The price of the underlying asset i.e. the stock price The amount of time until expiration The strike price of the option The volatility of the underlying asset (how much it moves up or down in a given period) The risk-free rate of return. This is usually the interest rate paid by the government or a bank on guaranteed investments like Treasury notes. Once these factors are entered into the model, it spits out a price that gives you the fair value of the derivative. Black and Scholes won the Noble Prize for developing this model, and it's still widely used today as the guide by which options are priced. Since derivatives allow you to control the underlying asset - either with the right to buy or sell it - you're implying that you can fulfil the transaction in the event that you have to buy or sell the asset. That means that with trillions of dollars worth of assets changing hands in today's marketplace, traders can get into trouble if they don't know what they're doing. In most cases, however, investors use derivatives as a trading vehicle to capture the profits from the movement of the underlying investment. Because of this, derivatives are often referred to as leveraged investment. And, whenever leverage is employed, the results can be magnified - both up and down.
Types of Derivatives:
1. Commodity derivatives and Financial derivatives: Derivatives contract can be entered into for different type commodities such as sugar, jute, pepper, gur, castor seeds etc. In India, futures contracts in 6 commodities are available as different commodities exchanges, for example, futures in pepper are available at Kochi, while futures in potatoes are available at Hopur, on the other hand, the
derivative in currencies, gilt-gifted securities, shares, shares indices etc., are known as financial derivatives. These are transacted at different exchanges all over the world. In India, dealing in Stock Index Futures has started recently. 2. Basic derivatives and Complex derivatives: The basic derivatives are the derivatives on underlying asset. Futures and Options are two basic derivatives. However, there are certain other derivatives such as swaps which may be classified as complex derivatives. In practice, different types of financial derivatives have been used as a tool of risk management. However, more popular among them (1) Futures, and (2) Options. These are being explained in the following section.
Futures
A futures contract, or simply called futures, is a contract to buy or sell a stated quantity or a commodity or a financial claim at a specified price at a future specified date. The parties to the futures have to buy or sell the asset regardless of what happens to its value during the intervening period or what shall be the price on the date for which the contract is finalized. Futures contracts are standardized contracts on foreign exchange and interest rates that are traded on a futures exchange. They are based on the delivery of a specified amount of foreign currency or an interest-bearing security at a future date. Thus, both forward and futures contracts are agreements to deliver or take delivery of a specified quantity of an asset on a future date at a pre-specified price. However, the important difference between forward and futures contracts is that the latter are marked-to-market on every trading day. Transaction agreements in assets can be broadly classified as: (i) Spot or Ready Delivery Contract where the asset is to be physically delivered immediately or within few days and payment made in cash, or (ii) Future Delivery contract where the physical delivery of the asset is slated for a future date and the payment to be made as agreed. The future delivery contracts may be classified as: a. Non- Transferable future delivery contract, where the contract must performed by the parties as per the terms and conditions mentioned therein, and b. Transferable future delivery contract, when the parties to the contract can transfer the rights and obligations under the contract to a third party. Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the futures at a certain price. Unlike forward contracts tile futures contracts are standardized and exchange traded contracts. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. Therefore, a future contract is a legally binding agreement between two parties to the contract. It is standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The exchange traded futures are a significant improvement over the forward contracts as they eliminate counter party risk and offer more liquidity. Index Futures The index futures are the most popular futures contracts as various participants in the market can use them in a variety of ways. They offer different users different opportunities as we have discussed in the class how the index futures can be used to realise those objectives.
Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The Forwards contracts are normally traded outside the purview of the exchange. Forward contracts are very useful in hedging and speculation.
The classic hedging application would be that of a wheat farmer forward selling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want to buy bread forward in order to assist production planning without the risk of price fluctuations. Thus forwards provide a useful tool for both the farmer and the bread factory to hedge their risks. If a speculator has information or analysis which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to raise and then take a reversing transaction to book the profits. The use of forward markets here supplies leverage to the speculator. Major Features of Futures (Forward v/s. Future): (1) Organized Exchange: - Unlike forward contracts which are traded in an OTC market, futures are traded on organized exchanges (just like stock market) which provides liquid market of futures. (2) Standardization: - Forward contracts are tailor-made to the buyers requirements. In the futures contract, the amount of currency covered by one future contract and maturity day, both are standardized by the exchange on which that future is traded. (3) Clearing House: - The clearinghouse of the futures exchange interacts itself between the buyer and the seller. Thus, all transactions are with clearinghouse, not directly between the purchaser and the seller. While in case of forwards, the transaction is between the buyer and seller, the A.D. being one party to the contract. There is no clearinghouse involved. (4) Margins: - Only member of clearinghouse of the futures exchange can trade in futures on the exchange. The general public uses the services of such members as brokers to trade on their behalf. The member is required to deposit a margin with the clearinghouse to perform trading. A member acting on behalf of a client, in turn requires the client to deposit a margin with the member. (5) Marking to Market: - At the end of each working day, the futures contract is marked to market, i.e., valued at closing price. Margin accounts of those who made losses are debited and those who earned gains are credited. Accordingly, losers have to bring more margin and gainers can draw off excess margin. E.g.- X buys a June delivery future on 14th April at a price of $1.60 per. The futures contract is for $1,00,000. On April 15 th, at the end of the day, the settlement price is $1.62 = 1. X made a gain of 2 cents per or $1250 per contract. This will be credited to Xs margin a/c. obviously; someone with a short position lost a matching amount. As against the above, in forwards, the gain or loss arises only on maturity. There are no intermediate cash flows. (6) Actual Delivery is Rare: - As against forwards where delivery of underlying currency is almost certain; in case of futures actual delivery takes place in less than 1% of the contracts traded. Futures are used as hedging device and as a way of betting on price movements. In the first two of these, the basic problem is that of too much flexibility, and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation but makes the contracts non tradable. Also tile OTC market here is unlike the centralization of price discovery that is obtained on all exchange. Counter party risk in forward markets is a simple idea: When one of the two sides of tile transaction chooses to declare bankruptcy, the other suffers. Therefore larger the time period of the contract larger the counter party risk. Even when forward markets trade standardized contracts and hence avoid the problem of liquidity, still the counter party risk remains a very large problem.
Options
Options are one of the most popular derivatives. Options derive their value from the underlying capital market or forex or other form of assets. These are highly leveraged Instruments. They can be used for hedging, speculating and arbitrage purposes. Types of options: Options are of two types. Call and Put option. A call option gives a buyer / holder a right but not an obligation to buy the underlying on or before a specified time at a specified price (usually called strike / exercise price) and quantity. Whereas a put option gives a holder of that option a right but not an obligation to sell the underlying on or before a specified time at a specified price and quantity. The buyer /holder of an option pay an upfront premium to the writer / seller of an option. In other words he pays the price of the option. A writer / seller of an option undertake an obligation to buy /sell the underlying on or before a specified time at specified price and quantity for a premium. This premium is collected upfront. Thus, the writer of an option has to price his option such a way that it takes all the possible scenarios into consideration and should be close to the fair price of the option.
Exercise style of options: Options are classified into two kinds depending on the exercise styles. They are American option and European option. In the American option the holder / buyer of an option is allowed to exercise the option any time during the life of the option. However in the European option exercise is allowed only at the maturity date of the option. Strike price of Options: World over options are generally traded on different variety of strike prices. These strike prices are determined by the exchange. For example if a call option is traded at a strike price equal to that of the underlying spot price, then the option is called At The -Money option, if the strike price is lesser than the underlying spot price, it is called In The -Money option and if the strike price is higher than the underlying spot price, it is called as Out - of Money option. In case of put option if the strike price is higher than the underlying spot price it is called In The Money and when the strike price is lower than the underlying spot price, it is called Out of Money option. At the money option is same for both a call and put on the same underlying and the same strike price. An option may be: - Exchange Traded Option (ETO), which is a standardized option, listed & traded on an organized exchange. - Over-the-counter Option (OTCO) is a non-standardized option that is created primarily keeping in mind the user specific needs. Option Premium: Option premium consists of two parts intrinsic value and Time value. The intrinsic value of a call option is the difference between the spot price and the strike price, whereas the intrinsic value of a put option is the difference between the strike price and the spot price. In the money options have intrinsic value. However, At the money and Out of money options have no intrinsic value. Time value of an option is the price a holder of an option has to pay to the seller of an option because of the risk the seller of an option takes. This is over and above the intrinsic value that an option holder pays. Typically, the premium charged by the seller of an option is equal to the sum of both intrinsic value and the time value. Option premium basically depends upon: (1) Difference between exercise price & spot price. (2) Maturity period. (3) Volatility of price movements. (4) Interest rates. (5) Supply & demand for options. NSE has started index options based on S&P CNX NIFTY, which have the American style of exercise. The options are of one month, two month and three month maturities. Options may also be classified as: (i) American options and European Options: In the American option, the option holder can exercise the right to buy or sell, at any time before the expiration or on the expiration date. However, in the European option, the right can be exercised only on the expiry date and not before. The possibility of early exercise of right makes the American option to be more valuable than the European option to the option holder. (ii) Naked options and Covered options: A call option is called a Covered option if it is covered/written against the assets owned by the option writer. In case of exercise of the call option by the option holder, the option writer can deliver the assets or the price differential. On the other hand, if the option is not covered by the physical asset, it is known as Naked option.
Q2. (a) Describe the sources of external finance and also narrate structured finance with suitable examples. Answer:The main sources of external finance for the developing countries could be classified under the following broad heads: 1. Bilateral aid (grants/loans) 2. Multilateral agencies like the International Momentary fund, the World Bank, the Asian Development Bank etc. 3. Export Credit offered by the industrial countries of finance export of capital goods 4. Commercial debt markets 5. Equity (direct, private and portfolio) 6. Miscellaneous sources.
The commercial market could be further classified under two heads domestic markets of different countries and the offshore markets. Each in turn can be divided into money and capital markets. We now proceed to look at each of these sources in some detail: 1. Bilateral aid (grants/loan)- Official Development Assistance (ODA) This comprises both bilateral aid and assistance provided through replenishment of resources of multilateral soft-lending agencies like IDA, funds of regional development banks, the EU, the UN, etc. some of this assistance comes in the form of grants as well. Multilateral agencies are an important source of overseas development assistance on soft terms. The most important of these is the international development association (ADA), formed in 1960. While bilateral assistance is often in the form of military aid- witness US assistance to Israel and Egypt- multilateral agencies have a strong economic development bias and the loans are mostly of financing development projects. Below data indicates the floe of ODA in various countries.
2. Multilateral Agencies: Commercial Terms Debt It is not at all uncommon for financing to be provided by governments or development banks. Because Government and Development bank financing is generally at favorable terms, many corporations consider these official sources of capital before considering the issue of stock, the sale of bonds, loans from commercial banks, or parallel loans from other corporations. Host governments of foreign investments provide financing when they believe projects will generate jobs, earn foreign exchange, or provide training for their workers. There are numerous examples of loans being provided to MNCs by the governments of, for example, Australia, Britain, Canada, and Spain, to attract manufacturing firms to make investments in their countries. Sometimes the state or provincial governments also offer financing, perhaps even competing with each other within a country to have plants built in their area. Several U.S. states have provided cheap financing and other concessions to induce Japanese and other foreign firms to establish operations. Canadian provincial and Australian state governments have also used special financing arrangements to attract investors. Even though the governments of poorer countries do not usually have the means to offer concessionary financing to investors, there are a number of development banks, which specialize in providing financing for investment in infrastructure, for irrigation, and for similar projects. While this financing is usually provided to the host government rather than to corporations involved in the construction of the projects, the corporations are indirectly being financed by the development bank loans to the host governments. A leading provider of financial assistance is the International Bank for Reconstruction and Development (IBRD), commonly known as the World Bank. The World Bank, which was established in 1944, is not a bank in the sense of accepting deposits and providing payment services between countries.
Rather, it is a lending institution that borrows from governments by selling them its bonds, and then uses the proceeds for development in undeveloped (or developing) nations. World Bank or IBRD loans have a maturity of up to 20 years. Interest rates are determined by the (relative low) cost of funds to the bank. Many developing countries do not meet the conditions for World Bank loans, so in 1960 an affiliated organization, the International Development Agency (IDA) was established to help even poorer countries. Credits, as the loans are called, have terms of up to 50 years and carry no interest charges. A second affiliate of the World Bank is the International Finance Corporation (IFC) The IFC provides loans for private investments and takes equity positions along with private-sector partners. 3. Export Credits Governments of major industrial countries have established export credit schemes to finance exports of capital goods and related technical services in association with their export insurance agencies which usually cover the political and commercial risks in the transaction. An export credit arises whenever a foreign buyer of exported goods or services is allowed to defer payment. Export credits generally enjoy government backed support which raises potential concerns about free and fair competition, therefore they have been subject to agreements and understandings within the framework of the OECD (subsequently integrated into EC law) as well as to an EC Directive on harmonisation of export credit insurance for transactions with medium and long-term cover. An "export credit" is in principle a financing arrangement which allows a foreign buyer of exported goods and/or services to defer payment over a period of time, but the expression is often used also for an insurance or guarantee. Export credits are generally divided into short-term (usually under two years), medium-term (usually two to five years) and long-term (usually over five years). Export credit is providing pre-shipment and post-shipment credit either in Indian rupees or in foreign currency to an exporter. The credit is given for short term i.e. upto 6 months, medium/ long term which extends more than 6 months according to the eligibility of the products and projects. Usually medium/ long term export credit is given after inspecting the supplier's credits. Export credits can be backed by official support meaning that government backed support is involved. Official support can take the form of direct credits/financing, refinancing, interest-rate support (where the government supports a fixed interest-rate for the life of the credit), aid financing (credits and grants), export credit insurance and guarantees. Institutions dealing with export credits are called Export Credit Agencies (ECAs). In case of official support an ECA can be a government department or a commercial institution administering an account for or on behalf of government, separate of the commercial business of the institution. The activities of ECAs include giving insurance or guarantees for the repayment of a loan by a financial institution to a buyer in a third country (buyer credit), giving insurance or guarantees against non-repayment of a credit extended by an exporter to a buyer in a third country (supplier credit) and providing direct loans or credits to third country buyers. To promote the export promotion drive, the Government of India established Export Credit Guarantee Corporation of India Limited (ECGC) in 1957 to cover the risk of exporting on credit. This organisation offers a range of services to exporters. They are as mentioned below:

It provides credit risk insurance covers to the exporters against there loss in export of goods and services. It offers guarantees to the banks and financial institutions in order to enable the exporters to obtain better facilities from them. It provides Overseas Investment Insurance to the Indian companies investing in joint ventures abroad as equity of loan.
Export Credit Insurance Export credit insurance protects the exporter from the consequences of the payment risks due to the far-reaching political and economic changes. Outbreak of war or civil war might block or delay the payment for goods already exported. Coup or an insurrection in the importing country may also bring the same result. Export credit insurance is obtained from the ECGC with the following issued covers:
Standard policies to protect the exporter against the risk of not receiving the payment while trading with overseas buyers on short-term credit. Specific policies which is designed to protect the exporter against the risk of not receiving the payment in respect of: o Exports on deferred payment terms o Services rendered to the foreign parties o Construction work which also includes the turnkey projects undertaken abroad.
The policies are one of the following:

Whole Turnover Policies in the form of 'Open Cover' in respect of shipments made during 24 months period DP, DA and open delivery terms. Shipment details have to be declared on monthly basis. Specific policies for exports of capital goods on medium or long-term credit, turnkey projects, civil construction works and technical services
Exim Bank offers the following Export Credit facilities, which can be availed of by Indian companies, commercial banks and overseas entities. For Indian Companies executing contracts overseas
Pre-shipment credit
Exim Bank's Pre-shipment Credit facility, in Indian Rupees and foreign currency, provides access to finance at the manufacturing stage - enabling exporters to purchase raw materials and other inputs.
Supplier's Credit
This facility enables Indian exporters to extend term credit to importers (overseas) of eligible goods at the post-shipment stage.
For Project Exporters
Indian project exporters incur Rupee expenditure while executing overseas project export contracts i.e. costs of mobilisation/acquisition of materials, personnel and equipment etc. Exim Bank's facility helps them meet these expenses. For Exporters of Consultancy and Technological Services Exim Bank offers a special credit facility to Indian exporters of consultancy and technology services, so that they can, in turn, extend term credit to overseas importers. Guarantee Facilities Indian companies can avail of these to furnish requisite guarantees to facilitate execution of export contracts and import transactions. For commercial Banks Exim Bank offers Rediscounting Facility to commercial banks, enabling them to rediscount export bills of their SSI customers, with usance not exceeding 90 days. Exim Bank also offer Refinance of Supplier's Credit, enabling commercial banks to offer credit to Indian exporters of eligible goods, who in turn extend them credit over 180 days to importers overseas.
4. Commercial debt markets

Unlike the supply of external debt, which is plentiful, the supply of domestic debt is severely limited in most developing countries. Analysis of 140 private sector infrastructure projects from the IFC's portfolio shows that only a sixth of debt financing (which represented 61 percent of total project cost) was domestic debt (International Finance Corporation 1996).
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Moreover, all of the domestic debt was from local commercial banks, which do not provide long-term finance. This is clearly not a viable financing pattern. If private sector investment in infrastructure is to increase substantially, more domestic debt must be secured, and the composition of this debt must shift to longer maturities. This can happen only if domestic debt markets in developing countries develop. Development of domestic debt markets Domestic debt markets in developing countries are underdeveloped for many reasons, and action to develop these markets has to be taken on several fronts. A high rate of domestic savings is the most important structural prerequisite for ensuring an adequate flow of domestic finance for private infrastructure. High savings rates are not enough, however. Most East Asian economies, for example, have very high rates of savings, and yet debt markets in these economies are underdeveloped, with long-term debt particularly scarce. A critical requirement for well-functioning debt markets is a sound macroeconomic balance, as reflected in modest fiscal deficits. High fiscal deficits have significant negative effects. If monetized they lead to inflation, which discourages savings in general and long-term saving in particular. If not monetized they put pressure on interest rates, which discourages investment, especially in projects with long gestation periods, such as infrastructure. High interest rates also tempt governments to intervene in financial markets to reduce the cost of government borrowing by forcing banks, insurance companies, provident funds, and pension funds to invest a high proportion of their assets in government securities. This reduces the cost of government borrowing, but it obviously does not eliminate the crowding out effect of high levels of government borrowing for non-government borrowers. In fact, the artificial lowering of interest rates on government securities distorts the government debt market, discouraging active trading in government securities and preventing the emergence of a reliable yield curve, all of which work against the development of an efficient debt market. Effective control over fiscal deficits is therefore an important element in any strategy for developing debt markets.
5. Equity (direct, private and portfolio)

Foreign Equity investments can be of three types: 5. 1. Foreign Direct Investment (FDI) FDI is investment involving a long-term relationship and lasting interest in and control by a resident entity in one economy in an enterprise resident in another economy. In FDI, the investor exerts significant influence on the management of the enterprise resident in the other economy. The ownership level required in order for a direct investment to exist is 10% of the voting shares. Such investment involves both the initial transaction between the two entities and all subsequent transactions between them and among foreign affiliates, both incorporated and unincorporated. FDI may be undertaken by individuals or by business entities. (Some countries use a definition of FDI that differs from the preceding one.) FDI flows have three components: equity capital, reinvested earnings, and other capital (including short- and longterm intra-company loans as well as trade credits). FDI inflows are capital received, either directly or through other related enterprises, in a foreign affiliate from a direct investor. FDI outflows are capital provided by a direct investor to its affiliate abroad. Cross-border mergers and acquisitions (M&A) involve FDI in a host country by merging with or acquiring an existing local firm. In the latter case, the acquisition involves an equity stake of 10% or more. The share of FDI accounted for by cross-border M&As is difficult to determine, since data sets are not directly comparable. First, the value of cross-border M&As includes funds raised in local and international financial markets. Second, FDI data are reported on a net basis, using the balance-of-payments concept, while data on cross-border M&A purchases or sales report only the total value of the transaction. Finally, payments for cross-border M&As are not necessarily made in a single year but may be spread over a longer period. Global foreign direct investment (FDI) flows have grown steadily in the past 30 years, with some declines between the early 1980s and the early 1990s. After climbing sharply in 1999 and 2000, investments fell dramatically during 20012002. The decrease resulted mainly from weak economic growth, tumbling stock markets that contributed to a steep decline in cross-border mergers and acquisitions, and institutional factors such as the winding down of privatization in several countries.
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In 2002, FDI inflows declined by 21% to $651 billion, or just half the peak amount in 2000. The decline was distributed across all major regions and countries except Central and Eastern Europe, where inflows were up by 15%. The main recipients of FDI inflows remain developed countries, with about 71% of the total in 2002, although the share of inflows to developing economies increased to 25% (from 18% during 19861990). Inflows to least developed countries, at $5 billion, represented a small but increasing share (3%) of developing countries inflows, compared to 2% in 1997. When FDI is broken down by economic activity, services are the most important sector: in 2001, they accounted for almost two-thirds of the total, compared to less than half in the late 1980s. Global FDI outflows declined by 9% in 2002, reaching $647 billion. Again, all regions experienced a decline except Central and Eastern Europe, which was up by 20%. Developing countries share in total outflows remained relatively stable during the past two decades, at around 7%. Although FDI flows declined much more sharply than gross domestic product figures, exports and domestic investment, they remain the biggest component of net resource flows to developing economies. Since 1990, they have been a growing part of total investment in developing economies. Some statistics of FDI inflow and outflow and FDI flows by region:
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5. 2. Portfolio Investments These are aimed at capital appreciation and portfolio investments have little say in management of the investee companies. They also nod not bring in any technology. Portfolio investments are of four types: Close ended country funds floated abroad- These operated like domestic mutual funds. Close ended funds have a specific maturity date and fund manager is under no obligation to buy the units from the subscribers during the currency of the fund. An advantage of the closed-end fund is that the fund manager neednt focus on redemptions. The ability to redeem shares of an open-ended fund means managers must keep cash on hand to
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cover redemptions or must sell shares to meet redemptions. Either option can be inefficient at best and detrimental to other shareholders if the securities in the fund are illiquid. This advantage is a key reason why many emerging market funds (where shares are illiquid) are created as closed-end funds. The holders are however free to sell to foreign buyers at the market price, which depends on the demand and supply, and often varies widely from the net asset values. All the initial India funds floated abroad were closeended funds. Open ended country funds. - These too are mutual funds but with no specific maturity date. Also, the fund manager is obliged to quote bid and offered prices, depending on the net asset value of the fund; and any investor is free to buy or sell at these prices. Several open-ended India funds have been floated in the last few years. Foreign Institutional Investors (FIIs) directly investing in the local stock market. India has recently permitted many FIIs to do so. They purchase rupees against foreign currencies for making investments at market prices and are free to sell when they choose; the resultant rupees, after payment of any local taxes, can then be used to buy forex in the market for repatriation of the investments. Equity (or convertible bond) issues in foreign markets. Recently, several Indian companies have such issues. Global Depository Receipts is a certificate issued by investment banker to general public against the issue of shares of some foreign country. If any company wants to issue GDR to raise funds from foreign; Firstly it has to contact with the merchant banker of home country & also have to make approval from RBI, then it contacts with the investment banker of foreign company, then investment banker will purchase the shares from the merchant banker & then issue it to public through green shoe option. When we not do not want money from the foreign then we buy shares from foreign public & shares came back to India. Reliance Industries Ltd. was the first Indian Company to raise funds through a GDR issue. Global Depository Receipt (GDR) - certificate issued by international bank, which can be subject of worldwide circulation on capital markets. GDR's are emitted by banks, which purchase shares of foreign companies and deposit it on the accounts. Global Depository Receipt facilitates trade of shares, especially those from emerging markets. Prices of GDR's are often close to values of related shares. Very similar to GDR's are ADR's. GDR's are also spelled as Global Depositary Receipt. 5. 3. Private Equity Private equity funds are extremely keen to identify and invest in growth opportunities in the Indian pre- IPO (initial public offer) market. PRIVATE equity (PE) funds from around the globe are being lured by the enormous opportunities that are on offer in many sectors of the Indian economy. Several domestic business groups and banks are also floating PE funds, hoping to capitalize on the huge requirements for finance from rapidly expanding sectors of the economy. Factors that are boosting the inflow of PE funds besides the prospects in different sectors are the sharp drop in stock market indices that have consequently resulted in a significant fall in stock offerings, the spurt in interest rates that are making borrowings dearer, and tough Reserve Bank of India (RBI) norms relating to external commercial borrowings and foreign currency convertible bonds. PE funds, once convinced about the soundness of a business organisation, its plans and revenue streams, are patient and willing to wait for a reasonable period for returns; unlike other investors they are not obsessed with quarterly performance reports and are also not easily unnerved by downturns in a business cycle. Not surprisingly, most of the PE funds inflow into India has been in sectors that generally have a relatively long gestation period. According to IndusView, a New Delhi-based corporate finance and cross-border advisory firm, the real estate and infrastructure sectors accounted for 50 per cent of the total $10 billion PE inflows into the country in 2007. The telecommunications sector attracted $2.1 billion in PE funding. Globally, real estate PE funds raised about $50 billion last year. The sub-prime mortgage crisis in the US and the sharp fall in property prices in many developed countries are forcing them to look towards countries like India and China. Bundeep Singh Rangar, London-based chairman of IndusView, believes that Indias PE market has the potential to expand four-fold over the coming years. The infrastructure sector will provide the necessary edge, he points out. India can also be expected to maintain the top slot in Asia, ahead of China. And of course, the other powerful Asian economies. The PE business took off in India in 2005, when the country attracted about $2 billion in such funding. A year later, India saw $7 billion in PE funds infusion, though China was the top market with $13 billion in investments. 6. Miscellaneous Sources FCNR Deposit: In the Indian context, one other source of external finance should be mentioned, viz., the Foreign Currency Non-Resident (FCNR) Deposit Scheme. Under this scheme, non-resident Indians and persons of Indian origin
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are permitted to make foreign currency deposits with Indian banks, carrying rates of interest with ceilings prescribed by RBI based on the ongoing market rates. Under the now discontinued FCNR(A) scheme, the exchange risk on such deposits used to be passed on by the commercial banks to the Reserve Bank. The commercial bank sold the foreign currency to the Reserve Bank at the ongoing rate, used the rupees proceeds for its domestic operations. And had a forward contract with the Reserve bank to buy the foreign currency back at the same rate at which it was sold, for repaying the foreign currency deposit when it matures, and interest thereon. Some features of FCNR deposits account maintained by commercial banks:
The account can be opened with funds remitted from abroad, or transferred from an existing NRE/FCNR account. FCNR accounts can be opened with designated currencies, which are: GBP, USD, Deutsche Mark, Japanese Yen and the Euro. Conversion to another designated currency is permitted at a cost to the account holder. Only term deposits can be maintained in FCNR accounts, in a time range of 6 months to 3 years. As per RBI guidelines, banks are free to offer interest on FCNR deposits below LIBOR rates, less 25 basis points for deposits between 6 months to one year, and LIBOR rates plus 50 basis points for deposits over a year. Banks are also free to decide on a fixed or a floating rate of interest on FCNR term deposits. Interest rates are reviewed periodically and determined by directives from the Reserve Bank (Department of Banking Operations and Development). The account holder can choose the periodicity of interest, from half-yearly to annual payments. The interest can be credited to a new FCNR (B) account or a NRE/NRO account. For permissible debits and credits, the regulations for FCNR accounts are similar to the NRE accounts. For conversion of currencies, from designated currency to rupees and vice versa, the days rate of conversion will apply. Funds from the FCNR account are allowed to move within the country at no extra cost to the account holder. For loans and overdrafts against FCNR accounts, the same conditions as the NRE accounts apply. In case of premature withdrawal of the FCNR Term Deposit, a penalty is levied. Interest paid on the account is calculated at a 1% below the committed rate if accounts are closed prematurely. However, no interest is paid on deposits held for less than 6 months, and a penalty would have to be paid as per directives from the apex bank. The RBI guidelines prevail on these terms, issued as and when required.
STRUCTURED FINANCE Structured Finance enables efficient refinancing and hedging profitable economic activity beyond the scope of conventional form of on-balance sheet securities with a view to reduce cost of capital and to mitigate market impediments on liquidity. Essentially they are risk transfer instruments. Structured finance instruments can be defined through three distinct characteristics: (1) pooling of assets (either cashbased or synthetically created); (2) delinking of the credit risk of the collateral asset pool from the credit risk of the originator, usually through the transfer of the underlying assets to a finite-lived, standalone special purpose vehicle (SPV); and (3) tranching of liabilities that are backed by the asset pool. While the first two characteristics are also present with classical pass-through securitizations, the tranching of liabilities sets structured finance products apart How it is structured? Most structured finance products (i) combine traditional asset classes with contingent claims, such as risk transfer derivatives and/or derivative claims on commodities, currencies or receivables from other reference assets, or (ii) replicate traditional asset classes through synthetication Who resorts to them? Structured finance is invoked by financial and non-financial institutions in both banking and capital markets if established forms of external finance are either (i) unavailable (or depleted) for a particular financing need, or (ii) traditional sources of funds are too expensive for issuers to mobilize sufficient fund for what would otherwise be an unattractive investment based on the issuers desired cost of capital What do they offer? Structured finance offers the issuers enormous flexibility in terms of maturity structure, security design and asset types, which allows issuers to provide enhanced return at a customized degree of diversification commensurate to an
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individual investors appetite for risk. Structured finance contributes to a more complete capital market by offering any mean-variance trade-off along the efficient frontier of optimal diversification at lower transaction cost. Structured finance facilitates breaking traditional financial instruments into their component risk and returns parts, them reassembling them to create more attractive instruments for issuers and investors. When done properly these transactions provide numerous benefits. For the issuer, they lower issuers funding costs by removing inefficiencies in the capital markets, and they enhance issuers liquidity by diversifying their funding sources and enabling them to monetize assets that would be difficult to sell outright. For investors, the principal benefit is flexibility. Investments can be tailored to fit the desired risk profile of an investor. Since structured finance enables them to take on exposures to many types of risk in the form of securities usually investment grade that can easily be sold in the secondary market. Investors too benefit from the increased liquidity. It also gives them the benefits of diversification by enabling them to take on exposure to aggregations of assets in ways that minimize risk. The complexity of structured finance Some of the sources of complexity in structured finance include pooling & tranching, non-default risks and structured finance ratings. Non-default risks include conflicts of interest, preservation of excess spread and performance of third parties. Risks of structured finance - Model risk - Tranche risk - Pool default risk - Counter Some Sample products in Structured Finance - Traditional Products o Credit insurance o Syndicated loans - Capital market products o Structured finance products Securitization Asset backed securities Mortgage backed securities Collateralized debt obligations o Collateralized loan obligations o Collateralized bond obligations Pure credit derivatives Credit default swaps Total return swaps Credit spread options Recovery swaps o Other instruments - Hybrid products o Regular hybrids Credit linked notes Synthetic CDOs o Indexed hybrids iTraxx/CDX correlation hedging and single tranche CDOs o Pools of pools & leveraged hybrids CDOs with structured finance collaterals e.g. CDOs of CDOs (of CDOs) and other securitized / structured products CDS on specific CDO tranches Examples of Structured Finance Some of the structures used recently by Indian Companies have been of the following nature;
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A. A large public sector company got the debt obligation guaranteed by a foreign bank. This allowed the debt of have the same rating as that of guaranteeing bank. In the absence of the guarantee, the rating would have been capped by Indias country rating which is currently below investment grade. The trade-off was between the lower interest rate, the debt issue attracted because of the higher rating, and the cost of guarantee commission. B. Another case involves the borrower undertaking to export stipulated volumes if his products, and to deposit export proceeds abroad, in dollars, in an escrow account. The lender has a lien on the account of the extent of the debt servicing obligations of the borrowing company. This structure resulted in a lower interest cost to the borrower than what it otherwise would have been. C. Air India was hoping to use a London-based special purpose vehicle (SPV) subsidiary to issue bonds. To improve the credit rating of the bonds, Air India had agreed to the proceeds of its tickets sold outside India being passed on the SPV. In turn, the SPV was the use these to service the bonds. The transaction did not materialize. In terms of raising international finance, one example of a Turkish Bank is worth citing, Turkey (like India) has a large number of its citizens working abroad. Such workers regularly remit money to their dependents in Turkey in foreign exchange. A Turkish bank which is active in remittance business, recently raised foreign currency finance by securitizing future remittances. In this case, as in the case of royalties, the amounts that may be received are forecasts, not contractual obligations. Therefore, the money raised through the securitization structure is but a fraction of the forecast receipts.
Q2. (b) Explain off shore banking? Give out its operational aspects. Answer:An Introduction to Offshore Banking Offshore banking can be explained as the carrying on of banking and financial activities in an environment, which is essentially free of fiscal, and exchange controls i.e. tax havens or low tax areas, commonly referred to as offshore finance centres. These conditions normally would also include favourable banking regulations or banking laws considerably less stringent than those in most domestic jurisdictions. Offshore Banking - maybe this term conjures up images of secret Swiss accounts, James Bond, and sipping Martinis at a chalet in Lichtenstein. The fact is though that doing a portion of your banking in a financial institution outside of your national borders is not only easy, it also offers numerous benefits to those who make their living via the internet. Is Offshore Banking Legal? This is among the first questions asked when discussing this topic. The answer is YES. Many of the largest companies in the USA do their banking offshore including Exxon and Boeing, among others. You do not need to be a giant corporation though to reap the benefits of an offshore bank account. You may wonder why you dont see many ads for offshore banking. If you live in the US, the reason is that federal law denies international banks the right to advertise within the borders of America. Of course this is to the benefit of domestic banks. Remember, you have just as much legal right to a bank account offshore as you do to a domestic account. Why Bank Offshore? For the internet marketer and any business that creates income online, there are several benefits to having an offshore bank account. These benefits encompass privacy, asset protection and wealth building. One concern that offshore banking helps deal with is privacy. The current laws in some countries, including the USA, allow the government full access to any ones domestic financial information for almost any reason at all. The act of creating a foreign bank account helps make some of your assets harder to access by those who should be minding their own business. A good foreign bank will usually not require your Social Security number, they wont answer questions from US sources about your credit and banking history, and they will not provide your financial information to any domestic data collection agency.
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An offshore account can also help you with wealth building. First, there are the tax advantages. Offshore accounts can be arranged in jurisdictions that do not impose taxes on income earned abroad. This can be very beneficial when arranged correctly. There is also the ability to earn a higher return on your investments with an offshore account. Many foreign banks are not as tightly regulated as domestic ones and can offer higher interest rates on accounts. This is due to their ability to make more lucrative investments and also the fact that the overhead to operate a bank is lower in many countries. Finally, the ability to expand your business globally increases when you create an additional bank account outside your own borders. Many offshore banks allow you to do business and hold your funds in multiple currencies. This allows expansion of your customer base which in return can help increase profits. Offshore Banks are used for a Variety of Purposes. Frequently they may be formed as a subsidiary of a domestic or international bank to: 1 Accept deposits outside the controlled environment. This is an increasingly popular activity, particularly for foreign currency deposits. 2 Book transactions which do not fall within the domestic jurisdiction such as large internationally syndicated loans particularly where the participating banks are located in various jurisdictions. 3 Make loans which are tax effective to their clients. 4 Avoid onerous debt-equity ratios and lending restrictions applicable in the more severely regulated jurisdictions in which they operate. 5 Provide their clients with banking secrecy. 6 Many other offshore banks are created by corporate groups to handle external borrowing or to consolidate intra-group finance or banking transactions. Corporations involved in international trade may use an offshore bank as a foreign or multi-currency management centre. Eurocurrency market underwriting are often raised through captive offshore banks or finance companies. The activities of international finance companies also fall within the category of offshore banking. These activities may include external loan raising, provision of confirming finance to clients and group entities, discounting or factoring of intra-group and other debts, and tax effective intra-group loans. The leasing of equipment through an offshore based captive finance company is another useful offshore banking concept. This activity may be for the purpose of providing vendor lease finance to group customers or to fund group asset acquisitions. Operational Aspects of Offshore Banking Formation The procedures for incorporation of an offshore bank vary in each location. However, most of the more suitable jurisdictions the incorporation of an offshore bank is effected by the usual English law registration system. An application for a permit to incorporate must be lodged together with an application for an offshore bank or financial institution licence. Licence applications must be accompanied by the information specified in the offshore bank guidelines. If the application satisfies the guidelines then a licence will be issued promptly. Normally the application is a confidential document and may be subject to the secrecy provisions of the relevant corporate legislation. Conversion into Euro Accounts A simple example would clarify the operational aspects, let us assume that an Indian shipping company was having a dollar current account with say Citibank in New York. For operational convenience, the shipping company decides to transfer the dollar account to say State Bank of India, London. Let us further assume that SBI London also has a dollar account with Citibank, New York. For opening the dollar account with SBI London, the shipping company instructs Citibank, New York, to close its account and transfer the balance to the account of SBI London, with itself. Citibank will do so and SBI London will open in its books a dollar account in the name of the shipping company. With this simple transaction, the domestic dollar account with Citibank, New York, has now been converted into an offshore dollar account with SBI London. With this description of a simple transaction, the reader would have noticed that the dollar deposit effectively has still remained in New York. There has been no change in the aggregate deposits of Citibank, New York, at all since the amount is merely transferred from the shipping companys account to that of SBI London.
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In the above example if SBI London had an account with another US Bank, and the balance was transferred there, while the deposits of Citibank would go down, those of the other Bank will go up correspondingly- in other words, the creation of an offshore dollar deposit leaves the total deposits of the US banking system unchanged. Banking Activities Subject to the terms of its license the offshore bank will be able to undertake any form of banking activity but the most common offshore banking operations include: Deposit taking Syndicated loans or Eurocurrency under writings Corporate loan raising Intra-group lending Foreign currency management Provision of confirming finance Lease finance Debt factoring Banking Activities Subject to the terms of its license the offshore bank will be able to undertake any form of banking activity but the most common offshore banking operations include: a. Deposit taking b. Syndicated loans or Eurocurrency under writings c. Corporate loan raising d. Intra-group lending e. Foreign currency management f. Provision of confirming finance g. Lease finance h. Debt factoring In other words, an offshore bank can carry out all usual banking operations of an ordinary onshore bank. However, in some jurisdictions an offshore banking license is issued on a special condition that the bank may accept deposits from only a limited circle of clients. Usually these are the banks share-holders or persons mentioned in the banks charter or license. Such a license is defined as limited. In this case the bank may have a limited number of clients. Sometimes, an off-shore bank may begin its activities with limited operations and widen the spectrum of its services by acquiring a less regulated license in the future. Foundation documents of an offshore bank usually provide for trust operations. The bank functions as a trustee and manages the clients securities portfolios. Investment portfolios may include not only financial resources but also precious metals and other assets. Clients are serviced on a trust contract basis. The following structures are often used: combinations of an offshore bank and an offshore investment fund, or offshore bank and an insurance company. Business activities of commercial banks are becoming more and more international and trust operations constitute a large part of these activities. Management The management and administration of the offshore bank should not be conducted in the domestic jurisdictions of the corporate group and care must be taken to ensure that offshore deposit-taking activities do not breach domestic banking laws. If too many of the management activities of the offshore bank are effected in the domestic locations the offshore bank may be deemed to be carrying on business there through a branch, with adverse consequences under both tax and banking legislation. The management functions should therefore be carried out by the offshore bank. The offshore bank can either employ its own permanent staff or base them in the offshore location or in another suitable management location. Alternatively it can engage the services of a local trust company or professional management firm who would work closely with the management of the corporate group. Most offshore banks choose the latter alternative which keeps management on an arms length basis. It should also be remembered that the appointment of local management in the offshore location will avoid potential complications with tax and banking authorities in the domestic jurisdictions.
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The management and administration of the offshore bank should not be conducted in the domestic jurisdictions of the corporate group and care must be taken to ensure that offshore deposit-taking activities do not breach domestic banking laws. If too many of the management activities of the offshore bank are effected in the domestic locations the offshore bank may be deemed to be carrying on business there through a branch, with adverse consequences under both tax and banking legislation. The management functions should therefore be carried out by the offshore bank. The offshore bank can either employ its own permanent staff and base them in the offshore location or in another suitable management location. Alternatively it can engage the services of a local trust company or professional management firm who would work closely with the management of the corporate group. Most offshore banks choose the latter alternative which keeps management on an arms length basis. It should also be remembered that the appointment of local management in the offshore location will avoid potential complications with tax and banking authorities in the domestic jurisdictions. THE GLOBAL SOLUTIONS GROUP INC., provides a full range of offshore bank management services and manages a number of international offshore banks, and has many years experience of selecting the most suitable offshore banking jurisdiction for its clients. THE GLOBAL SOLUTIONS GROUP INC., has several readymade Licensed Offshore Banks & Financial Companies available for immediate purchase and delivery. Clients wishing to establish or purchase an offshore bank are invited to contact our offices where they will receive prompt and personal attention from an experienced staff.
Q3. (a) What do you understand by Project Finance? What is the Importance of Project Finance for enterprises? Answer:Project financing is a specialized form of financing that may offer some cost advantages when very large amounts of capital are involved, says Finance professor Richard J. Herring. Hes also director of Wharton's Joseph H. Lauder Institute of Management and International Studies and adds, It can be tricky to structure, and is usually limited to projects where a good cash flow is anticipated. Often, a financing institution that's involved in project financing will build up expertise in certain industries, says Herring. The lender will take on engineers and others who can analyze each project and determine its viability. Project finance can be defined as: financing of an industrial (or infrastructure) project with myriad capital needs, usually based on non-recourse or limited recourse structures, where project debt and equity (and potentially leases) used to finance the project are paid back from the cash flow generated by the project, with the project's assets, rights and interests held as collateral. In other words, its an incredibly flexible and comprehensive financing solution that demands a long-term lending approach not typical in todays marketplace. However, the pace of project financing has been rising at a significant rate, according to Reuters Loan Pricing Corporation, which provides loan market news, data and analytics. In 2004, there was some $1.2 billion of project financing activity in the United States. A year later that number more than tripled to $3.7 billion. While most of these financings related to the energy sector, industrial project finance remains the domain of a select few institutions. Project financing is an innovative and timely financing technique that has been used on many high-profile corporate projects, including Euro Disneyland and the Eurotunnel. Employing a carefully engineered financing mix, it has long been used to fund large-scale natural resource projects, from pipelines and refineries to electric-generating facilities and hydro-electric projects. Increasingly, project financing is emerging as the preferred alternative to conventional methods of financing infrastructure and other large-scale projects worldwide. Project Financing discipline includes understanding the rationale for project financing, how to prepare the financial plan, assess the risks, design the financing mix, and raise the funds. In addition, one must understand the cogent analyses of why some project financing plans have succeeded while others have failed. A knowledge-base is
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required regarding the design of contractual arrangements to support project financing; issues for the host government legislative provisions, public/private infrastructure partnerships, public/private financing structures; credit requirements of lenders, and how to determine the project's borrowing capacity; how to prepare cash flow projections and use them to measure expected rates of return; tax and accounting considerations; and analytical techniques to validate the project's feasibility Project finance is finance for a particular project, such as a mine, toll road, railway, pipeline, power station, ship, hospital or prison, which is repaid from the cash-flow of that project. Project finance is different from traditional forms of finance because the financier principally looks to the assets and revenue of the project in order to secure and service the loan. In contrast to an ordinary borrowing situation, in a project financing the financier usually has little or no recourse to the non-project assets of the borrower or the sponsors of the project. In this situation, the credit risk associated with the borrower is not as important as in an ordinary loan transaction; what is most important is the identification, analysis, allocation and management of every risk associated with the project. In a no recourse or limited recourse project financing, the risks for a financier are great. Since the loan can only be repaid when the project is operational, if a major part of the project fails, the financiers are likely to lose a substantial amount of money. The assets that remain are usually highly specialised and possibly in a remote location. If saleable, they may have little value outside the project. Therefore, it is not surprising that financiers, and their advisers, go to substantial efforts to ensure that the risks associated with the project are reduced or eliminated as far as possible. It is also not surprising that because of the risks involved, the cost of such finance is generally higher and it is more time consuming for such finance to be provided. Infrastructure is the backbone of any economy and the key to achieving rapid sustainable rate of economic development and competitive advantage. Realising its importance governments commit substantial portions of their resources for development of the infrastructure sector. However despite such focus, governments in developing economies face severe impediments due to their limited spending power. This has prompted governments to open up the infrastructure sector to private sector and foreign investment and has increased reliance on innovative structures like public private partnerships. Infrastructure requirements for a country like India are massive, presenting enormous business potential for the private sector. Funding for infrastructure projects is complex and presents specific challenges that require specialist knowledge and understanding to create appropriate finance structures which will ensure that risks are dealt with effectively and efficiently. Infrastructure project finance requires involvement of multidisciplinary teams. Economists, engineers, accountants and finance specialist all need to work together to ensure that a project achieves its funding objectives. The long-term nature of infrastructure project funding dictates specialist knowledge of the many different institutions, both local and international that offer financing in this sector. Steps involved in Project Financing: Project Identification and Feasibility: Country review Acquisition search Risk Analysis Financial Modelling Commercial issues Contract structures Funding options Consortia structure Financial and Bid Structuring: Reviewing ender documentation Risk allocation Funding strategy Tax structuring Security structure Prepare bid/Project Information Memorandum
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Arranging Finance: Manage competition between funding agencies Negotiate term sheets Bring in underwriters; Banks, Institution, Bond underwriters Deal Closure: Design hedging strategies Documentation Managing the Due Diligence process Negotiation assistance Post Closure: Refinancing Enhancing value for shareholders M&A
Importance of Project Finance for enterprises

The advantage of these projects to Industries lies essentially in limiting the risks incurred. In effect, bankers are in a better position to bear such risks in view of diversification of their lending internationally. Finally, project financing may be rearrange in such a manner that the company may avail maximum plausible advantage related to depreciation, tax credits/facilities, deduction of financial charges etc. Lenders tend to receive higher compensation, commensurate with higher risks. Their participation in international financing has potential to augment their income. Further, they can supervise the project as its development progresses and may orient it in such a way so that their interest is better looked after. By participating in these projects, the bankers acquire expertise in dealing with certain types of projects. This, in turn, helps in promoting their business. Some featured importance are as follows: eliminate or reduce the lenders recourse to the sponsors permit an off-balance sheet treatment of the debt financing maximize the leverage of a project circumvent any restrictions or covenants binding the sponsors under their respective financial obligations avoid any negative impact of a project on the credit standing of the sponsors obtain better financial conditions when the credit risk of the project is better than the credit standing of the sponsors allow the lenders to appraise the project on a segregated and stand-alone basis obtain a better tax treatment for the benefit of the project, the sponsors or both reduce political risks affecting a project
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Q3. (b) What do you understand by globalization of financial markets? What factors have felicitated the process of globalization? Answer:Globalization of financial markets, trade, manufacturing, services and knowledge is a great opportunity for the global economy. Owing to this process, the developing countries may modernise and grow faster than they have ever done before. On the other hand, both manufacturers and consumers in the developed countries take advantage of the access to the huge global labour market, which makes it possible to lower the costs of manufacturing, enhance productivity and consequently lower the prices of many goods and services. Both consumers and producers are also beneficiaries of globalization of the financial markets, which offer a wide range of products and enable a better adjustment of the risk profile and the expected return or cost to the preferences of investors and borrowers. Globalization of financial markets is part of a wider phenomenon of globalization of national economies. The rapid growth of the international trade in goods and services, which has been in progress since the beginning of the 1960s, has entailed an increase in capital flows. Between 1970 and 2000 the value of world exports of goods and services increased twenty-five fold, accompanied by a fifty-fold increase in Foreign Direct Investment (FDI) (Chart 1 and Chart 2). Many countries, having realized that the FDI is an important factor that accelerates the economic growth, have introduced changes to their legal regulations, aimed to attract foreign capital (Table 1). The globalization process on the financial markets started following the decline of the Bretton Woods system. Globalization of the financial markets exhibited a pronounced acceleration in the 1980s and 1990s. Since 1973, international trade has been growing on average by 11% per annum (from 22% of the GDP in 1973 to over 40% of the GDP in 2002), whereas the capital flows1 increased from 7% of the global GDP in 1973 up to over 20% of the GDP in 2002.
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Along with an increase in the value of international trade, enterprises have become active participants of the FX market. Between 1989 and 2004 the turnover in the global spot FX market increased by nearly 100% (Chart 3).
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An increase in international capital flows and the development of information and communication technologies have triggered portfolio investments on international markets. On the other hand, enterprises and banks have increasingly frequently raised capital abroad. For instance, between 1989 and 2000, the value of cross-border investments in shares increased over twelve-fold, whereas between 1994 and 2005, the value of debt securities issued on foreign markets increased six-fold (Chart 4 and Chart 5). Non-bank financing of enterprises has also gained in significance. In 1980, enterprises raised USD 4.5 trillion on the capital market, whereas in 2004, the figure stood at over USD 60 trillion (Chart 6).
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As opposed to green-field investments, the portfolio capital is very mobile and, depending on the situation (macroeconomic or political) it may move easily among local markets. This may lead to high instability on the FX market causing significant exchange rates fluctuations. One of the methods of hedging against the risk of currency appreciation or depreciation is taking positions in derivatives. A dynamic growth of the derivatives market is the result of an increase in the cross-border flows in the financial markets. Between 1995 and 2004, the turnover on the global derivatives market grew nearly two-fold, whereas during the same period the activity on all exchange-traded derivatives grew almost three-fold (Chart-7).
From our point of view, the basic aim of financial market development must be to aid economic growth and development. The primary role of financial markets, broadly interpreted, is to intermediate resources from savers to investors, and allocate them in an efficient manner among competing uses in the economy, thereby contributing to growth both through increased investment and through enhanced efficiency in resource use. The Reserve Bank has taken a proactive role in the development of financial markets, particularly over the past decade and a half of overall economic policy reforms. There has been a complete transformation of the money market, the government securities
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market, and the foreign exchange market over this period. Development of these markets has been done in a calibrated, sequenced and careful manner in step with those in other markets in the real economy. The sequencing has also been informed by the need to develop market infrastructure, technology and capabilities of market participants and financial institutions in a consistent manner. In a low income economy like ours, the cost of downside risk is very high, so the objective of maintaining financial stability has to be constantly kept in view as we develop financial markets. What I would like to do today is to briefly recount the measures taken to develop various financial markets in India, document the outcomes and broadly sketch out the direction of the way forward. From the point of view of the central bank, developed financial markets are critical for effective transmission of monetary policy impulses to the rest of the economy. Monetary transmission cannot take place without efficient price discovery, particularly with respect to interest rates and exchange rates. Deep and liquid financial markets contribute to efficient price discovery in various segments of the financial market. Well-integrated markets improve efficacy of policy impulses by enabling quick transmission of changes in the central banks short-term policy rate to the entire spectrum of market rates, both short and long-term, in the money, the credit and the bond markets. However, various benefits emanating from the functioning of the financial markets depend critically upon the resilience of various segments of the market to withstand shocks and the strength of the risk management systems in place. In view of the critical role played by the financial markets in financing the growing needs of various sectors of the economy, it is important that financial markets are developed further and well-integrated. In recognition of the critical role of the financial markets, the initiation of the structural reforms in the early 1990s in India also encompassed a process of phased and coordinated deregulation and liberalisation of financial markets. Financial markets in India in the period before the early 1990s were marked by administered interest rates, quantitative ceilings, statutory pre-emptions, captive market for government securities, excessive reliance on central bank financing, pegged exchange rate, and current and capital account restrictions. As a result of various reforms, the financial markets have transited to a regime characterised by market-determined interest and exchange rates, price-based instruments of monetary policy, current account convertibility, phased capital account liberalisation and an auction-based system in the government securities market. Excessive fluctuations and volatility in financial markets can mask the underlying value and give rise to confusing signals, thereby hindering efficient price discovery. Accordingly, policy efforts have also aimed at ensuring orderly conditions in financial markets. Furthermore, deregulation, liberalisation, and globalisation of financial markets pose several risks to financial stability. Financial markets are often governed by herd behaviour and contagion and excessive competition among financial institutions can also lead to a race to the bottom. The East Asian crisis of the 1990s suggested that global financial markets can exacerbate domestic vulnerabilities. Notwithstanding the conventional wisdom that financial markets punish deviations from prudent policies, financial markets, at times, seem to tolerate imprudent behaviour for a remarkable stretch of time, while reacting pre-maturely at other times (Lipschitz, 2007). In recognition of these possible destabilising factors, while liberalising domestic financial markets in India, appropriate prudential safeguards have also been put in place. Enhancing efficiency, while at the same time avoiding instability in the system, has been the challenge for the regulators in India (Reddy, 2004). This approach to development and regulation of financial markets has imparted resilience to the financial markets. From the point of view of the economy as a whole, while developing financial markets it is essential to keep in view how such development helps overall growth and development. The price discovery of interest rates and exchange rates, and the integration of such prices across markets help in the efficient allocation of resources in the real sectors of the economy. Financial intermediaries like banks also gain from better determination of interest rates in financial markets so that they can price their own products better. Moreover, their own risk management can also improve through the availability of different varieties of financial instruments. The access of real sector entities to finance is also assisted by the appropriate development of the financial market and the availability of transparent information on benchmark interest rates and prevailing exchange rates. The approach of the Reserve Bank in the development of financial markets has been guided by these considerations, while also keeping in view the availability of appropriate skills and capacities for participation in financial markets both among financial market participants and real sector entities and individuals. The Reserve Bank's approach has therefore been one of consistent development of markets while exercising caution in favour of maintaining financial stability in the system.
Reasons for globalization of financial markets

The key factors that brought about the aforementioned changes in capital flows and in the structure of the global financial market comprise the following:
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liberalization of national financial markets and the related growing competition among financial institutions, technological progress in IT and telecommunications, faster flow of information and its standardisation, globalization of national economies in their various aspects (commerce, institutions, ownership structure, capital and knowledge). The liberalization of national financial markets has eliminated restrictions in the operations of both domestic and foreign financial entities. Regulations regarding the range of services performed by the banks and other financial institutions have been changed. Legal framework has been established to facilitate the activities of non-banking financial institutions. Last but not least, restrictions on non-residents access to domestic financial markets have been reduced or removed. However, the factor of the greatest significance from the point of view of globalization of financial markets was the liberalization of capital flows. First and foremost, it consisted in the removal of restrictions that impaired free capital flow among countries, including in particular: removal of restrictions related to FDI and trade in goods and services with nonresidents, transition of the developed countries to the floating exchange rate regimes, establishing of the euro area, and other supranational integration initiatives, reduction of tax on cross-border transactions (Chart 8). In some countries, liberalization of capital flows and financial markets ensued from the implementation of stability programmes recommended by the World Bank and the International Monetary Fund. As a consequence, a group of countries named emerging markets have appeared on the world economic map. These countries play a vital role both in the global financial system and in the global economy.
The technological progress in IT and telecommunications, in particular the dynamic growth of the Internet and database systems, has significantly impacted the globalization of financial markets. Technological changes would not have been possible without a huge reduction in the cost of computer memory and data transmission. At present, the cost of manufacturing of a microprocessor is nearly 1,000 times lower than it was 30 years ago, and the cost of data transmission (1 byte over a distance of 1 km) is over a hundred-fold lower. Modern technologies have enhanced the capacity of creating and marketing new, less expensive goods and services. The increased computing power has facilitated valuation of complex financial instruments, such as options, swaps and convertible bonds, which has contributed to a rapid development of derivatives market. The development of IT and telecommunications has streamlined prompt acquisition and processing of information necessary for operations on the financial market. Information used on the financial market has become as much of a commodity as any other (e.g. washing powder). It is produced according to specific standards and is comparable (the
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format of data on inflation, balance of payments or quarterly performance of a listed company are presented in a similar manner, irrespective of the country that publishes the data). The development of the modern financial market infrastructure has also covered regulatory changes (e.g. the bankruptcy law) and the establishment of modern transactional systems, payment systems, settlement systems, risk management systems, and information services such as Reuters or Bloomberg. Stock exchanges and brokers have created modern trading platforms which enable prompt offer-matching, executing transactions and straight through processing. Development of the infrastructure has removed barriers to further market globalization. For instance, a factor that impeded the FX market development in the 1990s was the settlement risk. In response to that, the banks that were the most active on the FX market created CLS a new settlement system that operates based on the payment versus payment principle. The new, supranational system has significantly reduced the credit risk and liquidity risk of FX operations, and thus increased banks activity on the FX market. At present, 15 currencies are settled in the CLS Bank. The system has also lowered costs incurred by the banks, as it helped decrease the number of payment instructions and the value of funds transferred in local payment systems.
Q4. (a) Discuss salient features of International Cash Management in a multinational group, also explain management of receivables. Answer:International cash management of multinational firms is distinct from national firms in respect of the following: Billing in foreign currencies given rise to exchange risk; Techniques of transfer of international funds are different; Exchange regulations put several constraints on foreign exchange flows. In view of the above distinct characteristics, the finance manager engaged in international business aims at reducing the exchange risk on the one hand and minimizing the float by speedy transfer on the other. Exchange rate risk may be covered or even avoided if billing is done in the national currency. For the purpose, the finance manager may; Take resource to advances in foreign currencies; Cover on the forward market by buying or selling; Cover on the futures market by buying or selling futures contracts; Cover on options market by selling and buying call or put options in foreign currencies; Cover through currency swaps. Similarly, interest rate risk may also be minimized. Cash management costs any be reduced by adopting various measures such as reduction of float. The term float represents the time period during which the funds are not available to the enterprise since they are in the process of being transferred. In international trade, the time taken in the transfers is often long (may be several weeks) and floats may be very significant. International money managers attempt to attain on a worldwide basis the traditional domestic objectives of cash management: (1) Bringing the companys cash resources within control as quickly and efficiently as possible and (2) Achieving the optimum conservation and utilization of these funds. Accomplishing the first goal requires establishing accurate, timely forecasting and reporting systems, improving cash collections and disbursements, and decreasing the cost of moving funds among affiliates. The second objective is achieved by minimizing the required level of cash balances, making money available when and where it is needed, and increasing the risk-adjusted return on those funds that can be invested.
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This section is divided into seven key areas of international cash management: (1) Organization, (2) Collection and disbursement of funds, (3) Netting of inter affiliate payments, (4) Investment of excess funds, (5) Establishment of an optimal level of worldwide corporate cash balances, (6) Cash planning and budgeting (7) Bank relations. Collection and Disbursement of Funds Accelerating collections both within a foreign country and across borders is a key element of international cash management. Material potential benefits exist because long delays often are encountered in collecting receivables, particularly on export sales, and in transferring funds among affiliates and corporate headquarters. Allowing for mail time and bank processing, delays of eight to ten business days are common from the moment an importer pays an invoice to the time when the exporter is credited with good funds-that is, when the funds are available for use. Given high interest rates, wide fluctuations in the foreign exchange markets, and the periodic imposition of credit restrictions that have characterized financial markets in some years, cash in transit has become more expensive and more exposed to risk. With increasing frequency, corporate management is participating in the establishment of an affiliates credit policy and the monitoring of collection performance. The principal goals of this intervention are to minimize float-that is, the transit time of payments-to reduce the investment in accounts receivable and to lower banking fees and other transaction costs. By converting receivables into cash as rapidly as possible, a company can increase its portfolio or reduce its borrowing and thereby earn a higher investment return or save interest expense. Considering either national or international collections, accelerating the receipt of funds usually involves: (1) Defining and analyzing the different available payment channels, (2) selecting the most efficient method, which can vary by country and by customer, and (3) giving specific instructions regarding procedures to the firms customers and banks. In addressing the first two points, the full costs of using the various methods must be determined, and the inherent delay of each must be calculated. Two main sources of delay in the collections process are (1) the time between the dates of payment and of receipt and (2) the time for the payment to clear through the banking system. Inasmuch as banks will be as inefficient as possible to increase their float, understanding the subtleties of domestic and international money transfers is requisite if a firm is to reduce the time that funds are held and extract the maximum value from its banking relationships. Above table lists the different methods multinationals use to expedite their collection of receivables. With respect to payment instructions to customers and banks, the use of cable remittances is a crucial means for companies to minimize delays in receipt of payments and in conversion of payments into cash, especially in Europe because European banks tend to defer the value of good funds when the payment is made by check or draft. In the case of international cash movements, having all affiliates transfer funds by telex enables the corporation to better plan because the vagaries of mail time are eliminated. Third parties, too, will be asked to use wire transfers. For most amounts, the fees required for telex are less than the savings generated by putting the money to use more quickly One of the cash managers biggest problems is that bank-to bank wire transfers do not always operate with great efficiency or reliability. Delays, crediting the wrong account, availability of funds, and many other operational problems are common. One solution to these problems is to be found in the SWIFT (Society for Worldwide Interbank Financial Telecommunications) network, first mentioned. SWIFT has standardized international message formats and employs a dedicated computer network to support funds transfer messages. The SWIFT network connects more than 7,000 banks and broker-dealers in 192 countries and processes more than five million transactions a day, representing about $5 trillion in payments. Its mission is to quickly transmit standard forms to allow its member banks to automatically process data by computer. All types of customer and bank transfers are transmitted, as well as foreign exchange deals, bank account statements, and administrative messages. To use SWIFT, the corporate client must deal with domestic banks that are subscribers and with foreign banks that are highly automated. Like many other proprietary data networks, SWIFT is facing growing competition from Internet-based systems that allow both banks and nonfinancial companies to connect to a secure payments network.
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To cope with some of the transmittal delays associated with checks or drafts, customers are instructed to remit to mobilization points that are centrally located in regions with large sales volumes. These funds are managed centrally or are transmitted to the selling subsidiary For example, European. Customers may be told to make all payments to Switzerland, where the corporation maintains a staff specializing in cash and portfolio management and collections. Sometimes customers are asked to pay directly into a designated account at a branch of the bank that is mobilizing the MNCs funds internationally. This method is particularly useful when banks have large branch networks. Another technique used is to have customers remit funds to a designated lock box, which is a postal box in the companys name. One or more times daily, a local bank opens the mail received at the lock box and deposits any checks immediately. Multinational banks now provide firms with rapid transfers of their funds among branches in different countries, generally giving their customers same-day value-that is, funds are credited that same day. Rapid transfers also can be accomplished through a banks correspondent network, although it becomes somewhat more difficult to arrange sameday value for funds. Chief financial officers are increasingly relying on computers and worldwide telecommunications networks to help manage the company cash portfolio. Many multinational firms will not deal with a bank that does not have a leading-edge electronic banking system. At the heart of todays high-tech corporate treasuries are the treasury work-station software packages that many big banks sell as supplements to their cash management systems. Linking the company with its bank and branch offices, the workstations let treasury personnel compute a companys worldwide cash position on a real-time basis. Thus, the second a transaction is made in, say, Rio de Janeiro, it is electronically recorded in Tokyo as well. This simultaneous record keeping lets companies keep their funds active at all times. Treasury personnel can use their workstation to initiate fund transfers from units with surplus cash to those units that require funds, thereby reducing the level of bank borrowings. Payments Netting in International Cash Management Many multinational corporations are now in the process of rationalizing their production on a global basis. This process involves a highly coordinated international inter-change of materials, parts, subassemblies, and finished products among the various units of the MNC, with many affiliates both buying from, and selling to, each other. The importance of these physical flows to the international financial executive is that they are accompanied by a heavy volume of inter affiliate fund flows. Of particular importance is the fact that a measurable cost is associated with these cross border fund transfers, including the cost of purchasing foreign exchange (the foreign exchange spread), the opportunity cost of float (time in transit), and other transaction costs, such as cable charges. These transaction costs are estimated to vary from 0.25% to 1.5% of the volume transferred. Thus, there is a clear incentive to minimize the total volume of intercompany fund flows. This can be achieved by payments netting.
Illustration
American Express In, early 1980, American Express (Amex) completed an eight month study of the cash cycles of its travel, credit card, and travelers check businesses operating in seven European countries. On the basis of that project, Amex developed an international cash management system that was expected to yield cash gains-increased investments or reduced borrowing of about $35 million in Europe alone. About half of these savings were projected to come from accelerated collection of receipts and better control of disbursements. The other half of projected gains represented improved bankbalance control, reduced bank charges, and improved value dating, and better control of foreign exchange. The components of the system are collection and disbursement methods, bank- account architecture, balance targeting, and foreign exchange management. The worldwide system is controlled on a regional basis, with some direction from the corporate treasurers office in New York. A regional treasurers office in Brighton, England, controls cash, financing, and foreign exchange transactions for Europe, the Middle East, and Africa. The most advantageous collection and disbursement method for every operating division in each country was found by analyzing the timing of mail and clearing floats. This analysis involved establishing what payment methods were used by customers in each country because checks are not necessarily the primary method of payment in Europe Measuring the mail time between certain sending and receiving points Identifying clearing systems and practices, which vary considerably among Countries.
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Analyzing for each method of payment the value-dating practice, the times for processing check deposits, and the bank charges per item Using these data, Amex changed some of its collection and disbursement methods. For example, it installed interception points in Europe to minimize the collection float. Next, Amex centralized the management of all its bank accounts in Europe on a regional basis. Allowing each subsidiary to set up its own independent bank account has the merit of simplicity, but it leads to a costly proliferation of different pools of funds. Amex restructured its bank accounts, eliminating some and ensuring that funds could move freely among the remaining accounts. By pooling its surplus funds, Amex can invest them for longer periods and also cut down on .the chance that one subsidiary will be borrowing funds while another has surplus funds. Conversely, by combining the borrowing needs of various operations, Amex can use term financing and dispense with more expensive over-drafts. Reducing the number of accounts made cash management less complicated and also reduced banking charges. The particular form of bank-account architecture used by Amex is a modular account structure that links separate accounts in each country with a master account. Management, on a daily basis, has only to focus on the one account through which all the country accounts have access to borrowing and investment facilities. Balance targeting is used: to control bank-account balances. The target is an average balance set for each account that reflects compensating balances, goodwill funds kept to foster the banking relationship, and the accuracy of cash forecasting. Aside from the target balance, the minimum information needed each morning to manage an account by balance targeting is the available opening balance and expected debts and credits. Foreign exchange management in Amexs international cash management system focuses on its transaction exposure. This exposure, which is due to the multicurrency denomination of travelers checks and credit card charges, fluctuates on a daily basis. Procedures to control these exposures and to coordinate foreign exchange transactions center on how Amex finances its working capital from country to country, as well as the manner in which inter affiliate debts are settled. For example, if increased spending by card-holders creates the need for more working capital, Amex must decide whether to raise funds in local currency or in dollars. As a general rule, day-to-day cash is obtained at the local level through overdrafts or overnight funds. To settle indebtedness among divisions, Amex uses inter affiliate settlements. For example, if a Swiss cardholder uses her card in Germany, the Swiss credit, card office pays the German office, which in turn pays the German restaurant or hotel in Euros. Amex uses net-ting, coordinated by the regional treasurers office in Brighton, to reduce settlement charges for example, suppose that a German cardholder used his card in Switzerland at the same time the Swiss cardholder charged with her card in Germany Instead of two transactions, one foreign exchange transaction settles the differences between the two offices. Accounts Receivable Management Firms grant trade credit to customers, both domestically and internationally, because they expect the investment in receivables to be profitable, either by expanding sales volume or by retaining sales that otherwise would be lost to competitors. Some companies also earn a profit on the financing charges they levy on credit sales. The need to scrutinize credit terms is particularly important in countries experiencing rapid rates of inflation. The incentive for customers to defer payment, liquidating their debts with less valuable money in the future, is great. Furthermore, credit standards abroad are often more relaxed than standards in the home market, especially in countries lacking alternative sources of credit for small customers. To remain competitive, MNCs may feel compelled to loosen their own credit standards. Finally, the compensation system in many companies tends to reward higher sales more than it penalizes an increased investment in accounts receivable. Local managers frequently have an incentive to expand sales even if the MNC overall does not benefit. The effort to better manage receivables overseas will not get far if financial and marketing do not coordinate their efforts. In many companies, finance and marketing work at cross purposes. Marketing thinks about selling, and finance thinks about speeding up cash flows. One way to ease the tensions between finance and marketing is to educate the sales force on how credit and collection affect company profits. Another way is to tie bonuses for salespeople to collected sales or to adjust sales bonuses for the interest cost of credit sales. Forcing managers to bear the opportunity cost of working capital ensures that their credit, inventory, and other working-capital decisions will be more economical. The management of receivables in a multinational group should take into account several factors, such as;
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Costs of creation, retention and recovery of receivables; Degree of liquidity of receivables. The management of intra-group receivables is different from that of external clients. Intra-group Receivables When a parent company has receivables of a subsidiary, it can use the technique of leads and lags for advancing or delaying settlements as per its needs. For instance, in order to finance an investment abroad it may decide to accord or make a subsidiary accord delays longer than those accorded normally for the sale of capital equipment. This procedure may also be adopted if the parent fears that exchange control or currency depreciation of the country of the subsidiary may render the transfer more difficult. These procedures can be very safely used (and without any problems) if the subsidiary is owned 100 per cent. In the case of the other types of subsidiaries, the interest of minority shareholders is also taken into account. Receivables from External Clients If a person company is in receipt of receivables (as payments of its exports) issued in strong currencies and if national currency depreciated, the company may wait till the last limit to encash the receivables. On the other hand, if the receivables are issued in a weak currency, it will be in the interest of the company to expedite recovery of the receivables. By adopting a policy of managing receivables, the treasury should take into account not only the direct cost but also the impact on the financial position of the company. In operational terms, there is a need to carry out a cost-benefit analysis in terms of cost of the receivables and the increase on profits by additional sales. Even if receivables are considered quasi-cash, they are not less risky. Conflicts may exist between departments of international marketing and finance respectively. Generally, management of receivables and payables if highly decentralized. However, foreign subsidiaries communicate information on regular basis on the parent company concerning the date and amount of receivables.
Q4. (b) Define foreign exchange? Narrate factors which influence bank margin. Answer:Foreign exchange is a two way transaction involving two currencies or more and in particular home currency and one or more foreign currencies. Rates at which they are exchanged are called exchange rates. There are various Rates for various purposes, instruments and periods of payment and receipt. Cross rates will apply when there are more than two currencies in the transaction. In case, the delivery or receipt is postponed, or purchase or sale takes place for a future period, forward premium or discount is there for those forward rates for various periods of say one month to six months over the spot rates. Besides the bank deals with the customer as an intermediary. It has to buy from the wholesale interbank market and sell in the retail to its customer. It has to sell to the wholesale market, if it has purchased from the customer. These are called cover transactions. The Bank has therefore a cover rate, applicable to its original deal in the wholesale market to which it adds or deducts its own margin, which is normally 0.5%. Exchange Arithmetic deals with the subject of customers deals with banks of purchase and sale of foreign currencies. The sale of foreign currencies is like sale of any commodity, spot or forward. In the case of foreign exchange, a sale is accompanied by a purchase a sale of foreign exchange means sale of foreign currency and the purchase of domestic currency. As those transactions are based on some principles, these principles and principles and practices are dealt with in whole chapter of foreign exchange.
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Purchase or sale of one national currency in exchange for another nation's currency, usually conducted in a market setting. Foreign exchange makes possible international transactions such as imports and exports and the movement of capital between countries. The value of one foreign currency in relation to another is defined by the exchange rate. Currency-literally foreign money-used in settlement of international trade between countries. Trading in foreign exchange is the means by which values are established for commodities and manufactured goods imported or exported between countries. Creditors and borrowers settle the resulting international trade obligations, such as bank drafts, bills of exchange, bankers' acceptances, and letters of credit, by exchanging different currencies at agreed upon rates. The result of all this international trade is that financial institutions accumulate surpluses of different currencies from loan repayments by foreign borrowers, and also from import-export trade financing on behalf of bank customers. The interbank foreign exchange market is an over-the-counter market, a network of commercial banks, central banks, brokers, and customers who communicate with each other by telex and telephone throughout the world's major financial centers. Foreign exchange traders also make markets or speculate in different currencies, usually anticipating future appreciation of stronger currencies against weaker ones, through the foreign exchange Forward Market and the Currency Futures market. Foreign exchange, methods and instruments used to adjust the payment of debts between two nations that employ different currency systems. A nation's balance of payments has an important effect on the exchange rate of its currency. Bills of exchange, drafts, checks, and telegraphic orders are the principal means of payment in international transactions. The rate of exchange is the price in local currency of one unit of foreign currency and is determined by the relative supply and demand of the currencies in the foreign exchange market. Buying or selling foreign currency in order to profit from sudden changes in the rate of exchange is known as arbitrage. The chief demand for foreign exchange within a country comes from importers of foreign goods, purchasers of foreign securities, government agencies purchasing goods and services abroad, and travelers. Foreign Exchange as a subject deals with the means and method by which rights to income and wealth in one countrys currency are converted into similar rights in terms of another countrys currency. It involves the investigation of the methods by which the currency of one country is exchanged for that of another, the causes which render such exchange necessary, the forms in which exchange may take place and the ratios or equivalent values at which such exchanges are effected. Such exchanges may be in the form of one currency to another or of conversion of credit instruments denominated in different currencies such as cheques, draft, airmail transfers, fax and, telegraphic transfers, cable transfers, bills of exchange, trade bills, bankers bill or any promissory notes. It is through these instruments a foreign currency account of banks that the banks are able to effect such exchange currencies or claims to currencies. Every exchange of goods and services is having a corresponding exchange of remittances involving two currencies, as depicted in Chart below.
INDIA
No currency will be physically exchanged as it is not legal tender in any country other than in the issuing country. So exchanges take place through book entries and/or through credit instruments through which exchange of
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currencies take place are Cash in physical form Telegraphic Transfers (TTs), Mail Transfers (MT), Demand Drafts (DDs), cheques, Bills of Exchange, etc. In the absence of banks the buyer-importer who has to pay in dollars has to hunt for an exporter-seller who received an equivalent amount of dollars from the foreign importer. Bank facilitates such transactions by acting intermediaries between buyers and sellers or importers and exporters. In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nations currency in terms of the home nations currency. For example an exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (USD, $) means that JPY 91 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 3.2 trillion USD worth of currency changes hands every day. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. Foreign Sector and Foreign Exchange Market Each economy has a foreign sector representing that economys external transactions. All such external transactions are either economic and commercial or financial transactions. These result in receipts into and payments out of the domestic economy. Such receipts and payments involve exchange of domestic currency as against all foreign currencies of countries with which economy has dealings. Such exchange transactions are put through in the exchange market for that currency. For each nation, therefore, there is an exchange market for that countrys currency vis--a-vis other currencies. These national foreign exchange markets are components of the international financial system. There is thus, as for any other currency, a market for the rupee. If an Indian bank buys dollars, it will pay rupees for dollars and if it sells dollars, it will receive rupees for dollars. The origin of these transactions in an export or an import, inward or outward remittances or any similar transactions between Indian residents and foreign residents. An exporter in India receives dollars from say, USA and he surrenders the bill of exchange along with other documents to his bank. The bank would have bought that currency from the exporter. The Bank has since been on the lookout for selling those dollars in the foreign exchange market for those in need of dollars. Let us say an importer in India importing from the USA is in need of dollars to pay to the exporter. Another bank is approached by the importer with a demand for dollars and the former must have sold dollars to the importer. Having sold dollars that bank would then buy the dollars to cover up their position from the former bank. Thus, basically demand for and supply of foreign currencies arises from exporters or importers or the public having some receipts from or payments to foreign countries. These receipts or payments may give rise to foreign credit instruments, which the banks buy or sell at specified rates. There are different rates for buying and selling in which an interest element is included and quoted by the banks if the bill or promissory more or any instrument of exchange is not a demand or sight bill but a usance note involving some period to rim to maturity for payment. Even in the case of sight bills, some grace period of 2 days and transit period of 10 to 20 days are allowed as fixed by the Foreign Exchange Dealers Association, depending upon the place on which it is drawn and interest element for these periods is also included in the rate quoted by banks. Banks generally cover up these positions in currencies by corresponding purchases or sales from other banks. Such a market as between banks is called inter-bank market. There are reputed brokers who act as intermediaries for banks in these transactions. They give bid and offer rates for purchase and sale of currencies and the margin between bid and offer rates is the profit for the bank or the intermediary wholesaler. In the retail market banks deal with their clients or customers. On an average daily turnover in the interbank market is nearly four times that in the retail trade or merchant trade with the public in the Forex Market in India (as per data published by the RBI). Factors Influencing Bank Margin The margin charged by the bank between buying and selling rate varies from Bank to Bank, customer to customer, depending upon the volume of transactions, customer relationship and the purpose for which foreign currencies are required etc. Good credit rating of the customer and his awareness of the market mechanics would get a better rate. A sale of a very large amount running into millions would however attract a worse rate than that for a modest amount of $1000 to 10,000. So is the case with very small amounts of $100 to $1000, due to the difficulty of making cover operations.
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The banks quote the rates on the basis of the rate at which they can cover it in the inter-bank market and then load it with an appropriate margin before giving a quote to their customers. The cover for sale of foreign currency (say $) will be the purchase price at which it can buy in the wholesale market, which will be the sale price of the market. Similarly, if the bank is buying a foreign currency, it will quote a rate, at which it can sell in the wholesale market, which will be the markets buying rate. Since the market rates are changing from day to day and from time to time within a say, the bank always gives the worst quote to the buyer and the best quote to the seller of the foreign currency; thus the buying rate is Rs. 43.65 per U.S. $ and selling rate is Rs. 43.90, which means that when bank buys $, it will give less rupees (43.65) but when it sells dollars, it wants to take more rupees (43.90). Generally the quotation is given up to four digits such as Rs. 43.3050/43.3150, which are the banks buying and selling rates for U.S. dollars, in the wholesale market which are quoted daily in financial press. In the case of quotation of foreign currency for one unit of domestic currency, Indian banks quote for Rs. 100 equivalent of U.S. $ 2.3094 (Rs. 100= U.S. $ 2.3094). Similarly one D.M. is quoted as Rs. 23.41/23.87 which are T.T. buying and selling rates respectively. If quoted in the reverse direction for Rs. 100, the quotation if D.M. 4.2716. Rupee has depreciated so much as compared to the major currencies that no quotation is given for one Rupee but only for Rs. 100/-. Now the practice is to give rates as so many rupees for each unit of foreign currency under this system, purchase of foreign currency is always at a lower rate than sale of the same Buying Rs. 45.75 Rs. 75.35 Draft/Cheques Selling 46.65 77.10 Buying 45.40 74.70 Currency Selling 46.90 77.50
U.S. Dollar Pound Sterling (as on 8th July) Currency rates are worse rates than those of drafts or cheques as in the case of latter, the bank does not part with currency immediately but with a time gap of about 10days for which it gets interest on the amount which is given credit to the customer in the case of drafts, cheques etc., in their quotation. The relation of sale purchase rates to the market rates is given by some margin which is banks own profit. The relationship of purchase and sale prices is depicted below:
Sale to Importer -Sale of dollars -Price Rs. 43.95
Market Price Rs. 43.55 per $
Purchase from Exporter Purchase of dollars Price Rs. 42.75
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Q5. (a) Define swap and explain its motivational and nature of swaps. Answer:Swaps and switches are derivatives and synthetic markets among the financial markets. These can be seen in guilt-edged markets, money market, forex market, interest rate and currency markets. These are derived from the existing instruments through exchange of one instrument for the other. Swap is defined as an exchange contract between two parties for two instruments of different yields, interest rates and currencies. Switch is also similar to swap. In guiltedged market, banks and FIs, exchange one loan of a definite maturity and yield for another of different maturity and yield. The asset portfolio is adjusted from time to time for changes in yield, liquidity and maturity and in the process, banks requires a short-term loan of two or three years and they have too many loans maturing between 5 to 10 years but less between 1 to 5 years. Switch is not exchange of a security for cash but an exchange of one security for other both in the spot market. Swap is an agreement for exchanging of forward dollars for spot dollars and vice versa or of floating rate instrument for a fixed rate instrument. Swap is of different varieties say coupon swaps, basis swaps and currency swaps from one currency to another. It can also be an exchange of forward for spot currency. Some swaps will hedge both interest rate risk and currency risks. Swaps and switched reduce the risks, and costs involved. They are hedge instruments, used as risk management instruments. They widen the market, increase depth and width of the market and sophistication of operations in the financial markets. MAJOR TYPES OF SWAP STRUCTURES All swaps involve exchange of a series of periodic payments between two parties, usually through an intermediary, which is normally a large international financial institution, which runs a "swap book". The two payment streams are estimated to have identical presents values at outset when discounted at the respective cost of funds in the relevant primary financial markets. The two major types are interest rate swaps (also known as coupon swaps) and currency swaps. The two are combined to give a cross-currency interest rate swap. A number of variations are possible within each major type. We will examine in some detail the structure of each of these below and indicate some of the variations. Interest Rate Swaps A standard fixed-to-floating interest rate swap, known in the market jargon as a plain vanilla coupon swap (also referred to as "exchange of borrowings") is an agreement between two parties, in which each contracts to make payments to the other on particular dates in the future till a specified termination date. One party, known as the fixed ratepayer, makes fixed payments all of which are determined at the outset. The other party known as the floating ratepayer will make payments the size of which depends upon the future evolution of a specified interest rate index (such as the 6-month LIBOR). The key features of this swap are: The Notional Principal The fixed and floating payments are calculated as if they were interest payments on a specified amount borrowed or lent. It is notional because the parties do not exchange this amount at any time; it is only used to compute the sequence of payments. In a standard swap the notional principal remains constant through the life of the swap. 1 T he Fixed Rate The rate applied to the notional principal to calculate the size of the fixed payment. Where the transaction is a straightforward 'plain vanilla' fixed/floating interest rate swap with the principal amount remaining constant throughout the transaction, swap dealers openly display the rates at which they are willing to pay or to receive fixed rate payments. A dealer might quote his rates as: US dollar fixed/floating: 2 yrs Treasury (4.50%) + 45/52 3 yrs Treasury (4.58%) + 48/56 4 yrs Treasury (4.75%) + 52/60 5 yrs Treasury (4.95%) + 55/68 and so on, out to perhaps 10 years.
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The dealer is in fact saying "I am willing to be the fixed-rate payer in a 2-year swap at 45 basis points above the current yield on Treasury Notes (i.e. 4.95%). I am also willing to be the fixed rate receiver at 52 basis points above the Treasury yield (i.e. 5.02%)." As the floating rate will be LIBOR in both cases, the dealer thus enjoys a profit margin of 7 basis points in the 2-year swap market. The swap rates are close to long-term interest rates charged to top quality borrowers. . Obviously, if the counter party wishes to receive or make fixed payments at a rate other than the rates quoted by the bank, the bank will adjust the floating leg by adding or subtracting a margin over LIBOR. Thus suppose 5-year treasury notes are yielding 8.50%. The bank is willing to pay 8.80% fixed in return for LIB OR; a firm wishes to receive fixed payments at 9.25%. The bank will require floating payments at LIBOR + a margin. This is an example of what are called off market swaps. Floating Rate In a standard swap at market rates, the floating rate is one of market indexes such as LIB OR, prime rate, T -bill rate etc. The maturity of the underlying index equals the interval between Payment dates. Trade Date, Effective Date, Reset Dates, and Payment Dates" Fixed rate payments are generally paid semiannually or annually. For instance, they may be paid every March 1 and September 1 from March 1,2001 to September 1,2005, this being the termination date of the swap. The trade date is the date on which the swap deal is concluded and the effective date is the date from which the first fixed and floating payments start to" accrue. For instance a 5-year swap is traded on. August30, 2000 the effective date is September 1, 2000, and ten payment dates from March 1,2001 to' September 1,2005. Floating rate payments in a standard swap are "set in advance paid in arrears", that is; the floating rate applicable to any period is fixed at the start of the period but the payment occurs at the end of the period. Each floating rate payment has three dates associated with it. D (S), the setting date is the date on which the floating rate applicable for the next payment is set. D (1) is the date from which the next floating payment starts to accrue and D (2) is the date on which the payment is due. D (S) is usually two-business day before D (l). D (l) is the day when the previous floating rate payment is made (for the first floating payment, D (1) is the effective date above). If both the fixed and floating payments are semiannual, D (2) will be the payment date for' both the payments and the interval D (1) to D (2) would be six months. It is possible to have the floating payment set and paid in arrears i.e. the rate is set and payment made on D (2). This is another instance of an "off-market" feature. 1 Fixed and Floating Payments The fixed and floating payments are calculated as follows: Fixed Payment = P x Rfx x Ffx "Floating Payment = P x Rfx x Ffx Here, P is the notional principal, Rfx is the fixed rate, Ffx is the floating rate set on the reset date, Ffx is known as the "Fixed rate day count fraction" and FjI is the "Floating rate day count fraction". The last two are time periods over which the interest is to be calculated. For floating payments it is either [(D2 D1)/360] or [(D2 D1)/365] that is, [Actual no of days/(360 or 365)] depending upon the currency while for the fixed payments it is either one of these or a third convention known as "30/360" basis.5 The "Actual/365" basis is known as "bond basis" and the "Actual/360" basis is called "money market basis" in the US. It is to be noted that in an interest rate swap, there is no exchange of underlying principal; only the streams of interest payments are exchanged between the two parties. Currency Swaps In a currency swap, the two payment streams being exchanged are denominated in two different currencies. Usually, an exchange of principal amounts at the beginning and a re-exchange at termination are also a feature of a currency swap. A typical fixed-to-fixed currency swap works as follows. One party raises a fixed rate liability in currency X say US dollars, while the other raises fixed rate funding in currency Y say EUR. The principal amounts are equivalent at the current market rate of exchange. At the initiation of the swap contract, the principal amounts are exchanged with the first party handing over USD to the second, and getting EUR in return. Subsequently, the first party makes periodic EUR payments to the second, computed as interest at a fixed rate on the EUR principal, while it receives from the second party payments in dollars again computed as interest on the dollar principal. At maturity, the dollar and EUR
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principals are re-exchanged. A fixed-to-floating currency swap also known as cross-currency coupon swap will have one payment calculated at a floating interest rate while the other is at a fixed interest rate. It is a combination of a fixedto-fixed currency swap and a fixed-to-floating interest rate swap. It is also possible to have both payments at floating rate but in different currencies. Contracts without the exchange and re-exchange of principals do exist. In most cases, an intermediary-a swap bank-structures the deal and routes the payments from one party to another. For both the interest rate and currency swaps, we have given 'examples of liability swaps, that is, exchanging one kind of liability for another. The same structures can be employed for asset swaps. For instance, a financial institution may have floating dollar assets (say corporate FRNs) funded with fixed rate dollar liabilities. It can contract to exchange the stream of floating payments with a stream of fixed rate payments with another party, which has the opposite problem. An investor with say CHF assets funded with USD denominated liabilities can enter into a currency swap to match the currency denomination of assets and liabilities. Motivation for Swaps Motivation behind swap Wrong reasons for swap: assumes arbitrage Right reasons for swap: assumes no arbitrage opportunities Comparative advantages in currency swap (information asymmetry): better access to domestic vs. foreign capital markets There are two commonly cited explanations for the use of swaps: risk management and comparative advantage (Kolb, 2000). Risk management is undeniably an important motivation for the general use of currency swaps. When either the operations or desired financial structure of a firm changes, currency swaps are a cost effective way to transform risk exposures and alter future cash flows. However, changes in operations and financial structures cannot explain swap-covered borrowing; by definition, such borrowing is intended to replicate risks, not transform them. Bond issuers raising funds in one currency with the express intention of swapping the funds for another currency are choosing to replicate cash flows that could be also be achieved by borrowing directly in the desired currency. Comparative advantage is a more convincing motivation for swap-covered foreign currency borrowing. Indeed, central banks in countries with large volumes of swap-covered borrowing frequently cite comparative advantage as the key motivation for such borrowing (e.g. see Eckhold, 1998; Drage et al, 2005; Olafsson, 2005; Ryan, 2007). In financial markets, comparative advantage exists when the same risk is priced differently in different markets. If borrowing costs differ across markets, then issuers can reduce their overall financing costs by raising funds in the market in which each has a comparative cost advantage and swapping the proceeds. Nature of Swaps A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. Assume that parent Company A (USA) has a subsidiary in UK called A (UK). Similarly there is a parent company B (UK) which has a subsidiary in USA, B (USA). The present company A USA wants to invest in its subsidiary in U.K. and needs Sterling for this purpose. And B UK wants to send funds to its subsidiary in U.S.A. called B (USA) and requires dollars for this purpose. Them with or without the help of an international bank to act as an intermediary, the parties can enter into a swap deal of the loans in sterling and dollar; without US company sending sterling to its UK subsidiary, B (UK) provides dollars to B (USA). These transactions can be shown in the following chart as flow of funds or swaps of loans.
USA
A Parent
Dollars Sterling
UK
A Subsidiary
B Subsidiary
B Parent
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In the above chart A parent has to borrow sterling as a loan and B parent has to borrow dollars as a loan. These loans can be swapped so that A parent gives dollars to B subsidiary and B parent gives sterling to A subsidiary as shown below:
USA
A Parent Dollars B Subsidiary
UK
B Parent Sterling A Subsidiary
Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study. You now know the basics of this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are looking for.
Q5. (b) Describe the Liberalisation of exchange Control Norms of Jun 1999 and what measures have been taken during recent liberalization. Answer:India embarked on a gradual shift towards capital account convertibility with the launch of the reforms in the early 1990s. Although foreign natural persons except NRIs are prohibited from investing in financial assets, such investments were permitted by FIIs and Overseas Corporate Bodies (OCBs) with suitable restrictions. Ever since September 14, 1992, when FIIs were first allowed to invest in all the securities traded on the primary and secondary markets, including shares, debentures and warrants issued by companies which were listed or were to be listed on the Stock Exchanges in India and in the schemes floated by domestic mutual funds, the holding of a single FII and of all FIIs, Non-resident Indians (NRIs) and OCBs in any company were subject to the limit of 5 percent and 24 per cent of the companys total issued capital, respectively. Furthermore, funds invested by FIIs had to have at least 50 participants with no one holding more than 5 per cent to ensure a broad base and preventing such investment acting as a camouflage for individual investment in the nature of FDI and requiring Government approval. Initially the idea of allowing FIIs was that they were broad-based, diversified funds, leaving out individual foreign investors and foreign companies. The only exception were the NRI and OCB portfolio investments through the secondary market, which were subject to individual ceilings of 5 per cent to prevent a possible take over. Individuals were left out because of the difficulties in checking on their antecedents, and of their lack of expertise in market matters and relatively short-term perspective. OCB investments through the portfolio route have been banned since November, 2001. In February, 2000, the FII regulations were amended to permit foreign corporate and high net worth individuals to also invest as sub-accounts of Securities and Exchange Board of India (SEBI)-registered FIIs. Foreign corporates and high net worth individuals fall outside the category of diversified investors. FIIs were also permitted to seek SEBI registration in respect of sub-accounts for their clients under the regulations. While initially FIIs were permitted to manage the sub-account of clients, the domestic portfolio managers or domestic asset management companies were also allowed to manage the funds of such sub-accounts and also to make application on behalf of such sub-accounts. Such sub-accounts could be an institution, or a fund, or a portfolio established or incorporated outside India, or a broad-based fund, or a proprietary fund, or even a foreign corporate or individual. So, in practice there are common categories of entities, which could be registered as both FIIs and sub-accounts. However, investment in to a subaccount is to be made either by FIIs, or by domestic portfolio manager or asset Management Company, and not by itself directly.
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In view of the recent concerns of some unregulated entities taking positions in the stock market through the mechanism of Participatory Notes (PNs) issued by FIIs, the issue was examined by the Ministry of Finance in consultation with the Reserve Bank of India (RBI) and SEBI. Following this consultation, in January 2004, SEBI stipulated that PNs are not to be issued to any non-regulated entity, and the principle of "know your clients may be strictly adhered to. SEBI has indicated that the existing non-eligible PNs, will be permitted to expire or to be wounddown on maturity, or within a period of 5 years, whichever is earlier. Besides, reporting requirement on a regular basis has been imposed on all the FIIs. The following entities, established or incorporated abroad, are eligible to be registered as FIIs: (a)Pension Funds, (b)Mutual Funds, (c)vestment Trusts, (d) Asset Management Companies, (e) Nominee Companies, (f) Banks, (g) Institutional Portfolio Managers, (h) Trustees, (i) Power of Attorney holders, (j) University funds, endowments, foundations or charitable trusts or charitable societies. Besides the above, a domestic portfolio manager or domestic asset management company is now also eligible to be registered as an FII to manage the funds of subaccounts. The FIIs can also invest on behalf of sub-accounts. The following entities are entitled to be registered as subaccounts: i) an institution or fund or portfolio established or incorporated outside India, ii) a foreign corporate or a foreign individual. FIIs registered with SEBI fall under the following categories: (a) Regular FIIs those who are required to invest not less than 70 per cent of their investment in equity-related instruments and up to 30 per cent in non-equity instruments. (b) 100 per cent debt-fund FIIs those who are permitted to invest only in debt instruments. A Working Group for Streamlining of the Procedures relating to FIIs constituted in April, 2003 by the Government, inter alia, recommended streamlining of SEBI registration procedure, and suggested that dual approval process of SEBI and RBI be changed to a single approval process of SEBI. This recommendation has since been implemented. Forward cover in respect of equity funds for outstanding investments of FIIs over and above such investments on June 11, 1998 was permitted. Subsequently, forward cover up to a maximum of 15 per cent of the outstanding position on June 11, 1998 was also permitted. This 15 per cent limit was liberalized to 100 per cent of portfolio value as on March 31, 1999 in January 2003. Like in other countries, the restrictions on FII investment have been progressively liberalized. From November 1996, any registered FII willing to make 100 per cent investment in debt securities were permitted to do so subject to specific approval from SEBI as a separate category of FIIs or sub-accounts as 100 per cent debt funds. Such investments by 100 per cent debt funds were, however, subject to fund-specific ceilings specified by SEBI and an overall debt cap of US$ 1-1.5 billion. Moreover, investments were allowed only in debt securities of companies listed or to be listed in stock exchanges. Investments were free from maturity limitations. From April 1998, FII investments were also allowed in dated Government securities. Treasury bills being money market instruments were originally outside the ambit of such investments, but were subsequently included from May, 1998. Such investments, which are external debt of the Government denominated in rupees, were encouraged to deepen the debt market. From April, 1997, the aggregate limit for all FIIs, which was 24 per cent, was allowed to be increased up to 30 per cent by the Indian company concerned by passing a resolution by its Board of Directors followed by a special resolution to that effect by its General Body. While permitting foreign Corporate/high net worth individuals in February, 2000 to invest through SEBI registered FII/domestic fund managers, it was noted that there was a clear distinction between portfolio investment and FDI. The basic presumption is that FIIs are not interested in management control. To allay fears of management control being exercised by portfolio investors, it was noted that adequate safety nets were in force, for example, (i) transaction of business in securities on the stock exchanges are only through stock brokers who have been granted a certificate by SEBI, (ii) every transaction is settled through a custodian who is under obligation to report to SEBI and RBI for all transactions on a daily basis, (iii) provisions of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (iv) monitoring of sectoral caps by RBI on a daily basis.
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In 1998, the aggregate portfolio investment limits of NRIs/PIOs/OCBs and FIIs were enhanced from 5 per cent to 10 per cent and the ceilings of FIIs and NRIs/OCBs were declared to be independent of each other. Aggregate FII portfolio investment ceiling was enhanced from 30 per cent to 40 per cent of the issued and paid up capital of a company [March 01 2000]. The enhanced ceiling was made applicable only under a special procedure that required approval by the Board of Directors and a Special Resolution by the General Body of the relevant company. The FII ceiling under the special procedure was further enhanced [March 08 2001] from 40 per cent to 49 per cent. Subsequently, the FII ceiling under the special procedure was raised up to the sectoral cap in September, 2001. Quite apart from the ceilings on FII investment, there were and are ceilings on FDI, and in some cases, unified ceilings for nonresident investments. There are two types of ceilings on FII investment: statutory and administrative. 23. Currently non-resident investments in public sector banks and insurance sector are capped under Acts at 20 per cent and 26 per cent respectively. Accordingly, FDI plus portfolio investments by FIIs and NRIs are capped at 20 per cent and 26 per cent under the above statutes. There are also sectors where administrative caps for non-resident investments have been prescribed. In these sectors (viz. telecom services, media, private sector banks) FDI plus portfolio investments by FIIs and NRIs cannot exceed the administrative caps fixed. The Government has done away with the track record scrutiny process for American Depository Receipts (ADR) and Global Depository Receipts (GDR) issues, thus liberalizing operational guidelines for Euro issues. Henceforth companies will not be required to go through the process of two-stage approval by the ministry of finance, an official announcement was made on Wednesday. Companies will be free to access ADR and GDR markets through the automatic route without the prior approval of the Government. Moreover, private placement of ADRs and GDRs would be eligible for automatic approval provided the issue is lead managed by an investment banker, registered with the Securities and Exchange Commission in the US or under Financial Services Act in UK, or appropriate regulatory authority in Europe, Singapore or Japan. Under the liberalized guidelines would be only against expansion of the existing capital base through issuance of fresh equity shares as underlying shares for ADRs and GDRs. The automatic route for ADR and GDR would also cover the issue of employee stock options by the Indian software companies in the IT sector as per the guidelines issued earlier. The issue of ADRs and GDRs arising out of business reorganization, merger and demerger would also be governed by automatic route subject to the earlier guidelines. As ADR and GDR are reckoned as part of FDI, such issues will have to conform to the existing FDI policy and will apply to areas where FDI is permissible. In all cases of automatic approval, companies would be required to obtain mandatory clearance under the FDI policy and the Companies Act prior to the ADR and GDR issues. Also, they will have to obtain the RBI approval under the provisions of FERA/FEMA prior to an overseas issue. The new guidelines stipulate that the companies will be required to furnish full particulars to finance ministry and exchange control department of RBI within 30 days of completion of such transactions. The new guidelines, the official note said, will extend to proposals which have already been filed with the finance ministry and also in cases wherein-principal approval has been obtained. Existing guidelines on Euro issues providing for the option of retention of issue proceeds or repatriation of funds into the country in anticipation of deployment towards the purposes, for which the funds was raised, would remain in force. Norms governing retention and deployment of funds abroad had already been prescribed by RBI. With regard to end use of proceeds, the official press note said that the existing bar on investments in stock markets and real estate would continue. The issue-related expenses (covering both fixed expenses like underwriting commissions, lead managers' charges, legal expenses and other reimbursable expenses) will be subject to a ceiling of four per cent in the case of GDR and seven per cent in the case of listing on US exchange. Issue expenses beyond the ceiling would need the RBI approval.
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International Finance &amp Banking

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IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

The policies are one of the following:

4. Commercial debt markets

IIMM/DH/02/2006/8154, International Finance & Banking

5. Equity (direct, private and portfolio)

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

Importance of Project Finance for enterprises

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

Reasons for globalization of financial markets

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

Sale to Importer -Sale of dollars -Price Rs. 43.95

Market Price Rs. 43.55 per $

Purchase from Exporter Purchase of dollars Price Rs. 42.75

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

IIMM/DH/02/2006/8154, International Finance & Banking

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