International Finance

by
NIJAY GUPTA
TASMAC
MUMBAI
ECONOMIC SCENARIO

 Forex Reserves touches USD 267.00 Bio

 Good Forex inflow earlier (now Outflow) by
Exporters/ECB’s/FII’s/- FDI’s leveraging on
capital market and less outflow by Importers
 Rupee remained between 48.50-49.00
 Inflation around -1.50%
 Forward premium around 2.00% for 1 year
 Libor at 1.50% p.a. for 3 to 6 months
Need & Importance of IF

 International Trade & Trade Settlement in

Foreign Exchange
 Globalization & Liberalization by countries
 Integration of Financial Markets with the
development of new financial instruments,
liberalization of regulations governing the
financial markets and increased cross
penetration of foreign ownership
 Cover Trade & Forex Risk with new
instruments & Products
Nature of International Financial
Management

 Refers to financial function of an overseas business.

 Deals with
 Investment Decision – What activities to finance –
• Capital Budgeting,
• Cross-border Mergers & Acquisitions.
 Financing Decision – How to finance those activities
 Money Management Decisions – How to manage firm’s
financial resources
• International Cash Management
• Minimizing Cash balance
• Minimizing currency conversion costs
• Minimizing foreign exchange risks
• Management of accounts receivable
• Management of Inventory
• International Taxation
International Financial Management
Vs. Domestic Financial Management

International Financial Domestic Financial Management

Management

Main object is to earn excess return Normal returns are expected

on Investments

Attempts to maximize returns are Enjoys relative freedom

often stopped by several constraints

Financial management requires an Domestic financial management is

understanding of unique risks e.g. free from such risks.
foreign exchange risks and political
risks
 Environment of IFM

Foreign
Currency
Exchange
Convertibility
market

International
International Financial International
Financial Management Monetary
Markets System

Balance of
Payments
 International
Monetary
System

Regional International
Economic Financial
Integration Markets

International Exchange
Market Exchange
Foreign Regional
Rates Economic Integration Legal System
Direct Government
Investment Policy
International
trade

Regional Economic
b t C a pital
Integration De
ts
Marke
 International
Monetary/Financial
Systems

International/National

es
Business
in
/B l
ic na
us Regional
om tio

Cooperatio
t
s on na

en
n
Ec ter

nm

Exchange
In

ro

Rate
vi

Regional Economic Integration

Management
En

/Exchange
Nationa
Rate Market
lFinanci
al
Sector
Economic
Environment e ral
Bilat
al vs
at er
lti l
u
M tems
Sys
Basic Ingredient of IF

 Same that of WTO i.e. due to free flows

between countries on account of:
 Trade –Trade Finance Products
 Capital – Financial Markets and
Instruments
 Arbitrage – Interest Rate between
different markets and different countries
 Movement of People - Need for Money
Transfer –Genuine/Non-Genuine
Key Issues
 How does the Global Monetary System
affect exchange rates?
 How did the current system evolve?
 What are the differences between the fixed
and floating exchange system?
 What is the role of the International
Monetary Fund and the World Bank in the
Global Monetary System?
 What are the implications of the global
monetary system for currency management
and business strategy?
Trade Theories, Developments,
Barriers and Regulations

 Theory of Absolute Advantage – One country

may be more efficient in producing a particular
good than another country and that country
may be capable of producing some other good
more efficiently than the first one
 Theory of Comparative Advantage – Both
countries enjoy comparative advantage in at
least one of the products and to be seen from
the point of Perfect competition, Productivity,
Full employment, Mobility and Technology
Developments, Barriers and
Regulations
 Growth/Developments of International Trade
 Risks involved in International Trade
 Emergence of Trading Blocks – Free Trade Area,
Custom Union, Common Market, Economic Union,
NAFTA, ASEAN, SAARC, The European Union
 Trade Barriers – Tariff –Custom/import duty, taxes/vat
–Non-Tariff Barriers – Quota, Embargo, Subsidies to
local goods. Then Technical Barriers, procurement
policies, international price fixing and Exchange
Control Regulations etc
 Various Regulations to Trade – FEMA, Exim Policy etc
Globalization and the Multinational
Firm
 Declining trade barriers, Collapse of Communist power
in Eastern Europe, move toward free market
economies by China and Latin America changes in
communication, information and transportation
technologies have globalized and integrated world
economy
 ‘IF’ differs from domestic finance due to – Foreign
exchange & political risks, market imperfections and
expanded opportunity set (firms gaining from greater
economies of scale and deployment of assets on
global basis) by using proper tools and instruments.
 Goals for IF - Maximization of Shareholders worth and
need for Corporate Governance
Globalization and the Multinational
Firm
 MNC’s produces goods in one country, raise
finance from different countries and sell in other
countries.
 Globalization of the World Economy –
Emergence of Globalized Financial Markets,
Advent of the Euro, Trade Liberalization (WTO,
NAFTA, EU) and Economic Integration (MNC’s
taking comparative advantage over another
country (Theory of comparative advantage) due
to their controlling capital and know-how i.e.
money & technical know-how power).
International Trade Finance in India –
Risk/Exposure
 Risk in Export-Import Business
 Exposure on:
 Buyer/Seller – Credit, Capital, Capacity, Character and
Conditions of business
 Country Risk – Political Risk, War or War like situation,
Internal Disturbance & Govt. Policy
 Exchange Rate Risk –Price/Volatility Risk –Translation/-
Transaction Risk
 Operation Risk, Settlement Risk
 Interest Rate Risk –Inflation, Economic conditions/exposure
 Product Risk - Culture
International Trade Finance in India- FINANCING
MECHANISM & CORRESPONDENT BANKS ACCOUNTS

 Permitted currencies for Payment

(Trade/Investments)
 Collection, Purchase, Discounting or Negotiation of
Export Documents
 Nostro Accounts
 Vostro Accounts
 ACU Dollar Account
 Foreign Currency Accounts for Residents: EEFC,
RFC account and RFC (Domestic) account
International Trade Finance in
India- INCOTERMS –ICC PARIS
 Most commonly used Terms of Shipment are:
 FOB - SHIP, AIR, RAIL(FOR), TRUCK(FOT)
 All cost till the time goods are kept “ON
BOARD” ship/air/rail/truck are borne by the
exporter
 CFR:-
 FOB PLUS the freight for the Voyage
 CIF:-
 CFR PLUS the Insurance for the Voyage
International Trade Finance in
India- INCOTERMS –ICC PARIS
 Other Incoterms not much in use:
 FAS : Free Along-side Ship (loading/unloading
expenses not included)
 CIFC: Cost, Insurance, Freight & Commission
 DAF: Deliver at Frontiers
 DDP: Delivered Duty Paid
 ICC, Paris have now grouped these Incoterms as
‘C’, ‘D’, ‘E’ and ‘F’.
International Trade Finance in India-
RISKS ASSOCIATED WITH TERMS OF
PAYMENTS
 ADVANCE PAYMENT : Currency
Fluctuations, need to be exported within one
year
 DP: The buyer may not come forward to take
up the documents
 DA: The buyer takes the documents but do
not pay on due date
 To cover these risks the Exporters prefers LC,
where a payment is guaranteed by a bank
 Importers prefer LC in order to maintain
delivery schedule by the Exporter
International Trade Finance in
India- TERMS OF PAYMENT-LC
LC is a sort of Guarantee issued by a Bank, on
behalf of the Buyer (applicant) favouring the
supplier (Beneficiary), undertakes to pay by
authorizing another bank (Negotiating Bank) to
pay on complying with the Terms & Conditions
mentioned therein.
 LC is also known as Documentary Credit as
Banks deals in Documents and not in goods
 Each LC should mention that “This LC is subject
to UCPDC publication no. 600, (2007 Revision)
ICC guidelines” to be operative
International Trade Finance in India-
TYPES OF DOCUMENTARY
CREDITS/LC’S
 REVOCABLE: Which can be cancelled by the
applicant without the consent of beneficiary
 IRREVOCABLE: Which can not be cancelled or
amended without the consent of beneficiary
 Irrv. CONFIRMED: Which has been confirmed by
advising, another bank in the same country or
another country
 Irrv. TRANSFERABLE: Which is transferred by
the Advising Bank at the request of Beneficiary to
third party
International Trade Finance in India-
TYPES OF DOCUMENTARY
CREDITS/LC’S
 Irrv. Deferred Payment: Wherein the payments are made
in Installments and deferred over one year
 Irr. Red Clause: Wherein the payment is made in
advance through an LC mechanism by the buyer’s bank
against the Indemnity & undertaking by the Beneficiary
to export the goods
 Irr. Restricted: Wherein the LC is restricted for
negotiation to a particular bank
International Trade Finance in India-
CHECKLIST ON RECEIPT OF LC

 Name & Address of the Applicant & Beneficiary

& Amount
 Should be in English language only
 Description of goods should be as per LC
 Terms of Shipment/Payment/Reimbursement
 Mode of Transport, Part/Trans-shipment
 Restricted or confirmed, charges thereon
 Inspection & other Terms & Conditions matches
with that of the Performa Invoice or Contract
 Shipment/ Expiry date and Negotiation Period
International Trade Finance in India-
EXPORT/IMPORT FINANCE SCHEME

 PRE-SHIPMENT CREDIT: (RUPEES/FC)

 Upto 180 Days : Not exceeding PLR
minus 4.5%
 Beyond 180 to 270 days: Not exceeding PLR
plus 0.5%
 PCFC upto 180 days: Not exceeding
LIBOR plus 3.50%
 PCFC 181 to 365 days: Not exceeding
LIBOR plus 5.50%
International Trade Finance in India-
EXPORT/IMPORT FINANCE SCHEME
 POST SHIPMENT CREDIT (RUPEES/FC)
 On DP Bills upto NTP : Not exceeding PLR minus 4.5%
 On Usance Bills:
 upto 90 days : Not exceeding PLR minus
4.5% (PLR -4.50% for SME)
 Beyond 90 to 6 months: Not exceeding PLR plus 0.5%
 Bills Reds. Scheme : Not exceeding LIBOR
plus 3.50%
 IMPORTERS are not given any concessional Finance, however they
take benefit through Buyer’s Credit from overseas Banks/Institutions
International Trade Finance in India-
INTERNATIONAL FACTORING
 Factoring is purchase of EXPORT receivable (with
or without recourse) on an ongoing basis.
 The management, collection & administration is
taken over by the factor for exports on open
accounts terms
 Finance is made available upto 90% of the invoice
value
 Offered by Global Trade Finance a subsidiary of
Exim Bank in India, Canfactors & HSBC Factors
etc
International Trade Finance in India-
INTERNATIONAL FORFAITING

 Forfaiting is purchase of medium to long-term

export receivables backed by a LC or banker’s
acceptance from the buyers bank at a discount on a
without recourse basis
 Exim Bank and Authorized Dealers offers this
product to exporters for a minimum amount of
USD 50,000/-
 RBI allows banks to pay forfaiting charges in
advance
International Trade Finance in India-
FACTORING : FORFAITING
 Suited for on going  Single transactions
open a/c sales not backed by LC or a
backed by LC or Bank Guarantee
accepted Bills of
Exchange  For long-term credit
 Provide short-term upto 10 yeas, though
credit upto 180 days available for Short
term too
International Trade Finance in India-
FACTORING : FORFAITING
 Requires regular  Deals concluded
arrangement for all transaction wise
the sales  Single discount
 Separate charges for charges for
Financing, collection, Guaranteeing Bank,
Admn, credit Country risk, credit
protection, providing period involved and
information and can currency of debt &
be with or without addl. Charge of
recourse commitment fee
International Monetary System

 It’s a system where Intl payments are made, movement of

capital accommodated and exchange rates of currencies
determined
 It went through 5 stages – Bimetallism (coinage in silver &
gold lead to Gresham’s law for fixing exchange ratio of 2
metals)), classical gold standard (exchange ratio decided on
gold contents of currencies), interwar period (no clear rule
lead to 44 nations meeting in 1944), Bretton Woods system
(established a par value in relation to USD which was fully
convertible to gold) and flexible exchange rate regime
(replaced Bretton Woods due to spectacular rise & fall of
USD in 1980).
 1987 –G-7 countries agreed for Managed-float system for
jointly intervening in Forex market to cover over- or
undervaluation of currencies
International Monetary System

 1979 – EEC launched European Monetary System (EMS) to

establish ‘zone of monetary stability’ in Europe
 EMS are ECU (European Currency Unit basket) and ERM
(Exchange Rate Mechanism) instruments based on parity grid that
member countries required to maintain for EMS accounting.
 1999 – 11 countries adopted common currency called Euro.
Greece adopted in 2001. Euro -12 helps reduced transactions cost,
elimination of exchange rate uncertainty and development of
continent wide capital markets
 European Monetary Union (EMU) common monetary policy for 12
euro countries formulated by ECB located at Frankfurt. European
System of Central Banks implements monetary policy of EMU in 12
–euro countries
 EMU members prefer Fixed Exchange rate whereas US & Japan
prefer Flexible exchange rates. Choice between two involves trade-
off between national policy autonomy and international economic
integration
International Monetary System

 Currency exchange rates depend on the structure of the

international monetary system
 Generally they are not freely convertible and do not float
freely
 Only 51 were freely convertible in 1997
 Another 50 were pegged to the exchange rate of
major currencies such as the US Dollar and the
French Franc or to baskets of other currencies
 Another 45 currencies were allowed by their
governments to float within a range of another
currency
 This is 153 of 190 UN member nations in 2007
 International Monetary System
 The international monetary system refers to the
institutional arrangements that countries adopt to govern
exchange rates.
 When the foreign exchange market determines the
relative value of a currency, that country is adhering to a
floating system.
 A pegged exchange rate means that the value of a
currency is fixed to a reference country’s currency and
then the exchange rate between that currency and other
currencies is determined by the reference currency
exchange rate.
 A dirty float occurs when the value of a currency is
determined by market forces, but with central bank
intervention if it depreciates too rapidly against an
important reference currency.
 Countries that adopt a fixed exchange rate system fix
their currencies against each other.
Evolution of the International
Monetary System
 Gold Standard
 Currencies pegged to the value of gold; convertibility
guaranteed
 The exchange rate between currencies was
determined based on how much gold a unit of each
currency would buy
 By 1880 most countries were on the gold standard
 Achieves balance of trade equilibrium for all countries
(value of exports equals value of imports); flow of gold
was used to make up differences
 Abandoned in 1914; attempt to resume after WWI
failed with Great Depression
Bretton Woods (1944 - 1973)

 44 countries met to design a new system in 1944

 Established International Monetary Fund (IMF) and
World Bank
 IMF maintained order in monetary system
 World Bank promoted general economic development
 Fixed exchange rates pegged to the US Dollar
 US Dollar pegged to gold at $35 per ounce
 Countries maintained their currencies ± 1% of the
fixed rate; government had to buy/sell their currency
to maintain level
The Role of the IMF
• Exchange rate discipline – National governments had to
manage inflation through their money supply
 The need to maintain a fixed exchange rate puts a brake on
competitive devaluations and brings stability to the world
trade environment.
 A fixed exchange rate regime imposes monetary discipline
on countries, thereby curtailing price inflation.
 Exchange rate flexibility
 Provided loans to help members states with temporary
balance-of-payment deficit;
• Allowed time to bring down inflation
• Relieved pressures to devalue
 Excessive drawing from IMF funds came with IMF
supervision of monetary and fiscal policies
 Allowed up to 10% devaluations and more with IMF
Special Drawing Rights (SDR)

 To help increase international reserves, The IMF

created Special Drawing Right (SDR) in 1969. SDRs
are defined in terms of a basket of major currencies
used in international trade and finance. At present, the
currencies in the basket are the euro, the pound
sterling, the Japanese yen and the United States
dollar. Before the introduction of the euro in 1999, the
Deutsche mark and the French franc were included
in the basket.
 SDRs are used as a unit of account by the IMF and
several other international organizations. A few
countries peg their currencies against SDRs, and it is
also used to denominate some private international
financial instruments
The Role of the World Bank

 World Bank (IBRD-International Bank for

Reconstruction and Development) role
 Refinance post-WWII reconstruction and
development
 Provide low-interest long term loans to
developing economies
 The International Development Agency (IDA),
an arm of the bank created in 1960
 Raises funds from member states
 Loans only to poorest countries
 50 year repayment at 1% per year interest
Collapse of Bretton Woods
 Devaluation pressures on US dollar after 20
years - Huge balance of payment deficit &
depletion of Gold reserves in US
 Lyndon Johnson policies
• Vietnam war financing
• Welfare program financing
 Nixon ended gold convertibility of US dollar in
1971
 US dollar was devalued and dealers started
speculating against it for further devaluation
 Bretton Woods fixed exchange rates abandoned
in January 1972
Jamaica Agreement 1976
 Floating rates declared acceptable
 Gold abandoned as reserve asset;
 IMF returned its gold reserves to its members at
current prices
 Proceeds were placed in a trust fund to help
poor nations
 IMF quotas – member country contributions –
increased; membership now 182 countries
 Less-developed, non-oil exporting countries
given more access to IMF
 IMF continued its role of helping countries cope with
macroeconomic and exchange rate problems
Implications for Business

 Currency management
 The monetary system is not perfect
 Both speculative activity and government
intervention affect the system
 Companies must use risk management
instruments
 Business strategy
 Minimize risk by placing assets in different
parts of the world, e.g., production
 Contract manufacturing
 Manage company-government relations
Key Issues
 What is the form and function of the foreign
exchange market?
 What is the difference between spot and
forward exchange rates?
 How are currency exchange rates
determined?
 What is the role of the foreign exchange
market in insuring against foreign exchange
risk?
 Why are some currencies not always
convertible into other currencies?
Foreign Exchange
 Foreign exchange is a commodity that consists
of currencies issued by countries other than one’s
own.
• The foreign exchange market
 Is the market where one buys (or sells)
the currency of country A with (or for)
the currency of country B
 A currency exchange rate
 Is simply the ratio of a unit of currency of
country A to a unit of the currency of country
B at the time of the buy or sell transaction
Determination of Exchange
Rates
 Purchasing Power Parity Theory -
 Put forward by Gustav Cassel after First World War - "The rate of
exchange between two currencies in the long run must stand
essentially on the quotient of the internal purchasing powers of these
currencies".
 The value of one currency in terms of another currency will be
determined by the relative values of two currencies as indicated by
their relative purchasing power over goods & services.
 Balance of Payment Theory
 Also known as 'Demand & Supply Theory'
 Holds that the foreign exchange rate, under free market condition, is
determined by the conditions of demand & supply in the foreign
exchange market (Just like the price of any commodity)
 Value of a currency appreciates when demand for it increases and
depreciates when the demand falls, in relation to its supply in the
FOREX market.
 The extent of demand & supply for a country's currency depends
upon its balance of payment position.
 Balance of Payments -Current Account Capital Account
Official Reserve Transactions

 A country’s balance of payments summarizes all

economic transactions that occur during a given time
period between residents of a country and residents of
other countries.
 Balance of payments statements measure a flow
because they summarize transactions in a given time
period (year).
 Transactions that don’t involve money are included.
(Example: Food sent by world hunger organizations
would be included.)
 Accounts are maintained according to double-entry
book keeping. (Debits- payments from us to the rest
of the world, Credits – payments by the rest of the
world to us
Components of Balance of Payment
Accounts

 Current account balance:

 Balance on goods and services – The
section of a country’s balance of payments
account that measures the difference in
value between a country’s exports of goods
and services and its imports of goods and
services. (Includes income earned from
foreign assets owned by Indians minus
income earned from India’s assets owned
abroad.)
 Unilateral transfers–payments of gifts and
grants among countries (India has negative
net unilateral transfers since World War II)
Implications of Current Account
Deficit (i.e. trade deficit)

 Is a trade deficit financed by a capital

accounts surplus bad?
 The trade deficit as an automatic
stabilizer
 How could the trade deficit be
removed?
 Exchange rate devaluation
 Economic recession
Current account

 Includes all transactions involving

goods and services, as well as
transfers between residents of
different countries
 Here, India typically runs deficit
 Exports < imports (deficit)
 Net unilateral transfers mostly deficit
Components of Balance of
Payment Accounts (cont
 Capital account – The record of a country’s
international transactions involving purchases or sales
of financial and real assets (borrowing, lending, and
investments).
 Official reserve transactions account – The section of
a country’s balance-of-payments account that reflects
the flow of gold, Special Drawing Rights, and
currencies among central banks
 A negative current account will be offset by a positive
capital account if exchange rates are flexible (no
intervention of official reserves
Capital account

 Calculates foreign investment

 Foreigners’ purchases of India’s
financial assets or real assets (India
credit)
 India purchase of foreign financial
assets or real assets (India debit
 Convertibility-Definition
 The ease with which a country's currency can be converted
into gold or another currency. Convertibility is extremely
important for international commerce. When a currency in
inconvertible, it poses a risk and barrier to trade with
foreigners who have no need for the domestic currency
 The quality of being exchangeable (especially the ability to
convert a currency into gold or other currencies without
restriction
 Government restrictions can often result in a currency with a
low convertibility. For example, a government with low
reserves of hard foreign currency often restrict currency
convertibility because the government would not be in a
position to intervene in the foreign exchange market (i.e.
revalue, devalue) to support their own currency if and when
necessary
 Rupee Convertibility
 The Indian Rupee is
1) for all intents and purposes, fully Convertible to the US$ on the
Trade Account and Current Account. This means Indians can buy
US$ for their Trade, Travel, Fees, Education, Interest, Dividend
payments etc. US Dollars can also be converted into Rupees
2) largely, NOT convertible to US$ on the Capital Account,
especially when the flow of capital is from India to outside
 However, degrees of convertibility have been brought in. For
instance,
- Indian companies can invest in/ set up subsidiaries abroad. Limits
are placed on the amount of investment
- Indian mutual funds, since last year, have been allowed to invest in
overseas markets, though we doubt if activity has picked up on this
front
- Dividend and Interest payments to investors abroad are unhindered
Rupee Convertibility
 Flow of Capital from outside India (investments into India)
are unencumbered from the "convertibility" point of view.
 Investors may need to garner various necessary permissions
as required to invest in the equity market, debt market or to
set up Greenfield projects or buy over existing companies.
These are, essentially, outside the ambit of "convertibility"
 Indian Rupee is not legally pegged to the Dollar. It is
market traded currency, though the trading itself is
controlled by various measures. Technically, the Indian
Rupee is in a "Managed Float" or "Dirty Float", like the
Yen.
Factors Determining Exchange Rates

Fundamental Reasons:
- Balance of Trade/Balance of Payment – surplus leads to stronger
currency.
- Inflation Rate
- Forex Reserve
- Economic Growth Rates –High/Low growth rate.
- Fiscal / Monetary Policy- deficit financing leads to depreciation of
currency.
- Interest Rates –currency with higher interest will appreciate in the short
term.
- Political Issues –Political stability leads to stable rates
(b). Technical Reasons
- Government Control can lead to unrealistic value.
- Free flow of Capital from lower interest rate to higher interest rates.
(c). Speculation – higher the speculation higher the volatility in rates
(d) Developments abroad – Sub- Prime, South-East Asian Crisis
(e) Demand & Supply of Foreign Exchange at any given of time
(f) Comments from FM/RBI- Governor
(g) Ratings by the Rating Agencies
Determinants of Foreign
Exchange Rate
 Foreign exchange is needed to carry out foreign
transactions
 The exchange rate is the price of one country’s
currency measured in terms of another country’s
currency
 Currency depreciation lowers the price of your
currency to foreigners (and lowers the price of your
exports and raises the price of imports)
 Currency appreciation increases the price of your
currency to foreigners (and increases the price of your
exports and lowers the price of imports)
Flexible and Fixed Exchange
Rates
 Flexible exchange rates – Rates determined by the
forces of supply and demand without government
intervention
 Fixed exchange rates – Rates pegged within a narrow
range of values by central banks’ ongoing purchases
and sales of currencies
 The Current System: Managed Float- an exchange
rate system that combines features of freely floating
rates with intervention by central banks (to moderate
fluctuations in exchange rates).
 The ideal system would foster international trade,
lower inflation, and promote a more stable economy
The Foreign Exchange
Market
 The Functions & Structure of the Forex Market
 Foreign Exchange
 Types of Transactions
 The Spot Market
 Spot Rate Quotations
 The Bid-Ask Spread
 Spot FX Trading
 Cross Exchange Rate Quotations
 Arbitrage
 Spot Foreign Exchange Market Microstructure
 The Forward Market
 Settlement Dates
 Quotes for Various Kinds of Merchant Transactions
 The Indian Scenario
Convertibility, Exchange Control
The FEDAI Rules Regarding Inter-bank Dealings
Forex Dealing Room Operations
Structure of the Forex
Market
Decentralized, over-the-counter market, also
known as the 'interbank' market
 Main participants: Central Banks, commercial
Banks (AD/s), corporations & private
speculators
 The free-floating currency system began in
1973, and was officially mandated in 1978
 Online trading began in the mid to late 1990's
Structure of the Forex
Market
Trading Hours
24 hour market
Sunday 5pm EST through Friday 4pm EST. Rollover at 5pm
EST
Trading begins in New Zealand, followed by Australia, Asia,
the Middle East, Europe, and America
Size
Largest market in the world
$ 3 trillion average daily turnover, equivalent to:
15 times the average daily turnover of global equity markets
Nearly 50 times the average daily turnover of the NYSE
The spot market accounts for about one-third of daily
turnover
Structure of the Forex
Market
Major Markets
 The US & UK account for more than 50% of turnover
 Major markets: London, New York, Tokyo
 Trading activity is heaviest when major markets overlap
 Nearly two-thirds of NY activity occurs in the morning hours while
European markets are open
Trading
 An estimated 95% of transactions are speculative
 More than 40% of trades last less than two days
 About 80% of trades last less than one week
 Brokers research: 90% of traders lose money, 5% break even, 5%
make money
 Around-the-clock FX trading
Average Electronic Conversions Per Hour

25,000

20,000

15,000

10,000

5,000

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Greenwich Mean Time

10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

In Tokyo In Tokyo opening closing open closing in America In NY opens
FX Rates

 What is Exchange Rate ?

 Exchange Rate is a rate at which one currency
can be exchanged into another currency. In other
words it is value one currency in terms of other.
say:
US $ 1 = Rs.45.18
This rate is the conversion rate of every US $ 1
to Rs. 45.18
 Methods of Quotation
 Method – I  Method – II
 One Orange = Rs 2  Rs. 10 = 5 Oranges
 One Apple = Rs 2.50  Rs. 10 = 4 Apples
Price under both the methods is the same though expressed differently

Method - I Method - II
DIRECT(FC fixed) INDIRECT( HC fixed)
USD 1 = Rs 45.18 Rs 100 = USD 2.2133
GBP 1 = Rs.85.99 Rs 100 = GBP 1.1629
EUR 1 = Rs 57.92 Rs 100 = EUR 1.7265

With Effect from 02.08.1993, all exchanges are quoted in

Direct Method
 Understanding Two Way Exchange Quotes

In Forex markets , there are two way quotes

i.e. both buying and selling rates are
given.
 1 USD = INR 45.16/ 18

 BUYING RATE $/RE = RE 45.16

 SELLING RATE $/RE = RE 45.18

In the abovementioned quote,

lowest is market buying rate and highest is market selling rate.
Understanding Two Way Exchange Quotes
One of the features of the FX markets is that this is the
nearest form of perfect markets existing today.

One of the reasons why this is so is that prices are always

Quoted as TWO WAY QUOTES

U S D 1 = C H F 1 . 2 5 7 0 / 7 3

C H F 1 . 2 5 7 0C H F 1 . 2 5 7 3

B U Y I N G R SA ET EL L I N G R A T E
 Understanding Exchange Rates

Dollar/Swiss Francs -- USD/CHF

 Note the order of the currencies
 “USD” comes before the “CHF”

 The first currency($) - Base currency

 Second currency (CHF) - Terms currency
 It is important to remember that Bid & Offer in trading
always refers to the BASE CURRENCY.
Understanding Exchange Quotes
 In the FX market, Time is of great importance.
 Therefore, there are short forms for everything.
 While quoting, the dealers use only the third & fourth
decimals.
 USD/CHF 1.2540 / 45
 USD/INR 45.1675 / 00
 GBP/USD 1.8000 / 10
 BIG FIGURE
 In a live dealing scenario dealers would quote only 40/45 ,
75/figure , figure/10 and the market assumes that all
players already know the BIG FIGURE
Calculating Cross Rates

 India is a market maker for Indian Rupee

 Dollar/ Rupee trading ( the first quotes) start in the Mumbai Market
 BUT WHAT ABOUT OTHER CURRENCIES ?
 WHERE DO RATES FOR CHF, GBP, EUR ETC COME FROM?
HOW ARE THEY CALCULATED?

 A CHF/RUPEE RATE IS A CROSS OF DOLLAR/RUPEE &

DOLLAR / CHF.
 DOLLAR / RUPEE = 45.35/36

 DOLLAR / CHF = 1.3440 / 45

 CHF / RUPEE = 33.73 / 75

 In other words, 45.36 / 1.3440 = 33.75 AND
 45.35 / 1.3445 = 33.73
Calculating Cross Rates

 India is a market maker for Indian Rupee

 Dollar/ Rupee trading ( the first quotes) start in the Mumbai Market
 BUT WHAT ABOUT OTHER CURRENCIES ?
 WHERE DO RATES FOR CHF, GBP, EUR ETC COME FROM?
HOW ARE THEY CALCULATED?

 A CHF/RUPEE RATE IS A CROSS OF DOLLAR/RUPEE &

DOLLAR / CHF.
 DOLLAR / RUPEE = 45.16/18

 DOLLAR / CHF = 1.2570 / 73

 CHF / RUPEE = 35.92 / 94

 In other words, 45.16 / 1.2570 = 35.92 AND
 45.18/ 1..2573 = 35.94
Forex market conventions
 Standard nomenclatures
 Concept of value date
 Dealing and settlement locations
 Standard ways of quoting
 Direct Quote
 Indirect Quote
 Exchange rate quote is always given as a number
of units of the quoted currency per unit of the
base currency eg. USD/INR
Forex market conventions-
contd
 Example of a Standard Quotation
 USD/CHF Spot: 1.4550/1.4560
 The left-side price is the bid i.e. the dealer will
buy 1 USD and the “bid” rate for USD is
CHF1.4550. His “offer” or “ask” rate for one
USD is CHF 1.4560 i.e. he would be paid CHF
1.4560 for 1 USD sold.
 For most currencies quotations the base
currency is the dollar. The major exceptions are
EUR,GBP,AUD and NZD
Forex market conventions-
contd
 Quotations in inter-bank are usually up to
four decimal places and the last two digits
are called pips or points.
 Direct and Indirect methods of quoting

 No fees charged

 Transaction cost in the bid-offer spread

 Message confirmations through SWIFT

Types of transactions
 Ready or Cash –value today
 Tomorrow or “tom”-value tomorrow
 Spot transactions –two business days after
trade date
 Forward transactions- any value date
beyond spot
 Swap transaction – combination of spot
and forward
Types of Transaction: Value Date Concept

Due to vastness of the market and origin of transactions and settlements may
take place at different time zones, most of times deal dates and settlement
date differs. Market uses different terminology which are used universally
to avoid conflict.
Type of TXN Date of Deal Value Date
Cash/Ready 15.11.2008 15.11.2008
Wednesday Wednesday

TOM 15.11.2008 16.11.2008

Wednesday Thursday

Spot 15.11.2008 17.11.2008

Wednesday Friday

Forward 15.11.2008 Any day after 17.11.2008

Wednesday
Types of Transaction: Value Date Concept

 Due to vastness of the market and origin of transactions and settlements may take
place at different time zones, most of times deal dates and settlement date differs.
Market uses different terminology which are used universally to avoid conflict
Type of TXN Date of Deal Value Date
Cash/Ready 17.11.08 17.11.08
Friday Friday
TOM 17.11.08 20.11.08
Friday Monday
Spot 17.11.08 21.11.08
Friday Tuesday

Forward 17.11.08 Any day after

Friday 21.11.08
Transactions in the Foreign
Exchange Market
 Spot exchange rates: the day’s rate
offered by a dealer/bank
 Spot trade involves the almost immediate
purchase or sale of foreign exchange.
 Typically, cash settlement is made within 2
business days. The spot market is an over-
the-counter (OTC) market where contracts
are tailored for each customer
Forward Rates

 What is a Forward Rate ?

 Rate agreed for settlement on an agreed date in
the future
 All rates are derived from Spot rates
 Forward rate is the spot rate adjusted for the
premium / discount

 Forward Rate = Spot Rate + / - premium or

discount
Transactions in the Foreign Exchange
Market

 Forward Exchange Rates

 Agreed in advance rates to buy/sell a currency on a
future date. Usually quoted 30, 90, 120, 365 days in
advance.
 May be at par, discount, or premium.
 Forward contracts can be used to hedge or cover
exposure to foreign exchange risk
 Forward Market - Participants
 Hedgers: traders that try to protect themselves from
future unfavorable exchange rate movements.
 Speculators: traders that expose themselves to
currency risk in order to profit from exchange rate
fluctuations.
Premium/Discount
 Forward price = Spot price plus or minus
forward margin.
 Premium –forward value of currency is higher
than spot rate. A currency with lower rate of
interest is said to be at premium in the forwards.
Forward margins added to spot rate.
 Discount – forward value of currency is lower
than spot rate. A currency with higher rate of
interest is said to be at discount. Forward
margins deducted from spot rate
Transactions in the Foreign Exchange
Market

 Swap Operation - Simultaneous sale of spot currency for the

forward purchase of the same currency or the purchase of spot
for the forward sale of the same currency - Spot currency
swapped against forward.
 When are foreign exchange swaps needed?
• Need a currency for a while, so buy it now and sell it
later.
• If foreign currency receivable is earlier than payable and
the company wants to use the foreign currency in
between the two dates.
• To effectively change the maturity dates of forward
contracts.
Transactions in the Foreign Exchange
Market

 Arbitrage - Currency arbitrage means buying a currency in

one market (say New York) at a low price and reselling,
moments later, in another market at a higher price.
 Buying low and selling high … given slightly different
exchange rate quotes in one location vs another.
 Could result in equalizing the exchange rates in different
markets.
 Possible because of the ease & speed of communication
between commercial centres in the world.
Assume that the rate of exchange in London is £ 1 = $2 while in
New York £ 1 = $2.10. One can purchase one pound sterling in
London for two dollars and earn a profit of $0.10 by selling the
pound sterling in New York for $2.10. This situation would lead to
an increase in demand for sterling in London and consequently, an
increase in the supply of sterling in New York. This could result in
equalizing the exchange rates in different markets.
Derivative Instruments

 Derivatives instruments are management tools

derived from underlying exposures (Assets) such
as Currency, Commodities, Shares, Bonds or any
other indices, used to reduce or neutralize the
exposure on the underlying contracts.
 Derivatives could be Over the Counter (OTC) i.e.
made to order or Exchange Traded Facilities
which are standardized in terms of quantity,
quality, start & ending dates.
Hedging
 Hedging - Covering of export risk. It
provides a Mechanism to exporters and
importers to guard themselves against
losses arising from fluctuations in exchange
rates.
 Instruments
 Forwards
 Futures
 Options
 Swaps
Hedging Instruments
• Forwards are custom-made contracts to buy or sell
foreign exchange in the future at a presently specific
price. Maturity and size of contracts can be determined
individually to almost exactly hedge the desired
position.

• Publicly traded on many exchanges worldwide, a

currency future is a contract that resembles a forward
contract. However, unlike the forward contract, the
currency future is for a standard amount on a standard
delivery date.
Hedging Instruments
• The currency option allows, but does not require, a
firm to buy or sell a specified amount of foreign
currency at a specified price at any time up to a
specified date. A call option grants the right to buy the
foreign currency in question; a put option grants the
right to sell the foreign currency.
.
• Swaps are agreements to exchange one currency for
another at specified dates and prices. They are
versatile, allowing easy hedging of complex
exposures. Documentation requirements may be
extensive.
FUTURE CONTRACTS
 Like forward contracts, future contracts
also represent a commitment to
exchange a specified quantity of one
currency for another, at a specified price
and on a specified future date
 Differences:
 Forward contracts =>customised while
Future contracts => standardised
What is an FX Option

 An FX option contract gives the buyer (or holder) the right,

but not the obligation, to:
 Buy Rupees, in the case of a Rupee call/ Dollar put
option, against Dollars (or sell Rupees against Dollars
in the case of a Rupee put/Dollar call option);
 For a predetermined quantity of Rupees;
 At a predetermined fixed price (the strike or exercise
price);
 On (if European style) or until (if American style) a
fixed future date;
 For a premium (option price) negotiated at the time of
dealing.
How does an FX Option Differ from a
Forward

 Consider an exporter who expects to receive $1MN in 3

months.
 The exporter can go in for
 Forward contract or Option contract
 Forward contract – performance is obligatory on the

for buyer and seller.*

• Option contract – performance is not obligatory for
for option holder.
 Suppose , exporter goes for option contract. He will agree
to sell $1 mn after 3 months. On due date, depending upon
$/RE rate, he will decide to exercise the option or not.
Foreign Exchange Exposures
or Risks
 Foreign Exchange Exposure refers to the
possibility that a firm will gain or lose due
to changes in exchange rates - the degree
to which, a company is affected by the
exchange rate changes.
 TranslationExposure
 Transaction Exposure
 Economic Exposure
Foreign Exchange Exposures
or Risks
 Translation Exposure sometimes called accounting
exposure measures the effect of an exchange rate
change on published financial statements of a firm.
 Transaction Exposure refers to the potential change
in the value of outstanding obligations due to changes
in the exchange rate between the inception of a
contract and the settlement of the contract
 Economic Exposure also called operating exposure,
competitive exposure, or revenue exposure, measures
the impact of an exchange rate change on the net
present value of expected future cash flows from a
foreign investment project.
Analyzing Country Risk

 Importance:
 To identify the common factors used by
MNC’s to measure a country’s political risk
 To identify the common factors used by
MNC’s to measure a country’s financial risk
 To explain the techniques used to measure
country risk &
 To explain how MNC’s use the assessment
of country risk when making financial
decisions
Political &
Financial Risk Factors
 Consumer’s Attitude in the Host country
 Host Government Actions
 Fund Transfers Blockage
 Currency Inconvertibility
 War, Terrorist attack, labor strike, scandal
within a country, country’s banking system,
Trade restrictions
 Bureaucracy & Corruption
 Economic Growth Indicators – Interest
rates, exchange rates, inflation & Demand
for product
Types and Techniques of
Country Risk Assessment
 Macro assessment & Micro assessment of
Country Risk (political & financial factors)
 Checklist Approach – judgment on political
& financial factors
 Delphi technique – collection of
independent opinions on country risk
without group discussion by the assessors
(like employees or outside consultants)
 Quantitative analysts
 Inspection visits
 Combination of techniques
Measuring Country
Risk

 Thru – Checklist approach – separate rating for

political & financial risk –assigning values from 1 – 5 or
weights
 Variation in methods of measuring country risk
 Using country risk rating for decision making
 Comparing risk ratings among countries
 Actual country risk ratings across countries
 Incorporating country risk in capital budgeting by
adjusting the discount rate or estimated cash flows
 Country Risk affecting Financial Decisions – Cases –
Gulf War, Asian Crisis, Terrorist attack on US and
Terrorism in Afghanistan, Pakistan, Hindustan,
Srilanka etc.
Reducing exposure to Host
Government Takeovers

 Use a short-term horizon

 Rely on unique supplies or technology

 Hire local labor

 Borrow local funds

 Purchase insurance

 Use project finance

Corporate Strategy & Foreign Direct
Investment – Objective & Motives
 To describe common motives for initiating direct
foreign investment &
 Illustrate the benefits of international diversification
 Revenue Relative Motives –Attract new sources of
demand, Enter profitable markets, Exploit monopolistic
advantages, React to trade restrictions, Diversify
internationally
 Cost Related Motives – Fully benefit from economies
of scale, Use foreign factors of production, use foreign
raw materials, use foreign technology, React to
exchange rate movements
Benefits of FDI
 Comparing Benefits of FDI among countries
 Comparing benefits of FDI over Time
 International Diversification: Benefits
 Diversification Analysis of International projects –
comparing Portfolios along the Frontier, Comparing
Frontiers among MNCs
 Diversification among Countries, Decision subsequent
to FDI
 Host Government views o FDI, Incentives to
encourage FEDI, Barriers to FDI, Government
Imposed conditions to Engage in FDI
Capital Budgeting in MNC/Foreign
Subsidiary - Objectives

 To compare the capital budgeting

analysis of an MNC’s subsidiary
versus its parent;
 To demonstrate how Multinational
capital budgeting can be applied to
determine whether an international
project should be implemented &
 Explain how the risk of international
projects can be assessed
Capital Budgeting in MNC/Foreign
Subsidiary - Perspective

 Subsidiary versus Parent

 Tax Differentials
 Restricted Remittances, Excessive
Remittances, Exchange Rate
Movements
 Summary of Factors like cash flows
before or after tax, conversion of
funds/remittances etc, Withholding tax
etc.
Input & Factors for MNC
Capital Budgeting
 Initial investment, consumer demand, price,
variable cost, fixed cost, project lifetime,
salvage (liquidation) value, restrictions on
fund transfers, tax laws, exchange rates,
Required rate of return
 Factors – Exchange rate fluctuations,
Inflation, financing arrangement blocked
funds, uncertain salvage value, Impact of
project on prevailing cash flows, Host
government incentives, Real options
Adjusting Project Risk
Assessments
 Risk Adjusted Discount Rate
 Sensitivity Analysis – What if
scenario?
 Simulation – Generation of a
probability distribution for NPV based
on a range of possible values for one
or more input variables with the help
of a computer package.
Capital Structure and
Multinational Cost of Capital -
Objective
 To explain how corporate and country
characteristics influence an MNC’s
cost of capital
 Explain why there are differences in
the costs of capital among countries &
 Explain how corporate and country
characteristics are considered by an
MNC when it establishes its capital
structure