If

INTERNATIONAL FINANCE
CONCEPTS QUESTIONS: Gold Bullion Standard: The basis of money remains a fixed weight of gold but the currency in circulation consist of paper notes with the authorities standing ready to convert unlimited amounts of paper currency in to gold and vice-versa, on demand at a fixed conversion ratio. Thus a pound sterling note can be exchanged for say x ounces of gold while a dollar note can be converted into say y ounces of gold on demand.
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2) Gold Exchange Standard: Gold Exchange Standard was established in order to create additional liquidity in the international markets. Hence the some of the countries committed themselves to convert their currencies into the currency of some other country on the gold standard rather than into gold. The authorities were ready to convert at a fixed rate, the paper currency issued by them into the paper currency of another country, which is operating a gold specie or gold bullion standard. Thus, if rupees are freely convertible into dollars and dollars in turn into gold, rupee can be said to be on a gold exchange standard. 3) The Gold Standard: This is the oldest system which was in operation till the beginning of the First World War and a for few years thereafter ie it was basically from 1870 - 1914. The essential feature of this system was that the gouvernment gave an unconditional guarentee to convert their paper money to gold at a prefixed rate at any point of time or demand. 4) Triffins Paradox: The Bretton Woods System had some contradictions which were pointed out by Prof. R Tryffin which were :- The system depended on the dollar performing and its role as a key currency. Countries other than the U.S had to accumulate dollar balances as the dollar was the means of International payment. This meant that the US had to run BOP deficits so that other countries could build up a stock of claims on the US. When the US deficits started mounting, other countries started losing faith in the ability of the US to convert their dollar asset into gold. 5) Fixed exchange rate As the name suggests, under fixed exchange rate system, the value of a currency in terms of another is fixed. These rates are determined by governments or central banks of the respective countries. The fixed exchange rates result from pegging their currencies to either some common commodity or to some particular currency. The rates remain constant or they may fluctuate within a narrow range. When a currency tends crossing over the limits, governments intervene to keep within the band. Normally countries pegs its currency to the currency in which the major transactions are carried out or some countries even peg their currencies to SDR. For example : - US dollar has 24 currencies pegged to itself whereas French franc has 14 currencies and 4 currencies are pegged to SDRs. The major advantage of this system is that it provides stability to international trade and exchange rate risk is reduced to some extent. Because of the fixed exchange rate system, exporters and importers are clear how much they have to pay each other on the due date. The disadvantage is that it is prone to speculation i.e. a speculator anticipating
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devaluation of pound sterling will buy US dollars at a forward rate so as to sell them when devaluation of the pound takes place. 6) Floating Exchange Rates: When the relative price of currencies are determined purely by force of demand and supply and when the authorities make no attempt to hold the exchange rate at any particular level within a specific band or move it in a certain direction by intervening in the exchange markets, it is referred to as Floating Exchange Rate. 7) Crawling Peg: A crawling peg rate is a hybrid of fixed and flexible exchange rate systems. Under this system, while the value of a currency is fixed in terms of a reference currency, this peg keeps on changing itself in accordance with the underlying economic fundamentals, thus letting the market forces play a role in the determination of the change in exchange rate. There are several bases which could be used to determine the direction of change in the exchange rate for example the actual exchange rate ruling the market, t there is gradual modifications with permissable variations around the parity restricted to a narrow band. The change in parity per unit period is subject to a ceiling with an additional short term constraint, e.g. parity change in a month cannot be more than 1/12 th of the yearly ceiling. Parity changes are carried out , based on a set of indicators. They may be discretionary, automatic or presumptive. The indicators are : current account deficits, changes in reserves, relative inflation rates and moving average of past spot rates. Countries such as Portugal and Brazil have in the part adopted variants of Crawling Peg. 8) Adjustable Peg: Adjustable Peg system was established which fixed the exchange rates, with the provision of changing them if the necessity rose. Under the new system, all the members of the newly set up IMF were to fix the par value of their currency either in terms of gold, or in terms of US dollar. The par value of the US dollar was fixed at $ 35 per ounce. All these values were fixed with the approval of the IMF, and were reflected in the change economic and financial scenario in the countries engaged in international trade. The member countries agreed to maintain the exchange rates for their currency within a band of one percent on either sides of the fixed par value. The extreme points were to be referred to as upper and lower support point, due to which requirement that the countries do not allow the exchange rate to go beyond these points. The monetary authorities were to stand ready to buy or sell the US dollar and thereby support the exchange rates. For this purpose, a country which would freely buy and sell gold at the aforementioned par value for the settlement of international transactions was deemed to be maintaining its exchange rate within the one percent band. 9) Special Drawing Rights(SDRs): The IMF created an asset called Special Drawing Rights by simply opening an account in the name of each member country and crediting it with a certain amount of SDRs. The total volume created has to be ratified by the gouverning board and its allocation among the members is propotional to their quotas. The members can use it for settling payments among themselves as well as for transactions with the fund. E.g. paying the reserve tranch contribution of an increase in their quotas. 10) Devaluation :
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The lowering of a countrys official exchange rate in relation to a foreign currency (or to gold) so that exports compete more favourably in the overseas markets. Devaluation is the opposite to revaluation. 11) Lerms: An acronym for liberalization Exchange Management System that was introduced from March 1, 1992 under which the rupee was made partially convertible. The objective was to encourage exporters and induce a greater inflow of remittances through proper channels as well as bring about greater efficiency in import substitution. Under the system, percent of eligible foreign exchange receipts such as exports earnings or remittances was to be converted at the market rate and the balance 40% at the official rate of exchange. Importers could obtain their requirements of foreign exchange from authorized dealers at the market rate. Because of certain weaknesses, this system was replaced by a unified exchange rate in March 1993. This unification was recommended as an important step towards full convertibility by the committee on balance of payments under the chairmanship of C Ragranajan. Under the unified rate system all foreign exchange transactions through authorized dealers out at market determined rate exchange. 12) Custom Union: Custom Union is a form of economic integration in which two or more nations agree to free all internal trade amongst themselves while levying a common external tariff on all non-member countries. The theory of custom unions and economic integration is associated primarily with the work of Prof. Jacob Viner in the 1940s. This theory mainly focuses on optimum utilization of resources present in the member countries. Integration provides the opportunity of industries that have not yet been established as well as for those that have to take advantage of economies of large scale production made possible by expanded markets. 13) Dirty float: The authorities are intervened more or less intensely in the foreign exchange market in which there are no officially declared parties, but there is official intervention that has come to be known as managed or dirty float. 14) Gold Tranche: Member countries have an absolute claim on the IMF upto the amountof gold subscriptions they have made. In operational terms, they can draw this amount (= 25% of their quota) from IMF any time. This is called reserve tranche or gold tranche and is treated as the reserve of the country concerned. However, this sum is reimbursed to the IMF within a specified period varying from 3 months to 5 years. 15) Credit Tranches : Any member can unconditionally borrow the part of its quota which it has contributed in the form of SDRs or foreign currency. When it can borrow upto 100% of its quota in four futher tranches it is called credit tranches. (Tranche means a slice) 16)International Liquidity : It refers to the stock of means of international payment 17) Extended Fund Facility (EFF):
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This facility was established in 1974 by the IMF to help countries address more protracted balance-of-payments problems with roots in the structure of the economy. Arrangements under the EFF are thus longer (3 years) and the repayment period can extend to 10 years, although repayment is expected within 4 -7 years. .DESCRIPTIVE QUESTIONS Q1. How far SDRs have been able to solve the problem of international liquidity? Ans: - As the Bretton Woods system started facing problems, and the pressure on the dollar increased, a new reserve asset named SDRs was created by IMF in 1967. This international currency was allocated to the IMF member countries in proportion of their quotas. The biggest benefit of SDRs was that there was a provision for international money to be created without any country needing to run a BoP deficit or to mine gold. Its value lay not in any backing by a currency or a real asset (like gold), but in the readiness of the IMF countries to accept it as a new form of international money. Any member country, when facing payment imbalances arising out of BoP deficits, could draw on these SDRs as long as it maintained an average balance of 30% of its total allocations. It could sell these SDRs to a surplus country in exchange for that countrys currency and use it for settlement of international payments. Every member country was obliged to accept up to 3 times its total allocations as a settlement of international payments. It was an interest bearing source of finance, i.e. countries holding their SDRs receive interest and the one drawing them pay interest. These rates were determined on the basis of the average money market interest rates prevailing in France, Germany, Japan, UK and US. Only the member countries of IMF and specific official institutions are eligible to hold SDRs. It is also an account of all IMF transactions. The value of a SDR was initially determined as equal to that of a dollar, i.e., one ounce of gold was equalized to 35 SDRs. Later, its value was revised and put equal to the weighted average value of 16 major currencies US dollar, yen, pound sterling, DM, and French Franc. Both the times the weights were based on the importance of the respective countries in world trade. An important advantage of SDRs was that its value was more stable than that of individual currencies. This happened because it derived its value from a number of currencies, whose values were unlikely to vary in the same direction and to the same extent thus making it a better unit than a single currency. However, despite the introduction of SDRs, the problem of international liquidity crisis was not solved. US gold holdings had reduced considerably and by 1979, its reserve turned negative as the BoP deficit increased drastically. There was great pressure on the US in the early 1971, because a number of countries had to buy a lot of dollars to defend their exchange rates. The condition of US worsened because it suffered from a trade deficit causing great unemployment. This problem continued for some period of time thus reducing the validity of SDRs to resolve the international liquidity crisis.
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Q.2) Discuss.
Bretton Woods System was valid as along as it lasted
Ans. Conference was held at Bretton Woods in USA in July, 1944, in order to put in place a new international monetary system. The main characteristics of the International Monetary System developed at Bretton Woods are summarized below: a) Fixed Rates in terms of gold, but only the US $ was convertible into gold as the US ensured convertibility of the dollars into gold at international level. b) A procedure for mutual international credits. c) Creation of International Monetary Fund to supervise and ensure smooth functioning of the system. Countries were expected to pursue the economic and monetary policies in a manner so that currency fluctuations remained within a permitted margin 11%. This cause meant the Central Bank of every country has to intervene to buy or sell foreign exchange, depending on the need. d) Devaluation or Revaluation of more than 5% had to be done with the permission of IMF. The Bretton Woods System lasted from 1944 to 1971. The Bretton Woods planners expected that after a brief transition (5 years) the international economy would recover and the system would enter into operation. From 1945 to 1947, the US actively pressed for implementation of the Bretton Woods system as originally conceived (US provided resources to the IMF and the World Bank and urged other countries to do likewise) By 1947, the US conclude that the Bretton Woods system was not working and that the Western system was on the verge of collapse (WWII had destroyed the European economic system, and the IMFs modest credit facilities were insufficient to deal with Europes huge needs). In 1960s the US balance of payment deficits started mounting. In 1968, convertibility of privately held Dollar into Gold was abandoned and in 1971 convertibility was completely abandoned. The US managed the international monetary system by providing liquidity: gold production was insufficient; the dollar was the only strong currency to meet the rising demands for international liquidity. The strength of the US economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of the US government to convert dollars into gold at that price made the dollar as good as gold. But there was a huge dollar shortage (the US was running trade surpluses); and in order for the system to work, it would be necessary for the US to reverse this flow and to run a payment deficit, which of course happened The primary factor for the collapse of the system was currency convertibility into Gold. This idea can be explained with the Triffins Paradox. It is said that the entire monetary system depended on the Dollar performing its role as the key currency. Countries other than the US had to accumulate dollar balances as the dollar was the means of international payments. This meant that the US had to run balance of payment deficits (Foreign Exchange Deficits) so that the other countries could build up a stock of claims on the US. As long as US deficits were moderate, this worked fine, but when they started mounting it lead to crisis of confidence viz. Other countries started losing faith in the ability of US to convert dollar into gold. Gold demands for such conversion began to be made in the early 60s by the French followed by other countries in suit. Soon it was obvious that US
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did not possess enough gold to honour its convertibility commitment if all holders of dollar assets decided to demand gold. Thus, a series of events finally led to the US abdicating its role as an anchor of the World Monetary System. Several attempts to revise the system trough a series of parity realignments, Dollar revaluation (in terms of gold) and widening the brands of permissible variations around central parties, failed thus making the Bretton Woods System totally invalid in 1978.
Q.3) What are the objectives of IMF ? How far has it achieved it ? Ans. The IMF is an international organisation consisting of 183 member countries. It was created : To promote international monetary corporation; To facilitate expansion and balanced growth of international trade; To promote exchange stability; To assist in the establishment of multilateral system of payments; To make its general resources temporarily available to its members experiencing balance of payment difficulties under adequate safeguard. To shorten the duration and lessen the degree of disequilibrium in the intenational balance of payments of members. According to the Articles of Agreement of IMF Article I, the main objectives of IMF are : To promote international monetary corporation through a permanent institution which provides machinery for consultation and collaboration on International Monetary Problems. To facilitate the expansion and balanced growth of international trade and contribute thereby to the promotion and maintenance of high levels of employment and real income to the development of the productive resources of all members as primary objectives of economic policy; To promote exchange stability to maintain orderly exchange agreement among the members and to avoid competitive exchange depreciation. To assist in the establishment of multilateral system of payments in respect of current transactions between members in the elimination of foreign exchange restrictions, which hamper the growth of world trade. To give confidence to the members by making the general resources of the fund temporarily available to them under adequate safeguard, thus providing them with opportunities to correct mal-adjustments in their balance of payment without resorting to measures destructive of national and international prosperity. In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balance of payment of members. The capital of IMF is contributed by totality of the subscription of member states known as Quotas. These Quotas are determined as per the economic importance of each country reflected / measured in terms of national income, exports etc. Since 1970 a new instrument of reserve has been created viz. SDR
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(Special Drawing Rights). The value of SDRs represent a weighted average of five currencies i.e. US $ - 40%, German Deutsche Mark 21%, U.K. pound 11%, French Francs 11% and Japanese Yen 17%. The weights reflect the relative strength of these countries. The Quotas of different countries are paid to the IMF in the ration of 25% as SDRs and 75% as in the national currency. The member countries can withdral equal amount of gold subscriptions (on 25% of the Quota) under the Gold Tranch System. Beyond 25% a country can draw upon its Credit Tranch. Approval from the IMF is necessary for a country to draw on its Credit Tranch . Temporary increase of Credit Tranch to 400% of the Quota has been allowed against the statutory 200% of the Quota. The approval becomes strict as the drawings on the credit rise. This tentional credit is used by the borrowing countries to finance their temporary disequilibrium in balance of payments. Besides these Tranches, the IMF has three permanent credit facilities : 1. Compensatory Financing : Compensatory Financing facility established in 1963 was available when temporary export shortfall existed for reasons beyong members control. 2. Buffer Stock Financing Facility : This facility was established in 1969 which was available when an International Buffer Stock of funds excepted as suitable fund exists. 3. Extended Facility : It was established in 1974 and was available to overcome structural balance of payment maladjustments. There are other temporary facilities created in response to specific needs such as oil price increase and special emergency funds credited under General Agreement to Borow (GAB). The IMF has increasingly become the lender of last resort for countries, especially in Africa, with desperate difficulties of external insolvency, extreme poverty, and adjustment. The IMF's role has as a consequence increasingly overlapped with the World Bank's International Development Association (IDA). It is to the credit of the IMF that it has managed to transform itself from an intimidating ogre to a welcome source of concessional assistance. The Fund has a valuable role in financing developing countries, a role that has been strengthened by the Enhanced Structural Adjustment Facility (ESAF), which lends on highly concessional terms to low-income countries. However it was not able to provide oversight of the international monetary system as a whole, but only to its most indigent members. Q4). Examine the transformation of the European Union from a political and economic union to a monetary union. Ans: - The basis of the European Monetary Union was to build a united Europe after the World War II. This was initiated by when the European nations created the European Coal and Steel community, with a view to freeing trade in these two sectors. The pricing policies and commercial practices of the member nations of this community were regulated by a supranational agency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxemburg and the Netherlands to form the European Economic Community (EEC), whereby they agreed to make Europe a common market. While they agreed to lift restrictions on movements of all factors of production and to harmonize domestic policies, the
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ultimate aim was economic integration. The EEC achieved the status of a customs union by 1968. In the same year, it adopted a Common Agricultural Policy (CAP), under which uniform prices were set for farm products in the member countries, and levies were imposed on imports from non- member countries to protect the regional industry from lower external prices. In the European unification, power was given to all member countries that they could veto any decision taken by other members. This hindrance was removed when the members approved of the Single European Act, in 1986, making it possible for a lot of proposals to be passed by weighted majority voting. This paved way for the unifications of the markets for capital and labour, which converted EEC practically into a market on January 1, 1993. The Heads of State and governments of the countries of the EU decided at Maastricht on 9th and 10th December 1991 to put in place the European Monetary Union (EMU). Adhering to the EMU meant irrevocable fixed exchange rates between different countries of the Union. The setting up of the EMU had been a step forward towards the introduction of a common currency in the member states of EU, as per the Maastricht Treaty. It had been ratified by all 12 countries which constituted the union at that point of time. The EMU completed the mechanism that started with the Customs Union of the Treaty of Rome and the big Common Market of the Single Act. The objectives of the EMU are: Adoption of an economic policy, based on a close coordination between economic policies of the member states. Fixing of irrevocable exchange rates leading to a single currency. Development of a single monetary policy having objective of price stability and the support to the economic policies of the member states in general. The primary advantage of EMU was that it helped in stabilizing exchange rates in the currencies of member states. It also helped in elimination of transaction costs, greater transparency in prices and greater credibility with respect to the world outside. Also, EMU signified giving up a independent national monetary policy. There seemed to be an agreement among the member states that the effect of the EMS would be beneficial for the economic growth of Europe. However it was anticipated there would be some problems in short and medium term. For instance, the programmes of structural adjustment carried out by the countries like Italy, Spain, Germany to reduce public deficits and inflation by a restrictive policy had negative effects on internal demand and growth. This policy also had negative effects on neighboring countries in terms of reduction of their international business. The countries which had not attained a required level of economic convergence found it difficult for maintaining the currency within the EMS. Thus the transformation of the European Union from a political and economic union to a monetary union has explained above along with the features of the EMU. A REPORT ON BALANCE OF PAYMENTS CONCEPT QUESTIONS
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BALANCE OF PAYMENTS The balance of payments of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world. It presents a classified record of all receipts on account of goods exported, services rendered and capital received by residents and payments made by theme on account of goods imported and services received from the capital transferred to non-residents or foreigners. - Reserve Bank of India The above definition can be summed up as following: - Balance of Payments is the summary of all the transactions between the residents of one country and rest of the world for a given period of time, usually one year. The definition given by RBI needs to be clarified further for the following points: A. Economic Transactions An economic transaction is an exchange of value, typically an act in which there is transfer of title to an economic good the rendering of an economic service, or the transfer of title to assets from one economic agent (individual, business, government, etc) to another. An international economic transaction evidently involves such transfer of title or rendering of service from residents of one country to another. Such a transfer may be a requited transfer (the transferee gives something of an economic value to the transferor in return) or an unrequited transfer (a unilateral gift). The following are the basic types of economic transactions that can be easily identified: 1. Purchase or sale of goods or services with a financial quid pro quo cash or a promise to pay. [One real and one financial transfer]. 2. Purchase or sale of goods or services in return for goods or services or a barter transaction. [Two real transfers]. 3. An exchange of financial items e.g. purchase of foreign securities with payment in cash or by a cheque drawn on a foreign deposit. [Two financial transfers]. 4. A unilateral gift in kind [One real transfer]. 5. A unilateral financial gift. [One financial transfer]. B. Resident The term resident is not identical with citizen though normally there is a substantial overlap. As regards individuals, residents are those individuals whose general centre of interest can be said to rest in the given economy. They consume goods and services; participate in economic activity within the territory of the country on other than temporary basis. This definition may turnout to be ambiguous in some cases. The Balance of Payments Manual published by the International Monetary Fund provides a set of rules to resolve such ambiguities. As regards non-individuals, a set of conventions have been evolved. E.g. government and non profit bodies serving resident individuals are residents of respective countries, for enterprises, the rules are somewhat complex, particularly to those concerning unincorporated branches of foreign multinationals. According to IMF rules these are considered to be residents of countries in which they operate, although they are not a separate legal entity from the parent located abroad.
International organisations like the UN, the World Bank, and the IMF are not considered to be residents of any national economy although their offices are located within the territories of any number of countries. To certain economists, the term BOP seems to be somewhat obscure. Yeager, for example, draws attention to the word payments in the term BOP; this gives a false impression that the set of BOP accounts records items that involve only payments. The truth is that the BOP statements records both payments and receipts by a country. It is, as Yeager says, more appropriate to regard the BOP as a balance of international transactions by a country. Similarly the word balance in the term BOP does not imply that a situation of comfortable equilibrium; it means that it is a balance sheet of receipts and payments having an accounting balance. Like other accounts, the BOP records each transaction as either a plus or a minus. The general rule in BOP accounting is the following:a) If a transaction earns foreign currency for the nation, it is a credit and is recorded as a plus item. b) If a transaction involves spending of foreign currency it is a debit and is recorded as a negative item. The BOP is a double entry accounting statement based on rules of debit and credit similar to those of business accounting & book-keeping, since it records both transactions and the money flows associated with those transactions. Also in case of statistical discrepancy the difference amount is adjusted with errors and omissions account and thus in accounting sense the BOP statement always balances. The various components of a BOP statement are: A. Current Account B. Capital Account C. IMF D. SDR Allocation E. Errors & Omissions F. Reserves and Monetary Gold BALANCE OF TRADE Balance of trade may be defined as the difference between the value of goods and services sold to foreigners by the residents and firms of the home country and the value of goods and services purchased by them from foreigners. In other words, the difference between the value of goods and services exported and imported by a country is the measure of balance of trade. If two sums (1) value of exports of goods and services and (2) value of imports of goods and services are exactly equal to each other, we say that there is balance of trade equilibrium or balance; if the former exceeds the latter, we say that there is a balance of trade surplus; and if the later exceeds the former, then we describe the situation as one of balance of trade deficit. Surplus is regarded as favourable while deficit is regarded as unfavourable. The above mentioned definition has been given by James. E. Meade a Nobel Prize British Economist. However, some economists define balance of trade as a difference between the value of merchandise (goods) exports and the value of
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merchandise imports, making it the same as the Goods Balance or the Balance of Merchandise Trade. There is n doubt that the balance of merchandise trade is of great significance to exporting countries, but still the BOT as defined by J. E. Meade has greater significance. Regardless of which idea is adopted, one thing is certain i.e. that balance of trade is a national injection and hence it is appropriate to regard an active balance (an excess of credits over debits) as a desirable state of affairs. Should this then be taken to imply that a passive trade balance (an excess of debits over credits) is necessarily a sign of undesirable state of affairs in a country? The answer is no. Because, take for example, the case of a developing country, which might be importing vast quantities of capital goods and technology to build a strong agricultural or industrial base. Such a country in the course of doing that might be forced to experience passive or adverse balance of trade and such a situation of passive balance of trade cannot be described as one of undesirable state of affairs. This would therefore again suggest that before drawing meaningful inferences as to whether passive trade balances of a country are desirable or undesirable, we must also know the composition of imports which are causing the conditions of adverse trade balance. BALANCE OF CURRENT ACCOUNT BOP on current account refers to the inclusion of three balances of namely Merchandise balance, Services balance and Unilateral Transfer balance. In other words it reflects the net flow of goods, services and unilateral transfers (gifts). The net value of the balances of visible trade and of invisible trade and of unilateral transfers defines the balance on current account. BOP on current account is also referred to as Net Foreign Investment because the sum represents the contribution of Foreign Trade to GNP. Thus the BOP on current account includes imports and exports of merchandise (trade balances), military transactions and service transactions (invisibles). The service account includes investment income (interests and dividends), tourism, financial charges (banking and insurances) and transportation expenses (shipping and air travel). Unilateral transfers include pensions, remittances and other transfers for which no specific services are rendered. It is also worth remembering that BOP on current account covers all the receipts on account of earnings (or opposed to borrowings) and all the payments arising out of spending (as opposed to lending). There is no reverse flow entailed in the BOP on current account transactions. BASIC BALANCE The basic balance was regarded as the best indicator of the economys position vis--vis other countries in the 1950s and the 1960s. It is defined as the sum of the BOP on current account and the net balance on long term capital, which were considered as the most stable elements in the balance of payments. A worsening of the basic balance [an increase in a deficit or a reduction in a surplus or even a move from the surplus to deficit] was seen as an indication of deterioration in the [relative] state of the economy. The short term capital account balance is not included in the basic balance. This is perhaps for two main reasons:
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a) Short term capital movements unlike long term capital movements are relatively volatile and unpredictable. They move in and out of the country in a period of less than a year or even sooner than that. It would therefore be improper to treat short term capital movements on the same footing as current account BOP transactions which are extremely durable in nature. Long term capital flows are relatively more durable and therefore they qualify to be treated along side the current account transactions to constitute basic balance. b) In many cases, countries dont have a separate short term capital account as they constitute a part of the Errors and Omissions Account. A deficit on the basic balance could come about in various ways, which are not mutually equivalent. E.g. suppose that the basic balance is in deficit because a current account deficit is accompanied by a deficit on the long term capital account. The long term capital outflow will, in the future, generate profits, dividends and interest payments which will improve the current account and so, ceteris paribus, will reduce or perhaps reduce the deficit. On the other hand, a basic balance surplus consisting of a deficit on current account that is more than covered by long term borrowings from abroad may lead to problems in future, when profits, dividends etc are paid to foreign investors. THE OFFICIAL SETTLEMENT CONCEPT An alternative approach for indicating, a deficit or surplus in the BOP is to consider the net monetary transfer that has been made by the monetary authorities is positive or negative, which is the so called settlement concept. If the net transfer is negative (i.e. there is an outflow) then the BOP is said to be in deficit, but if there is an inflow then it is surplus. The basic premise is that the monetary authorities are the ultimate financers of any deficit in the balance of payments (or the recipients of any surplus). These official settlements are thus seemed as the accommodating item, all other being autonomous. The monetary authorities may finance a deficit by depleting their reserves of foreign currencies, by borrowing from the IMF or by borrowing from other foreign monetary authorities. The later source is of particular importance when other monetary authorities hold the domestic currency as a part of their own reserves. A country whose currency is used as a reserve currency (such as the dollars of US) may be able to run a deficit in its balance of payments without either depleting its own reserves or borrowing from the IMF since the foreign authorities might be ready to purchase that currency and add it to its own reserves. The settlements approach is more relevant under a system of pegged exchange rates than when the exchange rates are floating. THE CAPITAL ACCOUNT The capital account records all international transactions that involve a resident of the country concerned changing either his assets with or his liabilities to a resident of another country. Transactions in the capital account reflect a change in a stock either assets or liabilities. It is often useful to make distinctions between various forms of capital account transactions. The basic distinctions are between private and official transactions, between portfolio and direct investment and by the term of the investment (i.e. short or long term). The distinction between private and official transaction is fairly
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transparent, and need not concern us too much, except for noting that the bulk of foreign investment is private. Direct investment is the act of purchasing an asset and the same time acquiring control of it (other than the ability to re-sell it). The acquisition of a firm resident in one country by a firm resident in another is an example of such a transaction, as is the transfer of funds from the parent company in order that the subsidiary company may itself acquire assets in its own country. Such business transactions form the major part of private direct investment in other countries, multinational corporations being especially important. There are of course some examples of such transactions by individuals, the most obvious being the purchase of the second home in another country. Portfolio investment by contrast is the acquisition of an asset that does not give the purchaser control. An obvious example is the purchase of shares in a foreign company or of bonds issued by a foreign government. Loans made to foreign firms or governments come into the same broad category. Such portfolio investment is often distinguished by the period of the loan (short, medium or long are conventional distinctions, although in many cases only the short and long categories are used). The distinction between short term and long term investment is often confusing, but usually relates to the specification of the asset rather than to the length of time of which it is held. For example, a firm or individual that holds a bank account with another country and increases its balance in that account will be engaging in short term investment, even if its intention is to keep that money in that account for many years. On the other hand, an individual buying a long term government bond in another country will be making a long term investment, even if that bond has only one month to go before the maturity. Portfolio investments may also be identified as either private or official, according to the sector from which they originate. The purchase of an asset in another country, whether it is direct or portfolio investment, would appear as a negative item in the capital account for the purchasing firms country, and as a positive item in the capital account for the other country. That capital outflows appear as a negative item in a countrys balance of payments, and capital inflows as positive items, often causes confusions. One way of avoiding this is to consider that direction in which the payment would go (if made directly). The purchase of a foreign asset would then involve the transfer of money to the foreign country, as would the purchase of an (imported) good, and so must appear as a negative item in the balance of payments of the purchasers country (and as a positive item in the accounts of the sellers country). The net value of the balances of direct and portfolio investment defines the balance on capital account. ACCOMMODATING & AUTONOMOUS CAPITAL FLOWS Economists have often found it useful to distinguish between autonomous and accommodating capital flows in the BOP. Transactions are said to Autonomous if their value is determined independently of the BOP. Accommodating capital flows on the other hand are determined by the net consequences of the autonomous items. An autonomous transaction is one undertaken for its own sake in response to the given configuration of prices, exchange rates, interest rates etc, usually in order to realise a profit or reduced costs. It does not take into account the
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situation elsewhere in the BOP. An accommodating transaction on the other hand is undertaken with the motive of settling the imbalance arising out of other transactions. An alternative nomenclature is that capital flows are above the line (autonomous) or below the line (accommodating). Obviously the sum of the accommodating and autonomous items must be zero, since all entries in the BOP account must come under one of the two headings. Whether the BOP is in surplus or deficit depends on the balance of the autonomous items. The BOP is said to be in surplus if autonomous receipts are greater than the autonomous payments and in deficit if vice a versa. Essentially the distinction between both the capital flow lies in the motives underlying a transaction, which are almost impossible to determine. We cannot attach the labels to particular groups of items in the BOP accounts without giving the matter some thought. For example a short term capital movement could be a reaction to difference in interest rates between two countries. If those interest rates are largely determined by influences other than the BOP, then such a transaction should be labelled as autonomous. Other short term capital movements may occur as a part of the financing of a transaction that is itself autonomous (say, the export of some good), and as such should be classified as accommodating. There is nevertheless a great temptation to assign the labels autonomous and accommodating to groups of item in the BOP. i.e. to assume, that the great majority of trade in goods and of long term capital movements are autonomous, and that most short term capital movements are accommodating, so that we shall not go far wrong by assigning those labels to the various components of the BOP accounts. Whether that is a reasonable approximation to the truth may depend in part on the policy regime that is in operation. For example what is an autonomous item under a system of fixed exchange rates and limited capital mobility may not be autonomous when the exchange rates are floating and capital may move freely between countries. BALANCE OF INVISIBLE TRADE Just as a country exports goods and imports goods a country also exports and imports what are called as services (invisibles). The service account records all the service exported and imported by a country in a year. Unlike goods which are tangible or visible services are intangible. Accordingly services transactions are regarded as invisible items in the BOP. They are invisible in the sense that service receipts and payments are not recorded at the port of entry or exit as in the case with the merchandise imports and exports receipts. Except for this there is no meaningful difference between goods and services receipts and payments. Both constitute earning and spending of foreign exchange. Goods and services accounts together constitute the largest and economically the most significant components in the BOP of any country.
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Credits Current Account Merchandise Exports (Sale of Goods) Invisible Exports (Sale of Services) Transport services sold abroad Insurance services sold abroad Foreign tourist expenditure in country Other services sold abroad Incomes received on loans and investments abroad. 3. Unilateral Transfers Private remittances received from abroad Pension payments received from abroad Government grants received from abroad Capital Account Foreign long-term investments in the home country (less redemptions and repayments) Direct investments in the home country Foreign investments in domestic securities Other investments of foreigners in the home country Foreign Governments loans to the home country. Foreign short-term investments in the home country.
Debits Current Account Merchandise Imports (purchase of Goods) Invisible Imports (Purchase of Services) Transport services purchased from abroad Insurance services purchased Tourist expenditure abroad
Other services purchased from abroad Income paid on loans and investments in the home country. 3. Uni lateral Transfers a. Private remittances abroad b. Pension payments abroad
Government grants abroad. Capital Account Long-term investments abroad (less redemptions and repayments) Direct Investments abroad Investments in foreign securities Other investments abroad Government loans to foreign countries Short-term investments abroad.
The service transactions take various forms. They basically include 1) transportation, banking, and insurance receipts and payments from and to the foreign countries, 2) tourism, travel services and tourist purchases of goods and services received from foreign visitors to home country and paid out in foreign countries by home country citizens, 3) expenses of students studying abroad and receipts from foreign students studying in the home country, 4) expenses of diplomatic and military personnel stationed overseas as well as the receipts from similar personnel who are stationed in the home country and 5) interest, profits, dividends and royalties received from foreign countries and paid out to foreign countries. These items are generally termed as investment income or receipts and payments arising out of what are called as capital services. Balance of Invisible Trade is a sum of all invisible service receipts and payments in which the sum could be positive or negative or zero. A positive sum is regarded as favourable to a country and a negative sum is considered as unfavourable. The terms are descriptive as well as prescriptive.
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BALANCE OF VISIBLE TRADE Balance of visible trade is also known as balance of merchandise trade, and it covers all transactions related to movable goods where the ownership of goods changes from residents to non-residents (exports) and from non-residents to residents (imports). The valuation should be on F.O.B basis so that international freight and insurance are treated as distinct services and not merged with the value of goods themselves. Exports valued on F.O.B basis are the credit entries. Data for these items are obtained from the various forms that the exporters have fill and submit to the designated authorities. Imports valued at C.I.F are the debit entries. Valuation at C.I.F. though inappropriate, is a forced choice due to data inadequacies. The difference between the total of debits and credits appears in the Net column. This is the Balance of Visible Trade. In visible trade if the receipts from exports of goods happen to be equal to the payments for the imports of goods, we describe the situation as one of zero goods balance. Otherwise there would be either a positive or negative goods balance, depending on whether we have receipts exceeding payments (positive) or payments exceeding receipts (negative). ERRORS AND OMISSIONS Errors and omissions is a statistical residue. It is used to balance the statement because in practice it is not possible to have complete and accurate data for reported items and because these cannot, therefore, ordinarily have equal entries for debits and credits. The entry for net errors and omissions often reflects unreported flows of private capital, although the conclusions that can be drawn from them vary a great deal from country to country, and even in the same country from time to time, depending on the reliability of the reported information. Developing countries, in particular, usually experience great difficulty in providing reliable information. Errors and omissions (or the balancing item) reflect the difficulties involved in recording accurately, if at all, a wide variety of transactions that occur within a given period of (usually 12 months). In some cases there is such large number of transactions that a sample is taken rather than recording each transaction, with the inevitable errors that occur when samples are used. In others problems may arise when one or other of the parts of a transaction takes more than one year: for example wit a large export contract covering several years some payment may be received by the exporter before any deliveries are made, but the last payment will not made until the contract has been completed. Dishonesty may also play a part, as when goods are smuggled, in which case the merchandise side of the transaction is unreported although payment will be made somehow and will be reflected somewhere in the accounts. Similarly the desire to avoid taxes may lead to under-reporting of some items in order to reduce tax liabilities. Finally, there are changes in the reserves of the country whose balance of payments we are considering, and changes in that part of the reserves of other countries that is held in the country concerned. Reserves are held in three forms: in foreign currency, usually but always the US dollar, as gold, and as Special Deposit Receipts (SDRs) borrowed from the IMF. Note that reserves do not have to be held within the country. Indeed most countries hold a proportion of their reserves in accounts with foreign central banks. The changes in the countrys reserves must of course reflect the net value of all the other recorded items in the balance of payments. These changes will of course
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be recorded accurately, and it is the discrepancy between the changes in reserves and the net value of the other record items that allows us to identify the errors and omissions. UNILATERAL TRANSFERS Unilateral transfers or unrequited receipts, are receipts which the residents of a country receive for free, without having to make any present or future payments in return. Receipts from abroad are entered as positive items, payments abroad as negative items. Thus the unilateral transfer account includes all gifts, grants and reparation receipts and payments to foreign countries. Unilateral transfer consist of two types of transfers: (a) government transfers (b) private transfers. Foreign economic aid or assistance and foreign military aid or assistance received by the home countrys government (or given by the home government to foreign governments) constitutes government to government transfers. The United States foreign aid to India, for BOP 9but a debit item in the US BOP). These are government to government donations or gifts. There no well worked out theory to explain the behaviour of this account because these flows depend upon political and institutional factors. The government donations (or aid or assistance) given to government of other countries is mixed bag given for either economic or political or humanitarian reasons. Private transfers, on the other hand, are funds received from or remitted to foreign countries on person to person basis. A Malaysian settled in the United States remitting $100 a month to his aged parents in Malaysia is a unilateral transfer inflow item in the Malaysian BOP. An American pensioner who is settled after retirement in say Italy and who is receiving monthly pension from America is also a private unilateral transfer causing a debit flow in the American BOP but a credit flow in the Italian BOP. Countries that attract retired people from other nations may therefore expect to receive an influx of foreign receipts in the form of pension payments. And countries which render foreign economic assistance on a massive scale can expect huge deficits in their unilateral transfer account. Unilateral transfer receipts and payments are also called unrequited transfers because as the name itself suggests the flow is only in one direction with no automatic reverse flow in the other direction. There is no repayment obligation attached to these transfers because they are not borrowings and lendings but gifts and grants exchanged between government and people in one country with the governments and peoples in the rest of the world. ILLUSTRATE THE ITEMS WHICH FALL UNDER CAPITAL ACCOUNT AND CURRENT ACCOUNT WITH EXAMPLES. CAPITAL ACCOUNT CONVERTIBILITY (CAC) While there is no formal definition of Capital Account Convertibility, the committee under the chairmanship of S.S. Tarapore has recommended a pragmatic working definition of CAC. Accordingly CAC refers to the freedom to convert local financial assets into foreign financial assets and vice a versa at market determined rates of exchange. It is associated with changes of ownership in foreign / domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC is coexistent with restrictions other than on external payments. It also does not preclude the imposition of monetary / fiscal measures relating to foreign exchange transactions, which are of prudential nature. Following are the prerequisites for CAC: 1. Maintenance of domestic economic stability.
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2. Adequate foreign exchange reserves. 3. Restrictions on inessential imports as long as the foreign exchange position is not very comfortable. 4. Comfortable current account position. 5. An appropriate industrial policy and a conducive investment climate. 6. An outward oriented development strategy and sufficient incentives for export growth. DESCRIPTIVE QUESTIONS DISCUSS THE RELEVANCE / IMPORTANCE OF THE BOP STATEMENTS? BOP statistics are regularly compiled, published and are continuously monitored by companies, banks and government agencies. A set of BOP accounts is useful in the same way as a motion picture camera. The accounts do not tell us what is good or bad, nor do they tell us what is causing what. But they do let us see what is happening so that we can reach our own conclusions. Below are 3 instances where the information provided by BOP accounting is very necessary: 1. Judging the stability of a floating exchange rate system is easier with BOP as the record of exchanges that take place between nations help track the accumulation of currencies in the hands of those individuals more willing to hold on to them. 2. Judging the stability of a fixed exchange rate system is also easier with the same record of international exchange. These exchanges again show the extent to which a currency is accumulating in foreign hands, raising questions about the ease of defending the fixed exchange rate in a future crisis. 3. To spot whether it is becoming more difficult for debtor counties to repay foreign creditors, one needs a set of accounts that shows the accumulation of debts, the repayment of interest and principal and the countries ability to earn foreign exchange for future repayment. A set of BOP accounts supplies this information. This point is further elaborated below. The BOP statement contains useful information for financial decision makers. In the short run, BOP deficit or surpluses may have an immediate impact on the exchange rate. Basically, BOP records all transactions that create demand for and supply of a currency. When exchange rates are market determined, BOP figures indicate excess demand or supply for the currency and the possible impact on the exchange rate. Taken in conjunction with recent past data, they may conform or indicate a reversal of perceived trends. They also signal a policy shift on the part of the monetary authorities of the country unilaterally or in concert with its trading partners. For instance, a country facing a current account deficit may raise interest to attract short term capital inflows to prevent depreciation of its currency. Countries suffering from chronic deficits may find their credit ratings being downgraded because the markets interpret the data as evidence that the country may have difficulties its debt. BOP accounts are intimately with the overall saving investment balance in a countrys national accounts. Continuing deficits or surpluses may lead to fiscal and monetary actions designed to correct the imbalance which in turn will affect exchange rates and interest rates in the country. In nutshell corporate finance managers must monitor the BOP data being put out by government agencies on a regular basis because they have both short term and long term implications for a host of economic and financial variables affecting the fortunes of the company.
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IN THE ACCOUNTING SENSE THE BOP ALWAYS BALANCES! The BOP is a double entry accounting statement based on rules of debit and credit similar to those of business accounting & book-keeping, since it records both transactions and the money flows associated with those transactions. For instance, exports (like sales of a business) are credits, and imports (like the purchases of a business) are debits. As in business accounting the BOP records increases in assets (direct investment abroad) and decreases in liabilities (repayment of debt) as debits, and decreases in assets (sale of foreign securities) and increases in liabilities (the utilisation of foreign goods) as credits. An elementary rule that may assist in understanding these conventions is that in such transactions it is the movement of a document, not of the money that is recorded. An investment made abroad involves the import of a documentary acknowledgement of the investment, it is therefore a debit. The BOP has one important category that has no counter part or at least no significant counter part in business accounting, i.e. international gifts and grants and other so called transfer payments. In general credits may be conceived as receipts and debits as payments. However this is not always possible. In particular the change in a countrys international reserves in gold and foreign exchange is treated as a debit if it is an increase and a credit if it is a decrease. The procedure is to offset changes in reserves against changes in the other items in the table so that the grand total is always zero, (except for errors and omissions). A transaction entering the BOP usually has two aspects and invariably gives rise to two entries, one a debit and the other a credit. Often the two aspects fall in different categories. For instance, an export against cash payment may result in an increase in the exporting countrys official foreign exchange holdings. Such a transaction is entered in the BOP as a credit for exports and as a debit for the capital account. Both aspects of a transaction may sometimes be appropriate to the same account. For instance the purchase of a foreign security may have as its counter part reduction in official foreign exchange holdings. Thus it is clear that if we record all the entries in BOP in a proper way, debits and credits will always be equal. So that in accounting sense the BOP will be in balance. DETAILED OUTLINE OF THE BOP STATEMENT & SUB ACCOUNTS Balance of Payments is the summary of all the transactions between the residents of one country and rest of the world for a given period of time, usually one year. A BOP statement (revised) includes the following sub accounts, as shown in the table below. Items Credits Debits Net G. Current Account 1. Merchandise a. Private b. Government 2. Invisibles a. Travel b. Transportation c. Insurance d. Investment Income e. Government (not included elsewhere) f. Miscellaneous
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3. Transfer Payments a. Official b. Private Total Current Account (1+2+3) H. Capital Account 2. Private a. Long Term b. Short Term 3. Banking 4. Official a. Loans b. Amortisation c. Miscellaneous Total Capital Account (1+2+3) I. J. K. L. IMF SDR Allocation Capital Account, IMF & SDR Allocation (B+C+D) Total Current Account, Capital Account, IMF & SDR Allocation (A+E)
M. Errors & Omissions N. Reserves and Monetary Gold Current Account The current account includes all transactions which give rise to or use up national income. The current account consists of two major items, namely, (a) merchandise export and imports and (b) invisible imports and exports. Merchandise exports i.e. sale of goods abroad, are credit entries because all transactions giving rise to monetary claims on foreigners represent credits. On the other hand, merchandise imports, i.e. purchase of goods abroad, are debit entries because all transactions giving rise to foreign money claims on the home country represent debits. Merchandise exports and imports form the most important international transactions of most of the countries. Invisible exports i.e. sale of services, are credit entries and invisible imports i.e. purchase of services are debit entries. Important invisible exports include sale abroad of services like insurance and transport etc. while important invisible imports are foreign tourist expenditures in the home country and income received on loans and investment abroad (interests or dividends). Transfers payments refer to unrequited receipts or unrequited payments which may be in cash or in kind and are divided into official and private transactions. Private transfer payments cover such transactions as charitable contributions and remittances to relatives in other countries. The main component of government transfer payments is economic aid in the form of grants. Capital Account The capital account separates the non monetary sector from the monetary one, that is to say, the trading or ordinary private business element in the economy together with the ordinary institutions of central or local government, from the
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central bank and the commercial bank, which are directly involved in framing or implementing monetary policies. The capital account consists of long term and short term capital transactions. Capital outflow represents debit and capital inflow represent credit. For instance, if an American firm invests rupees 100 million in India, this transaction will be represented as a debit in the US BOP and a credit in the BOP of India. Other Accounts The IMF account contains purchases (credits) and repurchases (debits) from the IMF. SDRs Special Drawing Rights are a reserve asset created by the IMF and allocated from time to time to member countries. Within certain limitations it can be used to settle international payments between monetary authorities of member countries. An allocation is a credit while retirement is a debit. The Reserve and Monetary Gold account records increases (debits) and decreases (credits) in reserve assets. Reserve assets consist of RBIs holdings of gold and foreign exchange (in the form of balances with foreign central banks and investment in foreign government securities) and governments holding of SDRs. Errors and Omissions is a statistical residue. Errors and omissions (or the balancing item) reflect the difficulties involved in recording accurately, if at all, a wide variety of transactions that occur within a given period of (usually 12 months). It is used to balance the statement because in practice it is not possible to have complete and accurate data for reported items and because these cannot, therefore, ordinarily have equal entries for debits and credits.
HOW WILL YOU IDENTIFY A DEFICIT OR SURPLUS IN BALANCE OF PAYMENTS? / MEANING OF DEFICIT AND SURPLUS IN THE BALANCE OF PAYMENTS. If the balance of payment is a double entry accounting record, then apart from errors and omissions, it must always balance. Obviously, the terms deficit or surplus cannot refer to the entire BOP but must indicate imbalance on a subset of accounts included in the BOP. The imbalance must be interpreted in some sense as an economic disequilibrium. Since the notion of disequilibrium is usually associated within a situation that calls for policy intervention of some sort, it is important to decide what is the optimal way of grouping the various accounts within the BOIP so that an imbalance in one set of accounts will give the appropriate signals to the policy makers. In the language of an accountant e divide the entire BOP into a set of accounts above the line and another set below the line. If the net balance (credits-debits) is positive above the line we will say that there is a balance of payments surplus; if it is negative e will say there is a balance of payments deficit. The net balance below the line should be equal in magnitude and opposite in sign to the net balance above the line. The items below the line can be said to be a compensatory nature they finance or settle the imbalance above the line. The critical question is how to make this division so that BOP statistics, in particular the deficit and surplus figures, will be economically meaningful. Suggestions made by economist and incorporated into the IMF guidelines emphasis the purpose or motive a transaction, as a criterion to decide whether a
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transaction should go above or below the line. The principle distinction between autonomous transaction and accommodating or compensatory transactions. Transactions are said to Autonomous if their value is determined independently of the BOP. Accommodating capital flows on the other hand are determined by the net consequences of the autonomous items. An autonomous transaction is one undertaken for its own sake in response to the given configuration of prices, exchange rates, interest rates etc, usually in order to realise a profit or reduced costs. It does not take into account the situation elsewhere in the BOP. An accommodating transaction on the other hand is undertaken with the motive of settling the imbalance arising out of other transactions. An alternative nomenclature is that capital flows are above the line (autonomous) or below the line (accommodating). The terms balance of payments deficit and balance of payments surplus will then be understood to mean deficit or surplus on all autonomous transactions taken together. The other measures of identifying a deficit or surplus in the BOP statement are: Deficit or Surplus in the Current Account and/or Trade Account. The Basic Balance which shows the relative deficit or surplus in the BOP. A DEFICIT IN THE BASIC BALANCE IS DESIRABLE OR UNDESIRABLE! The basic balance was regarded as the best indicator of the economys position vis--vis other countries in the 1950s and the 1960s. It is defined as the sum of the BOP on current account and the net balance on long term capital, which were considered as the most stable elements in the balance of payments. A worsening of the basic balance [an increase in a deficit or a reduction in a surplus or even a move from the surplus to deficit] is seen as an indication of deterioration in the [relative] state of the economy. Thus it is very much evident that a deficit in the basic balance is a clear indicator of worsening of the state of the countrys BOP position, and thus can be said to be undesirable at the very outset. However, on further thoughts, a deficit in the basic balance can also be understood to be desirable. This can be explained as follows: A deficit on the basic balance could come about in various ways, which are not mutually equivalent. E.g. suppose that the basic balance is in deficit because a current account deficit is accompanied by a deficit on the long term capital account. This deficit in long term capital account could be clearly observed in a developing countrys which might be investing heavily on capital goods for advancement on the agricultural and industrial fields. This long term capital outflow will, in the future, generate profits, dividends and interest payments which will improve the current account and so, ceteris paribus, will reduce or perhaps reduce the deficit. Thus a deficit in basic balance can be desirable as well as undesirable, as it clearly depends upon what is leading to a deficit in the long term capital account. SHORT NOTES BALANCE OF PAYMENTS (Refer to Concept Questions) CURRENT ACCOUNT
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The current account records exports and imports unilateral transfers. Exports whether of goods or entered as positive items in the account. Imports negative items. Exports are normally calculated f.o.b insurance etc are not included whereas imports are transportation, insurance cost etc are included.
of goods and services and services are by convention accordingly are entered as i.e. cost from transportation, normally calculated c.i.f. i.e.
In many cases the payment for imports and exports will result in transfer of money between the trading countries. For example a UK firm importing a good from US may settle its debt by instructing its UK bank to make a payment to the US account of the exporter. This is not necessarily the case however. If the UK firm holds a bank account in the US, then it may make payment to the US exporter from that account. In the former case the financial side of the transaction will appear in the UK BOP account as part of the net change in UK foreign currency reserves. In the later it will appear as the part of the capital account since the UK firm has reduced its claims on the US bank. BOP accounts usually differentiate between trades in goods and trade in services. The balance of imports and exports of the former is referred to in the UK accounts as the balance of visible trade in other countries it may be referred to as the balance of merchandise trade, or simply as the balance of trade. The net balance of exports and imports of services is called the balance of invisible trade in the UK statistics. Invisible trade is a much more heterogeneous category than is visible trade. It helps in distinguishing between factor and non-factor services. Trade in the later of which shipping, banking and insurance services and payments by residents as tourists abroad are usually the most important, is in economic terms little different from trade in goods. That is, exports and imports are flows of outputs whose values will be determined by the same variables that would affect the demand and supply for goods. Factors services, which consist in the main of interest, profits and dividends, are on the other hand payments for inputs. Exports and imports of such services will depend in large part on the accumulated stock of past investment in and borrowing from foreign residents. Unilateral transfer forms a major part of the current account. It refers to unrequited receipts or unrequited payments which may be in cash or in kind and are divided into official and private transactions. Unilateral transfers or unrequited receipts, are receipts which the residents of a country receive for free, without having to make any present or future payments in return. Receipts from abroad are entered as positive items, payments abroad as negative items. The net value of the balances of visible trade and of invisible trade and of unilateral transfers defines the balance on current account. CAPITAL ACCOUNT (Refer to Concept Questions) OFFICIAL RESERVES ACCOUNT Official reserve account forms a special feature of the capital account. This account records the changes in the part of the reserves of other countries that is held in the country concerned. These reserves are held in three forms: in foreign currency, usually but not always the US dollars, as gold, and as
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Special Deposit Receipts (SDRs) borrowed from the IMF. Note that the reserves do not have to be held by the country. Indeed most of the countries hold a proportion of the reserves in accounts with foreign central banks. The IMF account contains purchases (credits) and repurchases (debits) from the IMF. SDRs Special Drawing Rights are a reserve asset created by the IMF and allocated from time to time to member countries. Within certain limitations it can be used to settle international payments between monetary authorities of member countries. An allocation is a credit while retirement is a debit. The Reserve and Monetary Gold account records increases (debits) and decreases (credits) in reserve assets. Reserve assets consist of RBIs holdings of gold and foreign exchange (in the form of balances with foreign central banks and investment in foreign government securities) and governments holding of SDRs. The change in the reserves account measures a nations surplus or deficit on its current and capital account transactions by netting reserve liabilities from reserve assets. For example, a surplus will lead to an increase in official holdings of foreign currencies and/or gold; a deficit will normally cause a reduction in these assets. For most of the countries, there is a correlation between balance-of-payments deficits and reserve declines. A drop in reserves will occur, for instance, when a nation sells gold to acquire foreign currencies that it can use to meet the deficit in the balance of payments.
Chapter No. 7 Exposure and Risk in International Finance Concepts 1 & 2. Exposure and Risk Exposure is a measure of the sensitivity of the value of a financial item (asset, liability or cash flow) to changes in the relevant risk factor while risk is a measure of variability of the value of the item attributable to the risk factor. Let us understand this distinction clearly. April 1993 to about July 1995 the exchange rate between rupee and US dollar was almost rock steady. Consider a firm whose business involved both exports to and imports from the US. During this period the firm would have readily agreed that its operating cash flows were very sensitive to the rupee-dollar exchange rate, i.e.; it had significant exposure to this exchange rate; at the same time it would have said that it didnt perceive significant risk on this account because given the stability of the rupee-dollar fluctuations would have been perceived to be minimal. Thus, the magnitude of the risk is determined by the magnitude of the exposure and the degree of variability in the relevant risk factor. 3. Hedging: Hedging means a transaction undertaken specifically to offset some exposure arising out of the firms usual operations. In other words, a transaction that reduces the price risk of an underlying security or commodity position by making the appropriate offsetting derivative transaction. In hedging a firm tries to reduce the uncertainty of cash flows arising out of the exchange rate fluctuations. With the help of this a firm makes its cash flows certain by using the derivative markets.
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4. Speculation Speculation means a deliberate creation of a position for the express purpose of generating a profit from fluctuation in that particular market, accepting the added risk. A decision not to hedge an exposure arising out of operations is also equivalent to speculation. Opposite to hedging, in speculation a firm does not take two opposite positions in the any of the markets. They keep their positions open. 5. Call Option: A call option gives the buyer the right, but not the obligation, to buy the underlying instrument. Selling a call means that you have sold the right, but not the obligation, to someone to buy something from you. 6. Put Option: A put option gives the buyer the right, but not the obligation, to sell the underlying instrument. Selling a put means that you have sold the right, but not the obligation, to someone to sell something to you. 7. Strike Price: The predetermined price upon which the buyer and the seller of an option have agreed is the strike price, also called the exercise price or the striking price. Each option on an underlying instrument shall have multiple strike prices. 8. Currency Swaps: In a currency swap, the two payment streams being exchanged are denominated in two different currencies. Usually, an exchange of principal amount at the beginning and a re-exchange at termination are also a feature of a currency swap. A typical fixed-to-fixed currency swaps work 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 DEM. 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 getting DEM and the second party getting dollars. Subsequently, the first party makes periodic DEM payments to the second, computed as interest at a fixed rate on the DEM principal while it receives from the second party payment in dollars again computed as interest on the dollar principal. At maturity, the dollar and DEM principals are re-exchanged. A floating-to-floating currency swap will have both payments at floating rate but in different currencies. Contracts without the exchange and re-exchange do exist. In most cases, an intermediary- a swap bank- structures the deal and routes the payments from one party to another. A fixed-to-floating currency swap is a combination of a fixed-to-fixed currency swaps and a fixed-to-floating interest rate swap. Here, one payment stream is at a fixed rate in currency X while the other is at a floating rate in currency Y. 9. Futures Futures are exchanged traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/commodity in a designated future month at a price agreed upon by the buyer and seller. The contracts have certain standardized specification.
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10. Transaction Exposure This is a measure of the sensitivity of the home currency value of the assets and liabilities, which are denominated, in the foreign currency, to unanticipated changes in the exchange rates, when the assets or liabilities are liquidated. The foreign currency values of these items are contractually fixed, i.e.; do not vary with exchange rate. It is also known as contractual exposure. Some typical situations, which give rise to transactions exposure, are: (a) A currency has to be converted in order to make or receive payment for goods and services; (b)A currency has to be converted to repay a loan or make an interest payment; or (c) A currency has to be converted to make a dividend payment, royalty payment, etc. Note that in each case, the foreign value of the item is fixed; the uncertainty pertains to the home currency value. The important points to be noted are (1) transaction exposures usually have short time horizons and (2) operating cash flows are affected. 11. Translation Exposure Also called Balance Sheet Exposure, it is the exposure on assets and liabilities appearing in the balance sheet but which is not going to be liquidated in the foreseeable future. Translation risk is the related measure of variability. The key difference is the transaction and the translation exposure is that the former has impact on cash flows while the later has no direct effect on cash flows. (This is true only if there are no tax effects arising out of translation gains and losses.) Translation exposure typically arises when a parent multinational company is required to consolidate a foreign subsidiarys statements from its functional currency into the parents home currency. Thus suppose an Indian company has a UK subsidiary. At the beginning of the parents financial year the subsidiary has real estate, inventories and cash valued at, 1000000, 200000 and 150000 pound respectively. The spot rate is Rs. 52 per pound sterling by the close of the financial year these have changed to 950000 pounds, 205000 pounds and 160000 pounds respectively. However during the year there has been a drastic depreciation of pound to Rs. 47. If the parent is required to translate the subsidiarys balance sheet from pound sterling to Rupees at the current exchange rate, it has suffered a translation loss. The translation value of its assets has declined from Rs. 70200000 to Rs. 61805000. Note that no cash movement is involved since the subsidiary is not to be liquidated. Also note that there must have been a translation gain on subsidiarys liabilities, ex. Debt denominated pound sterling. 12. Contingent Exposure The principle focus is on the items which will have the impact on the cash flows of the firm and whose values are not contractually fixed in foreign currency terms. Contingent exposure has a much shorter time horizon. Typical situation giving rises to such exposures are a. An export and import deal is being negotiated and quantities and prices are yet not to be finalized. Fluctuations in the exchange rate will probably influence both and then it will be converted into transactions exposure.
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b. The firm has submitted a tender bid on an equipment supply contract. If the contract is awarded, transactions exposure will arise. c. A firm imports a product from abroad and sells it in the domestic market. Supplies from abroad are received continuously but for marketing reasons the firm publishes a home currency price list which holds good for six months while home currency revenues may be more or less certain, costs measured in home currency are exposed to currency fluctuations. In all the cases currency movements will affect future cash flows. 13. Competitive exposure Competitive exposure is the most crucial dimensions of the currency exposure. Its time horizon is longer than of transactional exposure say around three years and the focus is on the future cash flows and hence on long run survival and value of the firm. Consider a firm, which is involved in producing goods for exports and /or imports substitutes. It may also import a part of its raw materials, components etc. a change in exchange rate gives rise to no. of concerns for such a firm, example, 1. What will be the effect on sales volumes if prices are maintained? If prices are changed? Should prices be changed? For instance a firm exporting to a foreign market might benefit from reducing its foreign currency priced to foreign customers. Following an appreciation of foreign currency, a firm, which produces import substitutes, may contemplate in its domestic currency price to its domestic customers without hurting its sales. A firm supplying inputs to its customers who in turn are exporters will find that the demand for its product is sensitive to exchange rates. 2. Since a part of inputs are imported material cost will increase following a depreciation of the home currency. Even if all inputs are locally purchased, if their production requires imported inputs the firms material cost will be affected following a change in exchange rate. 3. Labour cost may also increase if cost of living increases and the wages have to be raised. 4. Interest cost on working capital may rise if in response to depreciation the authorities resort to monetary tightening. 5. Exchange rate changes are usually accompanied by if not caused by difference in inflation across countries. Domestic inflation will increase the firms material and labour cost quite independently of exchange rate changes. This will affect its competitiveness in all the markets but particularly so in markets where it is competing with firms of other countries 6. Real exchange rate changes also alter income distribution across countries. The real appreciation of the US dollar vis--vis deutsche mark implies and increases in real incomes of US residents and a fall in real incomes of Germans. For an American firm, which sells both at home, exports to Germany, the net impact depends upon the relative income elasticities in addition to any effect to relative price changes. Thus, the total impact of a real exchange rate change on a firms sales, costs and margins depends upon the response of consumers, suppliers, competitors and the government to this macroeconomic shock. In general, an exchange rate change will effect both future revenues as well as operating costs and hence exchange rates changes, relative inflation rates at
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home and abroad, extent of competition in the product and input markets, currency composition of the firms costs as compared to its competitors costs, price elasticities of export and import demand and supply and so forth.
Descriptive 1. What is currency risk? Enumerate the different types of currency risks with examples. Ans. Currency risk arises due to exposures explained in concepts 10 to 13 2. Discuss the exposure and risk occurring due to the changes in a) Interest rates b) Exchange rates Ans. a) Interest rate uncertainty exposes a firm to the following kinds of risks: 1. If the firm has borrowed on a floating rate basis, at very reset date, the rate for the following period would be set in line with the market rate. The firms future interest payments are therefore uncertain. An increase in rates will adversely affect the cash flows. 2. Consider a firm, which wants to undertake a fixed investment project. Suppose it requires foreign currency financing and is forced to borrow on a floating rate basis. Since its cost of capital is uncertain, an additional element of risk is introduced in project appraisal. 3. On the other hand, consider a firm, which has borrowed on a fixed rate basis to finance a fixed investment project. Subsequently inflation rate in the economy slows down and the market rate of interest declines. The cash flows from the project may decline as a result of the fall in the rate of inflation but the firm is logged into high cost borrowing. 4. A fund manager expects to receive a sizable inflow of funds in three months to be invested in five year interest rate will have declined thus reducing the return on his investments. 5. A bank has invested in a six-month loan at 18% and financed it by means of a three-month deposit at 16.5%. At the end of three months it must refinance its investment. If deposits rates go up in the mean while its margin will be reduced or may even turn negative. 6. A fund manager is holding a portfolio fixed income securities such as government and corporate bonds. Fluctuations in interest rates expose into two kinds of risks. The first is that the market value of his portfolio varies inversely with interest rates. This is the risk of capital gains or losses. Secondly he receives periodic interest payments on his holdings, which have to be reinvested. The return he can obtain on these reinvestments in uncertain. In each of these cases, an adverse movement in interest rates hurts the firm by either increasing the cost of borrowing or by reducing the return on investment or producing capital losses on its assets portfolio. During the early 80s investors preferences shifted towards floating rate instruments thus exposing borrowers to substantial interest rate risks. For most Indian companies the idea of interest rate risk is relatively new. In an environment of administered rates and fragmented, compartmentalized capital
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markets, neither investors nor borrowers felt the need to worry fluctuations in interest rates. With increasing resort to external commercial borrowings, Indian companies have had to recognize and learn to manage interest rate risk. Also, the Indian financial system is gradually moving in the direction of market determined interest rate risk. Also, the Indian financial system is gradually moving in the direction of market determined interest rates. During the last few years the environment has changed drastically. In particular, the steep rise in interest rates during 1995-1996 has led to the painful realization that careful management of the interest rate risk is crucial to a firms financial health. Ans. 2. b) Same as descriptive question no. 1 3. Discuss the available tools to manage risk involved due to fluctuations in exchange rates and interest rates. Ans. A firm may be able to reduce or eliminate currency exposure by means of internal and external hedging strategies. INTERNAL HEDGING STARTEGIES Invoicing A firm may be able to shift the entire risk to another party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency, but in the presence of well functioning forwards markets this will not yield any added benefit compared to a forward hedge. At times, it may diminish the firms competitive advantage if it refuses to invoice its cross-border sales in the buyers currency. In the following cases invoicing is used as a means of hedging: 1. Trade between developed countries in manufactured products is generally invoiced in the exporters currency. 2. Trade in primary products and capital assets are generally invoiced in a major vehicle currency such as the US dollar. 3. Trade between a developed and a less developed country tends to be invoiced in the developed countrys currency. 4. If a country has a higher and more volatile inflation rate than its trading partners, there is a tendency not to use that countrys currency in trade invoicing. Another hedging tool in this context is the use of currency cocktails for invoicing. Thus for instance, British importer of fertilizer from Germany can negotiate with the supplier that the invoice is partly in DEM & partly in Sterling. This way both the parties share exposure. Another possibility is to use one of the standard currency baskets such as the SDR or the ECU for invoicing trade transactions. Basket invoicing offers the advantage of diversification and can reduce the variance of home currency value of the payable or receivable as long as there is no perfect correlation between the constituent currencies. The risk is reduced but not eliminated. Also, there is no way by which the exposure can be hedged since there is no forward markets I these composite currencies. As a result, this technique has not become very popular. Netting and Offsetting: A firm with receivables and payables in diverse currencies can net out its exposure in each currency by matching receivables with payables. Thus a firm with exports to and imports from say Germany need not cover each transaction separately; it can use a receivable to settle all or part of a payable and take a
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hedge only for the net DEM payable or receivable. Even if the timings of the two flows do not match, it might be possible to lead or lag one of them to achieve a match. To be able to use netting effectively, the company must have continuously updated information on inter-subsidiary payments position as well as payables and receivables to outsiders. One way of ensuring efficient information gathering is to centralise cash management. Leading and lagging: Another internal way of managing transactions exposure is to shift the timing of exposures by leading or lagging payables and receivables. The general rule is lead, i.e. advance payables and lag, i.e. postpone receivables in strong currencies and, conversely, lead receivables and lag payables in weak currencies. Simply shifting the exposure in time is not enough; it has to be combined with a borrowing/lending transaction or a forward transaction to complete the hedge. Both these tools exist as a response to the existence of market imperfections. External Tools A. Using hedging for forwards market: In the normal course of business, a firm will have several contractual exposures in various currencies maturing at various dates. The net exposure in a given currency at a given date is simply the difference between the total inflows and the total outflows to be settled on that date. Thus suppose ABC Co. has the following items outstanding: Item Value Dates to maturity 1.USD receivable 800,000 60 2.NLG payable 2,000,000 90 3.USD interest payable 100,000 180 4.USD payable 200,000 60 5.USD purchased forward 300,000 60 6.USD loan installment due 250,000 60 7.NLG purchased forward 1,000,000 90 Its net exposure in USD at 60 days is: (800,000+300,000)-(200,000+250,000)=+USD 650,000 Whereas it has a net exposure in NLG of 1,000,000 at 90 days. The use of forward contracts to hedge transactions exposure at a single date is quite straightforward. A contractual net inflow of foreign currency is sold forward and a contractual net outflow is bought forward. This removes all uncertainty regarding the domestic currency value of the receivable or payable. Thus in the above example, to hedge the 60 day USD exposure, ABC Co. can sell forward USD 650,000 while for the NLG exposure it can buy NLG 1,000,000 90 day forward. What about exposures at different date? One obvious solution is to hedge each exposure separately with a forward sale or purchase contract as the case may be. Thus in the example, the firm can hedge the 60 day USD exposure with a forward sale and the 180 day USD exposure with a forward purchase. B. Hedging with the money market: Firms, which have access to international money markets for short-term borrowing as well as investment, can use the money market for hedging transactions exposure.
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E.g.: Suppose a German firm ABC has a 90 day Dutch Guilder receivable of NLG 10,000,000. It has access to Euro deposit markets in DEM as well as NLG. To cover this exposure it can execute the following sequence of transactions: 1. Borrow NLG in the euroNLG market for 90 days. 2. Convert spot to DEM. 3. Use DEM in its operations, e.g. to pay off a short-term bank loan or finance inventory. 4. When the receivable is settled, use it to pay off the NLG loan. Suppose the rates are as follows: NLG/DEM Spot: 101025/35 90day forward: 1.1045/65 EuroNLG interest rates: 5 1/4/5 EuroDEM interest rates: 4 3/4/5.00 Comparing the forward cover against the money market cover. With forward cover, each NLG sold will give an inflow of DEM (1/1.064)= DEM 0.9038, 90 days later. The present value of this (at 4.74%) is 0.9038/[1+ (0.0475/4)]= DEM 0.8931 To cover using the money market, for each NLG of receivable, borrow NLG 1/ [1+ (0.055/4)] = NLG 0.9864, sell this spot to get DEM (0.9864/1.1035) =DEM 0.8939 Pay off the NLG loan when the receivables mature. Thus the money markets cover; there is a net gain of DEM 0.0008 per NLG of receivable or DEM 8000 for the 10 million-guilder receivable. Sometimes the money market hedge may turn out to be the more economical alternative because of some constraints imposed by governments. For instance, domestic firms may not be allowed access to the Euromarket in their home currency or non-residents may not be permitted access to domestic money markets. This will lead to significant differentials between the Euromarket and domestic money market interest rates for the same currency. Since forward premia/ discounts are related to Euromarket interest differentials between two currencies, such an imperfection will present opportunities for cost saving. E.g. A Danish firm has imported computers worth $ 5 million from a US supplier. The payment is due in 180 days. The market rates are as follows: DKK/USD Spot: 5.5010/20 180 days forward: 5.4095/ 5.4110 Euro $: 9 1/2/ 9 Euro DKK: 6 1/4/ 6 Domestic DKK: 5 1/4/ 5 The Danish government has imposed a temporary ban on non-residents borrowing in the domestic money market. For each dollar of payable, forward cover involves an outflow of DKK 5.4110, 180 days from now. Instead for each dollar of payable, the firm can borrow DKK 502525 at 5.5%, acquit $ 0.9547 in the spot market and invest this at 9.50% in a Euro $ deposit to accumulate to one dollar to settle the payable. It will have to repay DKK 5.3969 [=5.2525* 1.0275], 180 days later. This represents a saving of DKK 0.0141 per dollar of payable or DKK 70,500 on the $5 million payable. From the above example it is clear that from time to time cost saving opportunities may arise either due to some market imperfection or natural market conditions, which an alert treasurer can exploit to make sizeable gains. Having decided to hedge an exposure, all available alternatives foe executing the hedge should be examined.
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C. Hedging with Currency Options: Currency options provide a more flexible means to cover transactions exposure. A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency while an inflow can be hedged by buying a put option. (Or writing a call option. This is a covered call strategy). Options are particularly useful for hedging uncertain cash flows, i.e. Cash flows those are contingent on other events. Typical situations are: a. International tenders: Foreign exchange inflows will materialise only if the bid is successful. If execution of the contract also involves purchase of materials, equipments, etc. from third countries, there are contingent foreign currency outflows too. b. Foreign currency receivables with substantial default risk or political risk, e.g. the host government of a foreign subsidiary might suddenly impose restrictions on dividend repatriation. c. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/bonds currently worth say DEM 50 million, which he is planning to liquidate in 6 months time. If he sells Dem 50 million forward and the portfolio declines in value because of a falling German stock market and rising interest rates, he will find himself to be over insured and short in DEM. E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on September 1. The market rates are as follows: DEM/GBP Spot: 2.8175/85 90-day Swap points: 60/55 September calls with a strike of 2.82 (DEM/GBP) are available for a premium of 0.20p per DEM. Evaluating the forward hedge versus purchase of call options both with reference to an open position. i. Open position: Suppose the firm decides to leave the payable unhedged. If at maturity the pound sterling/ DEM spot rate is St., the sterling value of the payable is (5,00,000) St. ii. Forward hedge: If the firm buys DEM 5,00,000 forward at the offer rate of DEM 2.8130/PS or PS0.3557/ DEM, the value of the payable is PS (5,00,000 * 0.3557)=PS 1,77,850. iii. A Call option: Instead the firm buys call options on DEM 5,00,000 for a total premium expense of PS 1000. At maturity, its cash outflow will be PS [(5,00,000)St +1025] for St<= 0.3546 and PS[5,00,000)(0.3546)+1025] = PS 178325 for St>=0.3546. Here it is assumed here that the premium expense is financed by a 90 day borrowing at 10%. D. Hedging with currency futures: Hedging contractual foreign currency flows with currency futures is in many respects similar to hedging with forward contracts. A receivable is hedged by selling futures while a payable is hedged by buying futures. A futures hedge differs from a forward hedge because of the intrinsic features of future contracts. The advantages of futures are, it easier and has greater liquidity. Banks will enter into forward contracts only with corporations (and in rare cases individuals) with the highest
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credit rating. Second, a futures hedge is much easier to unwind since there is an organized exchange with a large turnover. A firm may be able to reduce or eliminate interest rate exposure by mean of following hedging strategies. Forward rate Agreements: A FRA is an Agreement between two parties in which one of them (The seller of FRA), contracts to lend to other (Buyer), a specified amount of funds, in a specific currency, for a specific period starting at a specified future date, at an interest rate fixed at the time of agreement. A typical FRA quote from a bank might look like this: USD 6/9 months: 7.20 7.30% P.a. This is to be interpreted as follows. The bank is willing to accept a three month USD deposit starting six months from now, maturing nine months from now, at an interest rate of 7.20% P.a. (Bid Rate). The bank is willing to lend dollars for three months, starting six months from now at a interest rate of 7.30% P.a. (Ask Rate). The important thing to note is that there is no exchange of principal amount. Interest rate futures: Interest rate futures are one of the most successful financial innovations in recent years. The underlying asset is a debt instrument such as a treasury bill, a bond, and a time deposit in a bank and so on. For e.g. the International Monetary Market (a part of Chicago Mercantile Exchange) has a futures contract on US government treasury bills, three-month Eurodollar time deposits and US treasury notes and bonds. The LIFFE has contracts on Eurodollar deposits, sterling time deposits and UK government bonds. The Chicago Board of Trade offers contracts on long-term US treasury bonds. Interest rate futures are used by corporations, banks and financial institutions to hedge interest rate risk. A corporation planning to issue commercial paper for instance can use T-Bill futures to protect itself against an increase in interest rate. A corporate treasurer who expects some surplus cash in near future to be invested in short-term instruments may use the same as insurance against a fall in interest rates. A fixed income fund manager might use bond futures to protect the value of her fund against interest rate fluctuations. Speculators bet on interest rate movements or changes in the term structure in the hope of generating profits. 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 feature of this is: The Notional Principal: The fixed and floating payments are calculated 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
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payments. In a standard swap the notional principal remains constant through the life of the swap. Interest rate Options: A less conservative hedging device for interest rate exposure is interest rate options. A call option on interest rate gives the holder the right to borrow funds for a specified duration at a specified interest rate, without an obligation to do so. A put option on interest rate gives the holder the right to invest funds for a specified duration at a specified return without an obligation to do so. In both cases, the buyer of the option must pay the seller an up-front premium stated as a fraction of the face value of the contact. As interest rate cap consists of a series of call options on interest rate or a portfolio of calls. A cap protects the borrower from increase in interest rates at each reset date in a medium-to-long-term floating rate liability. Similarly, an interest rate floor is a series or portfolio of put options on interest rate, which protects a lender against fall in interest rate on rate dates of a floating rate asset. An interest rate collar is a combination of a cap and a floor. 5. Explain the importance and relevance of hedging in foreign exchange market. Ans. Foreign Exchange Market The foreign exchange market is the market in which currencies are brought and sold against each other. It is the largest market in the world. Foreign exchange market is an over the counter market. This means there is no single market place or an organized market place or an organized exchange (like a stock exchange) where traders meet and exchange currency. The traders sit in the offices (foreign exchange dealing rooms) of major commercial banks around the world and communicate with each other through telephones, telex, computer terminals and other electronic means of communication. Hedging: Hedging means a transaction undertaken specifically to offset some exposure arising out of the firms usual operations. In other words, a transaction that reduces the price risk of an underlying security or commodity position by making the appropriate offsetting derivative transaction. Different types of exposures Refer to concept questions 10 to 13. Conclusion Hence after looking at the different types of exposures, traders faces it is very clear that Hedging with the help of derivatives will ensure a safe transaction in Foreign exchange market. 6. Is it possible to hedge the foreign exchange risk in the forwards market? Ans. It is not possible to hedge forex risk fully. This is so because as long as there exists currency as a medium of exchange the person holding the currency is exposed to different types of risks e.g. political, financial, This can be explained with the help of example of an Indian exporter. If he has contracted for exports worth 1000 USD and the spot rate was 45 Rs./$ for a period of 6months with a co. in USA. He would receive his payments 6 months from now, the commercial risk involved here is with respect to the fluctuations in exchange rates. If the rates 6 months from now become 50 Rs/$ then he would
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receive 50000 USD i.e. he incurs a profit of 5000 USD and vice a versa when the value of Rs. appreciate. In above case, if we hedge our position the cash flow would be certain, but still we have Rs. i.e. a currency in our hand with which risk prevails. Here comes in the political risk i.e. even when the Indian exporter has the home currency. In case the countrys economy crashes the currency will loose all it value throughout the world. Thus, with the help of above e.g. it can be proved that as long as currency is involved we have risk. 7. Explain with an example how to cover exchange risk in the forwards market. Ans. Please refer to answer 3 (A) 8. What factors determine the value of an option? Ans. The factors are a. Maturity of an option: higher the price higher the value of an option and vice a versa b. Spot price of underlying assets: c. Strike price of underlying assets: d. Interest rate structure in the market: higher the interest rate structure in the market higher the value of an option and vice a versa e. Volatility: higher the volatility in the market higher the value of an option and vice a versa. This is so because higher the volatility in the market, higher the potential for earning more, thus the buyer of an option has to pay more premium. 9. Explain with examples how options are used to cover exchange risks? Ans. Currency options provide corporate treasurer another tool for hedging foreign exchange risks arising out of firms operations. Unlike forward contract, options allow the hedger to gain from favorable exchange rate movements, while been unprotected from unfavorable movements. However forward contracts are costless while options involve up front premium cost. a) Hedging a Foreign Currency with calls. In late February an American importer anticipates a yen payment of JYP 100 million to a Japanese supplier sometime late in May. The current USD/JYP spot is 0.007739 (which implies a JYP/USD rate of 129.22.). A June yen call option on the PHLX, with strike price of $0.0078 per yen is available for a premium of 0.0108 cents per yen or $0.000108 per yen. Each yen contract is for JPY 6.25 million. Premium per contract is therefore: $(0.000108 * 6250000) = $675. The firm decides to purchase 16 calls for a premium of $10800 .In addition there is a brokerage fee of $20 per contract. Thus the total expense in buying the option is $11,120.The firm has in effect ensured that its buying rate for yen will not exceed $0.0078+ $(11120/100,000,000)= $0.0078112 per yen. The price the firm will actually end up paying for yen depends on the spot rate at the time of payment .For further clarification the following 2 e.g. are considered: 1. Yen depreciates to $0.0075 per yen (Yen / $ 133.33) in late May when the payment becomes due .The firm will not exercise its options. It can sell 16 calls in the market provided the resale value exceeds the brokerage commission it will have to pay. (The June calls will still have some positive premium) .It buys yen in the spot market .In this case the price per yen it
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will have paid is $0.0075 + $0.0000112 - ${(Sale of value options 320) / 100000000} If the resale value of the options is less than $320, it will simply let the options lapse .In this case the effective rate will be $0.0075112 per yen or yen 133.13 per $. It would have been better to leave the payable uncovered. The forward purchase at $0.0078 would have fixed the rate at that value and would be worse than the option. 2. Yen appreciates to $0.08 Now the firm can exercise the options and procure the yen at the strike price of $0.0078.In addition, there will be transaction cost associated with the exercise. Alternatively, it can sell the option and buy the yen in the spot market. Assume that June yen calls are trading at $0.00023per yen in late May. With the latter alternative, the dollar will be $800000- $(0.00023 * 16* 6250000)+ $320= $777320. Including the premium, the effective rate the firm has paid is $(0.0077732+0.0000112) = $0.0077844. b) Hedging a receivable with a put option A German chemical firm has supplied goods worth Pound 26 million to a British customer. The payment is due in two months. The current DEM/GBP spot rate is 2.8356 and two month forward rate is 2.8050. An American put option on sterling with 3 month maturity and strike price of DEM 2.8050 is available in the inter bank market with a premium of DEM 0.03 per sterling. The firm purchases a put option on pound 26 million .The premium paid is DEM (0.03 * 26000000) = DEM 780000. There are no other costs. Effectively the firm has put a floor on the value of its receivable at approximately DEM 2.7750 per sterling (= 2.8050-0.03). Again two e.g. are considered: 1. The pound sterling depreciates to DEM 2.7550 .The firm exercises its put option and delivers pound 26 million to the bank at the price of 2.8050. The effective rate is 2.7750. It would have been better off with a forward contract. Sterling appreciates to DEM 2.8575. The option has no secondary market and the firm allows it to lapse. It sells the receivable in the spot market. Net of the premium paid, it obtains an effective rate of 2.8275, which is better than forward rate. If the interest forgone on premium payment is accounted for, the superiority of the option over the forward contract will be slightly reduced. 10. Write a short note on currency swaps Ans. Please refer to concept answer 8 11. What types of exchange exposure in a multinational enterprise subject to? Ans. Please refer to descriptive answer 1
International Equity Markets Concepts FDI -FDI is the acquisition of a controlling interest in a foreign firm or affiliate (branch, subsidiary, etc.). There are a variety of ways that FDI can occur, including building new foreign facilities from scratch ("Greenfield investment"), merging with a foreign firm, taking over a foreign firm, and entering a partnership with a foreign firm (Example; a joint venture).
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Horizontal FDI involves investing in a firm that is in the same industry. Vertical FDI involves investing in a supplier or customer firm. PI -Portfolio investments consist mainly of the holding of transferable securities or guaranteed by the govt. of the capital importing country. Such holdings do not amount to right to control the company. E.g. shares, debenture, bonds etc.
GDR -Global Depositary Receipts mean any instrument in the form of a depositary receipt or certificate (by whatever name it is called) created by the Overseas Depositary Bank outside India and issued to non-resident investors against the issue of ordinary shares or Foreign Currency Convertible Bonds of issuing company. They are negotiable certificates that usually represent a companys publicly traded equities and can be denominated in any freely convertible foreign currency. They are listed on a European stock exchange, often Luxembourg or London. Each DR represents a multiple number or fraction of underlying shares or alternatively the shares correspond to a fixed ratio, for example, 1 GDR = 10 Shares. ADR -A GDR issued in America is an American Depositary Receipt (ADR). An ADR represents an ownership interest in foreign securities. It is a negotiable instrument issued by an American Depository bank certifying that shares of a non-US issuing company are held by the depositorys custodian bank abroad. Each unit of ADR is called an American Depository Share (ADS). They are an ideal way for foreign companies to raise funds to expand their international capital base and get name and product exposure in the US. ADR could be listed on the New York stock exchange, NASDAQ or could be issued as private placement securities under rule 144a in the US. 1. A1. Explain and discuss the various factors responsible for FDI inflows. Introduction
Foreign investment can take two forms: foreign equity investors can simply buy a stake in an enterprise or take a direct interest in its management. The first, indirect form of investment is called foreign portfolio investment. Foreign direct investment (FDI) involves more than just buying a share or a security. It is the amount of financing provided by a foreign owner who is also directly involved in the management of the enterprise. For statistical purposes, the International Monetary Find (IMF) defines foreign investment as (FDI) when the investor holds 10% or more of the equity of an enterprise.
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Foreign investment has clearly been a major factor in stimulating economic growth and development in recent times. Foreign Direct Investment (FDI) is one of the most important sources of capital. FDI links the host economy with the global markets and fosters economic growth. The main factors are:
1.
2.
3.
4.
5.
6.
7.
8.
Market size and growth rate are principal determinants of FDI flows - Every nation has to compete in the international market for scarce resources. Macro-Economic stability and low inflation have been successful in attracting external capital. Maintaining inflation under 5% and recording a growth rate of 7% would make India an attractive place for foreign investments. India is a favorite among Asian countries because of it's sheer size. A hospitable environment for foreign investors - by providing essential guarantees for investors to: Enter and exit Operate on equal terms alongside local operators Repatriate their investments when needed Availability of the required infrastructure - in form of serviceable roads, ports, telecommunications, airports, water and power facilities is a pre-requisite for attracting large volumes foreign investments. Method and ease of entry - There are currently six possible entry routes/ clearing mechanisms for FDI, depending on the sector, extent of foreign equity desired, level of investment and geographical location of the project. This system is perceived to be complex by many foreign investors and analysts. Consequently it appears that the number of entry routes should be reduced to only two, viz. the Automatic Approval (AA) Route of RBI and the FIPB. Scope of operations - The Indian system has both a positive list and a negative list. The positive list comprises of sectors where automatic approval is granted, subject to certain conditions. In the negative list foreign investment is currently not allowed. Political stability - Different governments follow a different policy framework for FDI. One government may follow a liberal approach whereas the other may follow a conservative one. Thus political instability deters FDI from coming to any country. While India has now emerged as the second most-sought-after FDI destination in Asia after China, the actual inflows into India are less than a tenth of those received by China. This should make the government reflect on the shortcomings in the policy framework. Incidentally, successive governments wasted considerable time identifying the desirable sectors where the FDI could be encouraged and those where it must be discouraged. Some coalition partners in the present as well as the previous government were totally opposed to inviting FDI because of their misplaced sense of Swadeshi. Access to resources and low production costs - the availability of natural, capital, technological and human resources are an important consideration when attracting FDI inflows. Also, the costs at which these resources can be obtained are a deciding factor. Cultural-cum-geographic proximity the similarities in culture and geographic nearness to the foreign investors own land makes the destination country easier for the investor to enter, since he is surer of
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9.
certain factors, or rather, more comfortable getting into a land which is as similar as home. Access to export markets the markets that one can service from the destination country, i.e. it's strategic location gives the country a one-up against competing nations in attracting foreign investments. Not only the location, but also its trade relations with the neighboring nations is an important factor. Explain and discuss the objectives of FDI and PI. Need for foreign capital
2. A2.
The following arguments are advanced in favour of foreign capital: 1. Sustaining a high level of investment - Since the underdeveloped countries want to industrialized themselves within a short period of time, it becomes necessary to raise the level of investment substantially. This requires, in turn, a high level of savings. However, because of general poverty of masses, the savings are often very low. Hence emerges a resource gap between investment and savings. This gap has to be filled through foreign capital. Technological gap - The under developed countries have very low level of technology as compared to the advanced countries. However they possess strong urge for industrialization to develop their economies and to wriggle out of the low level equilibrium trap in which they are caught. This raises the necessity for importing technology from advanced countries. Such technology usually comes with foreign capital when it assumes the form of private foreign investment or foreign collaboration. In the Indian case technical assistance received from abroad has helped in filling the technological gap through the following three ways: (a) Provision for expert services (b) Training of Indian personnel (c) Education research and training institution in the country Exploitation of natural resources - A number of underdeveloped countries possess huge mineral resources, which await exploitation. These countries themselves do not possess the required technical skill and expertise to accomplish this task. As a consequence, they have to depend upon foreign capital to undertake the exploitation of their mineral wealth. Undertaking the initial risk - Many under developed countries suffer from acute private entrepreneurs. This creates obstacles in the programs of industrialization. An argument advanced in favour of the foreign capital is that it undertakes the risk of investment in host countries and thus provides the much-needed impetus to the process of industrialization. Once the programme of industrialization gets started with the initiative of foreign capital, domestic industrial activity starts picking up as more and more of the host country enter the industrial field. Development of basic economic infrastructure - It has been observed that the domestic capital of the under developed countries is often too inadequate to build up the economic infra structure of its own.
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2.
3.
4.
5.
Thus these countries require the assistance of foreign capital to undertake this task. In the latter half of the 20th century, especially during the last 3-4 decades, international financial institutions and many governments of advanced countries have made substantial capital available to the under developed countries to develop their system of transport and communications, generation and distribution of electricity, development of irrigation facilities, etc. 6. Improvement in balance of payments position - In the initial phase of the economic development, the under developed countries need much larger imports (in the form of machinery, capital goods, industrial raw materials, spares and components), then they can possibly export. As a result, the balance of payments generally turns adverse. This creates a gap between the earnings and foreign exchange. Foreign capital presents short run solution to the problem.
This shows that the economic development of an underdeveloped country should obviously receive a boost as a result of foreign capital. Accordingly, if foreign capital is obtained on easy terms and without any strings, it should be welcomed. However, as noted by John P. Lewis, despite denials, the fact is that all foreign aid carries strings and every foreign aid relationship involves bargaining, however genteel, between aiding and receiving parties. 3. A3. Discuss the different instruments available with a corporate body in India to raise equity capital abroad. Introduction
Equity capital can flow to a developing country in the following ways: 1. Developed country investors can directly purchase shares in the stock market of a developing country. 2. Companies from developing countries, can issue shares or depository receipts in stock markets of developed countries Out of both these options, the second one is concerned with an Indian corporates ability to raise equity from foreign markets. Types of Equity Instruments Equity instruments can be classified into the following categories based on the different characteristics with which they are floated in the market: Equity shares Equity shares represent ownership capital, as equity shareholders collectively own the company. Preference shares Preference shares refer to a form of shares, which lie in between pure equity and debt. These are shares, which do not carry voting rights.
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Warrants Warrant is a certificate giving the holder the right to purchase securities at a stipulated price within a specified time limit or perpetually. Sometimes a warrant is offered with securities as an inducement to buy. The warrant acts as a sweetener because the holder of the warrant has the right but not the obligation of investing in the equity at the indicated rate The above three are instruments that are used in domestic markets. The GDRs and ADRs are instruments used in foreign markets to raise equity. We will now go ahead with the explanations of GDRs and ADRs and how they can be used to raise finance for an Indian corporate from international markets. Note -(Before going on to the mechanism about how ADRs and GDRs wrok, we need to know a few concepts. These concepts do not form a part of the answer. They are only given here for better understanding of the mechanism.) Relevant Concepts Domestic Custodian Bank It means, a banking company, which acts as a custodian bank for the ordinary shares or Foreign Currency Convertible Bonds, which are issued by it against depository receipts or certificates. Issuing Company It means, any Indian company permitted to issue Foreign Currency Convertible Bonds, or ordinary shares of that company against depository receipts. Overseas Depository Bank It means, a bank authorized by the Issuing Company to issue depository receipts against issue of Foreign Currency Convertible Bonds or ordinary shares of the Issuing Company Mechanism- how it works In the recent years, a number of European and Japanese companies have got themselves listed on foreign stock exchanges such as New York and London. Shares of many firms are traded indirectly in the form of depository receipts. In this mechanism, a depository, usually a large international bank, who receives dividends, reports etc. and issues claims against these shares, holds the shares issued by a firm. The claims are called depository receipts with each receipt being a claim on specified number of shares. The depository receipts are denominated in a convertible currency, usually the US$. The depository receipts may be listed and traded on major stock exchanges or may trade in the OTC market. The issuer firm pays dividend in its home currency, which is converted into Dollars by the depository and distributed to the holders of the depository receipts. This way, the issuing firm avoids listing fees and onerous disclosure and reporting requirements, which would be obligatory if it were to be directly listed on the foreign stock exchange.
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This mechanism originated in the US and is called the American Depository Receipt. The recent years have seen the emergence of European Depository Receipts (EDRs) and Global Depository Receipts, which can be used to tap multiple markets with a single instrument.
Indian Corporate Delivery of ordinary shares or bonds Co-ordinate activities
Appoint
Lead Manager Co-ordinate activities
Domestic Custodian Bank
Instruction to issue depository receipts or certificates
Overseas Depository Bank
Listing Purchase of Depository receipts
Foreign Exchange
Stock
Investor Base
Payment of Interest / Dividend
INTERNATIONAL FINANCIAL INSTITUTIONS CONCEPTS: 1. ODA (Official Development Assistance) Many developing countries continue to struggle under the grips of extreme poverty. The trends in globalization and economic transition have had both a bright and dark side. Certain countries have been left behind by or out of the entire process, and in others, the gulf between the rich and poor has widened. As a result of this they are in a constant need of funds and other forms of assistance to develop them. The assistance provided for this purpose from one country to another is termed as ODA. Previously it was granted to a country that needed to rebuild itself after the war. ODA came in the form of infusions of aid from the international community, ODA is a vehicle through which countries strive to cultivate a sound international environment and promote ties of goodwill with other countries ODA was instrumental in helping lay essential infrastructure and in other ways set the stage for the economic takeoff of developing countries. ODA can serve as a vital diplomatic tool for to help create a desirable international climate and promote closer ties with other states. The main goals of ODA can be included in following points:
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Providing humanitarian assistance for the purpose of attaining global prosperity and development. Tackling Global Issues such as global environmental degradation, the population explosion, the food and energy crises, AIDS and other infectious diseases, to drug abuse, terrorism, crimes against international society, and now financial turmoil. Creating a harmonious environment of security in terms of ensuring peace and security for the human race and the world at large,
2. Foreign Aid One of the important methods of financing trade is through aid. Larger trade is possible through larger aid and it is in this context that a study of the mechanics of aid is relevant in international finance. Movement of money from one country to another in the form of aid is referred to as the foreign aid. The donor countries not only look into their own capacity to grant aid but at the recipient countrys capacity to absorb aid. The latter is judged by the efficiency and productivity in the resource allocation in the pattern of planning and investment and in priorities of allocation, the methods of raising resources and the overall performance of the economy. Availability of foreign aid for the purpose of investment would accelerate growth by helping the cooperating factors at home to be fully deployed and by accelerating the rate of investment. This would enable the necessary technical innovation and accelerate the entrepreneurial function. Foreign aid augments domestic economic growth. The pattern of flows under foreign aid does not depend upon pure economic factors nor on pure commercial considerations but more on politico-economic factors. The effect of foreign aid on the foreign exchange market is to: increase the supply and ease the pressures of demand, to facilitate the transfer mechanism in the currency markets and to obviate the need for frequent changes in the exchange rates, pending the process of structural adjustment in the domestic economy. The inflow of foreign aid would however increase the money supply, which may not lead to inflationary pressures so long as funds are efficiently and productively used in the development process. The basic postulate is that foreign aids fills in the gaps make available non-available and complimentary resources and augments the investment process. 3. Multilateral Investment Guarantee Multilateral Investment Guarantee is a non-commercial guarantee (insurance) for investments made in developing countries. Such a guarantee protects investors against the risks of transfer restriction (including convertibility), expropriation, war and civil disturbance and breach of contract. MIG has a joint sponsorship by developed and developing countries and multilateral character. MIG supplements national and private agencies supporting foreign direct investment through their own investment insurance programmes. The MIG encourages foreign investments by providing viable alternatives in investment insurance against non-commercial risks in developing countries thereby creating
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investment opportunities in those countries. E.g. Investors who would like to invest in a developing country like Africa would surely like to get a cover for their investments and can attain this insurance through a Multilateral Guarantee and thus can invest jointly in such an investment project.
4. Multilateral Aid Multilateral means "many sides". Here organisations that involve many countries, give help. This aid is run by groups such as the World Health Organisation (WHO) and United Nations Educational, Scientific and Cultural Organisation (UNESCO) both of which are part of the United Nations (UN). Economic aid for development by the developed countries is based on political affinities with the recipient country. Such an aid may be bilateral or multilateral. Multilateral aid is through international financial institutions for use in the import of goods and services from any country. Multilateral aid is usable anywhere and hence its rate of utilization will be high. 5. Bilateral Aid Bilateral means "two sides". This type of aid is from one country to another. An example would be Britain giving money and sending experts to help build a dam in Turkey. Quite often bilateral aid is also tied Aid. This is the most common type of aid. In this type of aid the giving (or donor) country also benefits economically from the aid. This happens, as the receiving country has to buy goods and services from the donor country to get the aid in the first place. In building a dam, for example, the Britain may insist that their companies, experts and equipment are used. Whether the aid is given may depend on the receiving country agreeing to buy e.g. military jets from the donor. Bilateral aid is from one government to the other. Generally bilateral aid constitutes the bulk of the total aid granted to any country. It may be tied or untied. II Descriptive Questions 1. Although the job of reconstruction is over long ago, the development of poor countries is yet to take place. Discuss in the light of the above comment the role-played by the World Bank. The World Bank Group is one of the world's largest sources of development assistance. In fiscal year 2001, the institution provided more than US$17 billion in loans to its client countries. The World Bank consists of the IBRD, IDA, IFC, MIGA and the International Centre for Settlement of Investment Disputes (ICSID). It works in more than 100 developing economies with the primary focus of helping the poorest people and the poorest countries. For all its clients the Bank emphasizes the need for:
Investing in people, particularly through basic health and education Focusing on social development, inclusion, governance, and institution-building as key elements of poverty reduction Strengthening the ability of the governments to deliver quality services, efficiently and transparently
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Protecting the environment Supporting and encouraging private business development Promoting reforms to create a stable macroeconomic environment, conducive to investment and long-term planning. The bank also carries out economic and other reports such as Poverty Assessments, Public expenditure Reviews, Country Economic Memoranda, Social and Structural Reviews, Sector Reports, Knowledge sharing etc.
The Bank has established Advisory Services to provide information and knowledge on numerous facets of the Bank's work, such as environmentally and socially sustainable development, health, nutrition and population, the financial sector, and law and justice. The Advisory Services draw on the work of Thematic Groups, which are organized and coordinated by Bank staff, and focus on specific development topics. Thematic Groups share lessons learned in order to improve the quality of Bank activities. Several groups have prepared toolkits for development practitioners. Topics have included project design; management and monitoring; legal, financial, and procurement requirements; gender; food and nutrition; and resettlement safeguards. Development of Poor Countries The reason why the development of poor countries is yet to take place is the fact that gaps in income with the wealthier countries are still widening, and the worst conditions of privation still affect as many as 1.3 billion people one-fifth the entire global population. About one-third of the world's children suffer symptoms of malnutrition, and about one-half the entire human population has no access to even the most basic medicines. The state of geopolitical flux that has followed in the wake of the Cold War, the world has actually witnessed a proliferation in regional conflicts. By some estimates, at least 26 million people worldwide were displaced by civil war in 1996. Furthermore, in many conflicts, the weaker members of society, particularly women and children, have most frequently been the victims of the carnage, which includes human rights atrocities Poverty and warfare are not the only threats to human dignity and civilization. Humanity faces an array of other formidable problems as well, from global environmental degradation, the population explosion, the food and energy crises, AIDS and other infectious diseases, to drug abuse, terrorism, crimes against international society, and now financial turmoil. In terms of ensuring peace and security for the human race and the world at large, these problems demand a concerted and far-reaching approach by the world community. For instance, environmental problems of global scale have a serious impact at the ecosystem level, and as such, they pose a major threat to humankind and the rest of the living world. In addition to the issue of industrial waste, the world is also confronted by the urbanization-based deterioration of our living environment, cross-border acid rain, global warming, and the depletion of global forest resources and biodiversity. These pressures now threaten ecosystems and human populations worldwide, developing regions included. In a world that has become increasingly interdependent, no longer can the national interests of any single country be contemplated in isolation from the interests of international society at large. The World Bank has so far worked extensively in the interest of the international society but because of the above-mentioned problems the complete development of poor countries has not been possible.
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2. Distinguish between foreign capital and foreign aid. Explain the origin and evolution of IDA. Foreign Capital 1. Foreign capital implies funds that are raised from foreign investors for investment purposes in development projects in a host country. Foreign Aid Movement of money from one country to another in the form of aid for development is referred to as the foreign aid.
2. Foreign capital can enter the country Foreign aid flows to developing countries in the form of: in the form of loans, assistance and outright grants from various - Direct Investment: means the governmental and international concerns of the investing country organizations. exercise de facto control over the assets created in the capital importing country by means of that investment. E.g. MNCs
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Indirect Investment: better known as portfolio investment consists mainly of the holding of transferable securities or guaranteed by the govt. of the capital importing country. Such holdings do not amount to right to control the company. E.g. shares, debenture, bonds etc.
Foreign aid is more important than 3. Foreign capital has nothing to do with foreign capital because the financial social expenditures such as education, needs of the developing countries public health, technical training and cannot be alone met by raising foreign research. capital. Foreign aid facilitates investment in lowyielding and slow projects. Such an aid can be used by the recipient country in accordance with its development programmes. Foreign aid is important for easing of foreign exchange constraint in a country with sluggish export growth and other foreign exchange problems. - It minimizes inflationary pressures - It also overcomes the balance of payments difficulties.
4. Foreign capital helps reduce shortage of domestic savings through the inflow of capital equipment and raw materials thereby raising the marginal rate of capital formation. - It overcomes not only capital deficiency but also technological backwardness. - It also helps in industrializing the economy. - It creates more employment.
5.There
are
no
special
Foreign aid is allocated on long repayment repayment schedules, at lower interest

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schedules or soft terms.
rates and softer terms. Debt servicing becomes a burden if aid is tied or the terms of aid are onerous.
6. It generates money in the economy Generally repayment of principal and and helps in minimizing the inflationary interest exceed the gross external aid pressures. with the result that there is net outflow on this account.
6.Foreign capital helps in movement of Foreign aid leads to dependency technical know-how and advancements amongst the developing countries & is and proves to be of great dynamism. often used for extremely wasteful projects. 7. Foreign capital is advanced to the developing countries mainly after Trade follows aid: i.e. aids make way for observing the opportunities and investments in the recipient countries evaluating the credibility of the recipient resources. country.
Origin and Evolution of IDA IDA is the World Banks concessional lending window. It provides long-term loans at zero interest to the poorest of the developing countries. IDA helps build the human capital, policies, institutions and physical infrastructure that these countries urgently need to achieve faster, environmentally sustainable growth. IDAs goal is to reduce disparities across and within countries especially in access to primary education, basic health and water supply and sanitation and to bring more people into the mainstream by raising their productivity. When the International Bank for Reconstruction and Development (IBRD), better known as the World Bank, was established in 1944, its first tasks was to help Europe recover from the devastation of World War II. Once Europe was rebuilt, the bank turned its attention to the developing countries. As the 1950s progressed, it became clear that the poorest developing countries could not afford to borrow needed capital for development on the terms offered by the Bank. They required easier terms. With the US taking the initiative, a group of Bank member countries decided to set up an agency that could lend to very poor developing nations on highly concessional terms. They called the agency the International Development Association (IDA). Its founders saw it as a way for the haves of the world to help the have-nots. But they also wanted IDA to be instilled with the discipline of a
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bank. For this reason, US president Dwight D. Eisenhower proposed, and other countries agreed, that IDA should be part of the World Bank. IDAs articles of Agreement became effective in 1960. The first IDA loans (known as credits) were approved in 1961, to Honduras, India, Sudan and Chile. Since 1960, IDA has lent $107 billion to 106 countries. It lends, on average about $ 6 to 7 billion a year for different types of development projects. IBRD and IDA are run on the same lines. They share the same staff, the same headquarters, report to the same president and use the same rigorous standards when evaluating projects. IDA simply takes money from a different drawer. A country must be a member of IBRD before it can join IDA; 162 countries are IDA members. IDA lends to countries that have a per capita income in 2000 of less than $885 and lack the financial ability to borrow from IBRD. At present 79 countries are eligible to borrow from IDA. IDA credits have maturities of 35 to 40 years with a 10-year grace period on repayment of principal. There is no interest charge, but credits do carry a small service charge of 0.75 % on disbursed balances. 3. Bring out the need for a multilateral guarantee for investment especially in developing countries and discuss the role played by MIGA. Need for a multilateral guarantee in developing countries is as follows: Investors investing in developing countries needed some sort of insurance cover for their monies, hence the need for MIG. For augmenting the capacity of other public or private insurers of political risks through co-insurance or re-insurance. For insuring investment in countries restricted or excluded by the policies of other national insurers or through specific policies adopted by governments; For servicing investors who do not have access to other official political risk insurers; For providing coverage to investors of different nationalities in a multinational syndicate, thereby affording convenience in insurance contracting and claims settlement, For providing coverage of forms of investment not offered. To enhance the flow to developing countries of capital and technology for productive purposes under conditions consistent with their developmental needs, policies and objectives, on the basis of fair and stable standards for the treatment of foreign investment.
Role played by MIGA MIGA is a member of the World Bank Group and membership is open to all World Bank members. The MIGA was created in 1988 to promote foreign direct investment into emerging economies to improve peoples lives and reduce poverty. MIGA fulfills this mandate and contributes to development by offering political risk insurance to investors and lenders, and by helping developing countries attract and retain private investment. MIGA provides investment guarantees against non-commercial risks to eligible foreign investors for qualified investments in developing member countries. MIGAs coverage is against the
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following risks, transfer restriction, expropriation, breach of contract, war and civil disturbance. MIGA insures new cross-border investments originating in any MIGa member country, destined for other developing member country. Projects supported by MIGA have widespread benefits: Local jobs were created Tax revenue was generated Skills and technological know-how were transferred. Local communities often receive significant secondary benefits through improved infrastructure, including roads, electricity, hospitals, schools and clean water. Foreign Direct Investment supported by MIGA also encourages similar local investments and spurs the growth of local businesses that supply related goods and services. As a result, developing countries have a greater chance to break the cycle of poverty. Since its inception MIGA has issued more than 500 guarantees for projects in 78 developing countries. The total coverage issued exceeds $9 billion, bringing the estimated amount of foreign direct investment facilitated since inception to more than $41 billion. MIGAs technical assistance services also play an integral role in catalyzing foreign direct investment by helping developing countries around the world define and implement strategies to promote investment. MIGA develops and deploys tools and technologies to support the spread of information on investment opportunities. The agency uses its legal services to further smooth possible impediments to investment. Through its dispute mediation program, MIGA helps government and investors resolve their differences and ultimately improve the countrys investment climate. MIGA compliments the activities of other investment insurers and works with partners through its coinsurance and reinsurance programs to expand the capacity of the political risk insurance industrys income. To date, MIGA has officially established 18 such partnerships.
4. Distinguish between bilateral aid and multilateral aid flows. Why is multilateral aid preferable to bilateral aid? Bilateral Aid Multilateral Aid This type of aid flows from one country Multilateral aid is through international to another. financial institutions for use in the import of goods and services from any country. It generally results in higher project costs. Multilateral aid is usable anywhere and hence its rate of utilization will be high. It constitutes the bulk of the aid taken Multilateral aid is generally more by the developing countries. preferable than the bilateral aid because of the benefits that it offers. Preference for Multilateral Aid:
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Multilateral aids are preferred over bilateral aids mainly because of the following reasons: Since this type of aid is through international financial institutions the host country does not owe to a particular country but to the pool of resources. Bilateral aid essentially flows from one country to another and change in policies of the donating country would definitely affect the recipient country. Foreign exchange fluctuations would also not be affecting the recipient country. The terms of multilateral aids tend to be milder as compared to that of the bilateral aid. It safeguards the interest of the donor countries since it is through a common source. The project costs become higher when aid is on bilateral basis when the alternative avenues of supplies of goods or services are cheaper and the recipient country has to pay a higher price for the goods imported and for the services rendered from abroad with the result that the debt burden becomes heavier.
POLICIES OF WORLD BANK. What procedures does the World Bank follow? The World Bank has established policies and procedures that help ensure its operations are economically, financially, socially, and environmentally sound. Policies and procedures are codified in the Bank's Operational Manual. They are subject to extensive review while being formulated, and to compliance monitoring once approved Policy Definitions and Documentation Policy Formulation and Review Compliance Monitoring Disclosure of Information Fiduciary Policies Safeguard Policies Policy Definitions and Documentation The Operational Manual is available online. Volume I deals with the Bank's core development objectives and goals, and the instruments for pursuing them. Volume II covers the requirements applicable to Bank-financed lending operations. The Manual covers several different kinds of operational statements: Operational Policies, Bank Procedures, Good Practices, and Operational Directives. Operational Policies (OPs) are short, focused statements that follow from the Bank's Articles of Agreement, the general conditions and policies approved by the Board of Executive Directors. They establish the parameters for the conduct of operations, describe the circumstances in which exceptions to policy are admissible, and spell out who authorizes exceptions. Bank Procedures (BPs) explain how Bank staff carry out the OPs by describing the procedures and documentation required to ensure Bankwide consistency and quality. Good Practices (GPs) contain advice and guidance on policy implementation such as the history of the issue, the sectoral context, analytical framework, and examples of
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good practice. Operational Directives (ODs) contain a mixture of policies, procedures, and guidance; these are gradually being replaced by OPs/BPs/GPs. The Operational Policies and Bank Procedures are detailed in the Manual. Operational Directives that are still in effect can also be found in the Manual. Good Practices are maintained and made available by the various Bank units responsible for specific policies. Policy Formulation and Review The Bank's Operations Policy and Country Services Vice Presidency (OPCS) guides policy formulation and review, a process that is managed by the appropriate Network Vice Presidency. Formulation or review of a policy entails bringing together experienced regional and network staff, legal experts, and policy writers. If the policy is complex, the task may take several years, entailing an iterative process of drafting and revising. An initial draft is prepared, often based on sector or thematic strategy work relevant to the policy. The draft statement is then circulated for comments to internal experts, clients, external experts and partners such as NGOs, and the public. Finally, the policy is submitted for comments and approval to responsible units, the Bank's Managing Directors and the Board. Compliance Monitoring The Bank's credibility rests on effective implementation of its policies. Monitoring compliance with policies is the responsibility of the Operations Poilcy and Country Services Vice Presidency (OPCS). OPCS works to strengthen systems for monitoring compliance. It works in collaboration with the Bank's other vice presidencies, and with other World Bank Group organizations. The Bank has also set up the Inspection Panel, an independent forum for private citizens who believe that their rights or interests have been or could be directly harmed by a Bank-financed project. If people living in a project area believe that harm has resulted or will result from the failure of the Bank to follow its policies and procedures, they or a representative may request a review of the project by the Inspection Panel. Disclosure of Information The Bank has established its Disclosure Policy to support important goals: to be open about its activities, to explain its work to the widest possible audience, and to promote overall accountability and transparency in the development process. The Bank seeks to provide balanced information, reporting and learning from the failures or disappointments in its operations as well as the successes. Recent extensions of the Disclosure Policy include the release of a greater number of project-related documents; disclosure of the Chairman's summaries of Board discussions on Country Assistance Strategies (CASs) and Sector Strategy Papers (SSPs); and a more systematic approach to accessing Bank archives. The Bank continues to review the provisions and implementation of its Disclosure Policy on a regular basis. Fiduciary Policies These policies govern the use and flow of Bank funds, including procurement. The Operations Policy and Country Services Vice Presidency (OPCS) provides guidelines for the procurement of goods and services in Bank projects. The guidelines help ensure that funds are used for their intended purposes, with
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economy, efficiency, and transparency. They also ensure competitive bidding and help protect Bank-funded projects from fraud and corruption. Bank projects are periodically audited by independent firms to make sure that the procurement rules are being followed. Any allegations of fraud or corruption that surface are referred to the Oversight Committee for follow-up, including investigations where appropriate. If allegations prove true, the Bank may terminate the employment of a staff member, debar firms implicated, and/or cancel the funds allocated to the contract in question. Safeguard Policies These policies help ensure that Bank operations do no harm to people and the environment. There are 10 safeguard policies, comprising the Bank's policy on Environmental Assessment (EA) and those policies that fall within the scope of EA: Cultural Property; Disputed Areas; Forestry; Indigenous Peoples; International Waterways; Involuntary Resettlement; Natural Habitats; Pest Management; and Safety of Dams. The Bank conducts environmental screening of each proposed project, to determine the appropriate extent and type of EA to be undertaken, and whether or not the project may trigger other safeguard policies. The Bank classifies the proposed project into one of four categories (A, B, C, and FI) depending on the type, location, sensitivity, and scale of the project and the nature and magnitude of its potential environmental impacts. MIGA Our Mission The Multilateral Investment Guarantee Agency (MIGA) was created in 1988 as a member of the World Bank Group to promote foreign direct investment into emerging economies to improve people's lives and reduce poverty. MIGA fulfills this mandate and contributes to development by offering political risk insurance (guarantees) to investors and lenders, and by helping developing countries attract and retain private investment. Our Principles MIGA is led in its mission by four guiding principles: focusing on clients serving investors, lenders, and host country governments by supporting private enterprise and promoting foreign investment; engaging in partnerships working with other insurers, government agencies, and international organizations to ensure complementarity of services and approach; promoting developmental impact striving to improve the lives of people in emerging economies, consistent with the goals of host countries and sound business, environmental, and social principles; ensuring financial soundness balancing developmental goals and financial objectives through prudent underwriting and sound risk management. Our Members MIGA membership, which currently stands at 154, is open to all World Bank members. The agency has a capital stock of SDR1 billion. In March 1999, MIGA's Council of Governors adopted a resolution for a capital increase of approximately $850 million. The agency received another $150 million in operating capital from the World Bank.
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Development Impact Projects supported by MIGA have widespread benefits: local jobs are created, tax revenue is generated, skills and technological know-how are transferred. Local communities often receive significant secondary benefits through improved infrastructure, including roads, electricity, hospitals, schools, and clean water. Foreign direct investment supported by MIGA also encourages similar local investments and spurs the growth of local businesses that supply related goods and services. As a result, developing countries have a greater chance to break the cycle of poverty. MIGA's guarantee coverage requires investors to adhere to social and environmental standards that are considered to be the world's best. Without World Bank Group involvement, projects often go ahead without adequate safeguards. Unique Strengths MIGA both supports and draws on the extensive resources of the World Bank Group, applying unparalleled knowledge of emerging economies to the projects it guarantees. MIGA's unique strengths also derive from its structure as an international organization that acts as an umbrella of deterrence against government actions that could disrupt investments, and allows it to influence the resolution of potential disputes. MIGA's capacity to serve as an objective intermediary enhances investor confidence that an investment going into an emerging economy will be protected against non-commercial risks. THE WORLD BANK The World Bank Group is one of the world's largest sources of development assistance. In Fiscal Year 2001, the institution provided than US$17 billion in loans to its client countries. It works in more than 100 developing economies with the primary focus of helping the poorest people and the poorest countries. For all its clients the Bank emphasizes the need for: OBJECTIVES: 1. Investing in people, particularly through basic health and education 2. Focusing on social development, inclusion governance, and institutionbuilding as key elements of poverty reduction. 3. Strengthening the ability of the governments to deliver quality services, efficiently and transparently 4. Protecting the environment. 5. Supporting and encouraging private business development 6. Promoting reforms to create a stable macroeconomic environment, conducive to investment and long-term planning. Founded in 1944, the World Bank Group is one of the world's largest sources of development assistance. The Bank, which provided US$17. billion in loans to its client countries in fiscal year 2001, is now working in more than 100 developing economies, bringing a mix of finance and ideas to improve living standards and eliminate the worst forms of poverty. For each of its clients, the Bank works with government agencies, nongovernmental organizations, the private sector to formulate assistance strategies. Its country offices worldwide deliver the Bank's program in countries, liaise with government and civil society, and work the increase understanding of development issues.
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FINANCIAL ASSISTANCE The World Bank raises money for its development programs by tapping the world's capital markets, and, in the case of the IDA,through contributions from wealthier member governments. The International Bank for Reconstruction and Development, which accounts for about more than half of the Bank's annual lending, raises almost all its money in financial markets. One of the world's most prudent and conservatively managed financial institutions,the IBRD sells AAA-rated bonds and other debt securities to pension funds, insurance companies, corporations, other banks, a individuals around the globe. IBRD charges interest to its borrowers at rates which reflect its cost of borrowing. Loans must be repaid in 15 to20 years; there is a three-to-fiveyear grace period before repayment of principal begins. Less than 5 percent of the IBRD's funds are paid in by countries when they join the Bank. Member governments purchase shares, the number of which is based on their related economic strength, but pay in only a small portion of the value of those shares. The unpaid balance is "on-call" should the Bank suffer losses so grave that it can no longer pay its creditors something that has never happened. This guarantee capital can only be used to pay bond holders, not to cover administrative cost or to make loans. The IBRD's rules require that loans outstanding and disbursed may not exceed the combined total of capital and reserves. The International Development Association was established in 1960 to provide concessional assistance to countries that are too poor to borrow at commercial rates. IDA helps to promote growth and reduce poverty in the same ways as does the IBRD, but IDA uses interest-free loans (which are known as IDA) "credits", technical assistance, and policy advice. IDA credits account for about one-foot of all Bank lending. Borrowers pay a fee of less than 1 percent of the loan to cover administrative costs. Repayment is required in 35 or 40 years with a 10-year grace period. Nearly 40 countries contribute to IDA's funding,which is replenished every three years. Donor nations include not only industrial member countries such as France, Germany, Japan, the United Kingdom, and the United States, but also developing countries such as Argentina, Botswana, Brazil, Hungary, Korea, the Russian Federation, and Turkey, some of which were once IDA borrowers themselves. IDA's funding is managed in the same prudent, conservative, and cautious way as is the IBRD's. As with the IBRD, there has never been a default on an IDA credit. Products and Service What services does the World Bank provide? Though known best for its financial services, the World Bank also provides analytic and advisory services and is involved in learning and capacity ,building in developing countries worldwide. Financial Services Analytical & Advisory Learning & Capacity Building Financial Services - include the following three areas:
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1. Lending Instruments Depending upon eligibility, a member country will draw on loans from either IBRD or IDA to support a lending project. The Bank offers borrowers a number of lending instruments designed for different kinds of investment and adjustment projects. Most investment projects use Specific Investment Loans (SILs) or Sector Investment and Maintenance Loans (SIMs), while most adjustment projects use Structural Adjustment (SALs) and Sector Adjustment (SECALs) loans. 2. Cofinancing,: The Bank's Resource Mobilization and Cofinancing activities help its members obtain financial assistance from other sources. Cofinancing refers to funding committed by an external official bilateral or multilateral partner, an export credit agency, or a private source in the context of a specific Bank-funded project. Trust funds enable the Bank, along with bilateral and multilateral donors, to mobilize funds for investment operations, as well as debt relief, emergency reconstruction, and technical assistance. Guarantees promote private financing in borrowing countries by covering risks the private sector is not normally ready to absorb or manage. 3. Grants: Grant making complements the Bank's lending services. Grants are seed money for pilot projects with innovative approaches and technologies.Grants help the Bank leverage its financial and human resources, become catalysts for collaboration with partner organizations to promote shared regional and global objectives. The World Bank's Development Grant Facility (DGF) provides overall strategy, allocations, and management of Bank grant-making activities. The DGF has supported programs in such sectors as rural development environment, health, education, economic policy, and private sector development. Analytic and Advisory Services The Bank undertakes a broad range of analytic and advisory activities to support its development mission. Research by the Development Economics Vice Presidency (DEC) informs the Bank's work on board issues such as the environment, poverty, trade and globalization. Country clients benefit from a tailored program of economic and sector work (ESW) geared to their specific development challenges. ESW examines a country's economic prospects, including, for example, its banking or its financial sectors, and trade, poverty, and social safety net issues. The Bank's diagnostic work is shared with clients and partners, and draws on theirs. The results often form the basis for assistance strategies,government investment programs, and projects supported by IBRD and IDA lending. The Bank has established Advisory Services to provide information and knowledge on numerous facets of the Bank's work, such environmentally and socially sustainable development, health, nutrition and population, the financial sector, and law and justice. The Advisory Services draw on the work of Thematic Groups, which are organized and coordinated by Bank staff, and focus on specific development topics. Thematic Groups share lessons learned in order to improve the quality of Bank activities. Several groups have prepared toolkits for development practitioners. Topics have included project design; management and monitoring; legal, financial,
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and procurement requirements; gender; food and nutrition; and resettlement safeguards. Learning & Capacity Building The Bank conducts learning and knowledge sharing programs to enhance the skills and development of its clients, staff, and partners. The lead unit in this area is the World Bank Institute (WBI), whose work includes training courses, policy consultations, partnership with training and research institutions worldwide, and the creation and support of knowledge networks related to international development. Another key initiative is the Staff Exchange Program, which arranges temporary secondment of Bank Group staff and staff of participating companies and rganizations. The program enhances the professional and technical skills of participating staff and promotes cultural exchange, fresh perspectives, and diversity forthe institutions involved. IFC The International Finance Corporation (IFC) promotes sustainable private sector investment in developing countries as a way to reduce poverty and improve people's lives. IFC is a member of the World Bank Group and is headquartered in Washington, DC. It shares the primary objective of all World Bank Group institutions: to improve the quality of the lives of people in its developing member countries. IFC Mission Statement. Established in 1956, IFC is the largest multilateral source of loan and equity financing for private sector projects in the developing world. It promotes sustainable private sector development primarily by: The History of IFC The world was a different place 40 years ago. No one spoke of emerging markets. There was no worldwide trend toward privatization, no communications revolution, no globalized economy. World population was less than half of what it is today. The economies of poor countries were still in very early stages of development, lacking the human resources, physical infrastructure and sound institutions needed to raise incomes and improve living standards. The responsibility for development was almost universally assigned to the public sector. Private sector investment in developing countries was small, and not much thought was given to increasing it. It was into this environment that the International Finance Corporation was born in 1956. For several years officials of the World Bank had been supporting the creation of a new and different entity to complement their own. The World Bank had been founded to finance post-World War II reconstruction and development projects by lending money to member governments, and had been doing so effectively. Yet in its initial years, some senior staff had seen the need for creating a related institution to spur greater OBJECTIVES OF IFC: Financing private sector projects located in the developing world. Helping private companies in the developing world mobilize financing in international financial markets. Providing advice and technical assistance to businesses and governments.
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IFC Mission Statement The mission of IFC, part of the World Bank Group, is to promote sustainable private sector development in developing countries, helping to reduce poverty and improve people's lives. TYPES OF ASSISTANCE OFFERED: IFC's Products and Services: Ownership and Management IFC has 175 member countries, which collectively determine its policies and approve investments. To join IFC, a country must first be a member of the IBRD. IFC's corporate powers are vested in its Board of Governors , to which member countries appoint representatives. IFC's share capital, which is paid in, is provided by its member countries, and voting is in proportion to the number of shares held. IFC's authorized capital is $2.45 billion. Statement of Capital Stock and Voting Power . The Board of Governors delegates many of its powers to the Board of Directors , which is composed of the Executive Directors of the IBRD, and which represents IFC's member countries. The Board of Directors reviews all projects. Although IFC coordinates its activities in many areas with the other institutions in the World Bank Group, IFC generally operates independently as it is legally and financially autonomous with its own Articles of Agreement, share capital, management and staff. Funding of IFC's Activities IFC's equity and quasi-equity investments are funded out of its net worth: the total of paid in capital and retained earnings. Strong shareholder support and the substantial paid-in capital base have allowed IFC to raise most of the funds for its lending activities in the international financial markets through its triple-A rated bond issues. Of the funding required for its lending operations, 80 percent is borrowed through public bond issues or private placements. The remaining 20 percent is borrowed from the IBRD. Established in 1956, IFC is the largest multilateral source of loan and equity financing for private sector projects in developing countries. It promotes sustainable private sector development primarily by: Financing private sector projects located in the developing world. Helping private companies in the developing world mobilize financing in international financial markets. Providing advice and technical assistance to businesses and governments. IFC's particular focus is to promote economic development by encouraging the growth of productive enterprise and efficient capital markets in its member countries. In this context, the advisory work with governments helps create conditions that stimulate the flow of both domestic and foreign private savings and investment. IFC participates in an investment only when it can make a special contribution that complements the role of market operators. Accordingly, it plays a catalytic role, stimulating and mobilizing private investment in the developing world by demonstrating that investments there can be profitable. Project Finance IFC offers a full array of financial products and services to companies in its developing member countries. These include, but are not restricted to:
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Long-term loans in major and local currencies, at fixed or variable rates. Equity investments. Quasi-equity instruments (such as subordinated loans, preferred stock, income notes, convertible debt). Syndicated loans. Risk management (such as intermediation of currency and interest rate swaps, provision of hedging facilities). Intermediary finance. IFC can provide financial instruments singly or in whatever combination necessary to ensure that projects are adequately funded from the outset. It can also help structure financial packages, coordinating financing from foreign and local banks and companies, and export credit agencies. IFC charges market rates for its products and does not accept government guarantees. To be eligible for IFC financing, projects must be profitable for investors, benefit the economy of the host country, and comply with stringent environmental and social guidelines. IFC finances projects in all types of industries and sectors, for example: manufacturing, infrastructure, tourism, health and education, and financial services. Financial service projects represent a significant share of new approvals and range from investments in nascent leasing, insurance and mortgage markets to student loans and credit lines to local banks which, in turn, provide microfinance or business loans to Small and Medium Enterprises. Although IFC is primarily a financier of private sector projects, it may provide finance for a company with some government ownership, provided there is private sector participation and the venture is run on a commercial basis. It can finance companies that are wholly locally owned as well as joint ventures between foreign and local shareholders.

Resource Mobilization Owing to its success record and special standing as a multilateral institution, IFC is able to act as a catalyst for private investment. Its participation in a project enhances investor confidence and attracts other lenders and shareholders. IFC mobilizes financing directly for sound companies in developing countries by syndicating loans with international commercial banks and underwriting investment funds and corporate securities issues. It also handles private placements of securities. IFC operates on commercial terms, targeting profitability. The Corporation has made a profit every year since its inception. Advisory Services IFC advises business in developing countries on a wide variety of matters, including physical and financial restructuring; the formulation of business plans; identification of markets, products, technologies, and financial and technical partners; and mobilization of project finance. It can provide advisory services in the context of an investment, or independently for a fee, in line with market practice. IFC also advises governments in developing countries on how to create an enabling business environment and it provides guidance on attracting foreign direct investment. For example, it helps develop domestic capital markets. It also provides assistance in areas such as restructuring and privatization of state-owned enterprises. ACHEIVEMENTS OF IFC
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2000

Record for new investment approvals in Sub-Saharan Africa (US$1.2 billion). Investment approvals in financial services sector surpass 45%, reaching Small and Medium Enterprises (SMEs), leasing companies, stock markets, microfinance institutions, pension funds etc. Five joint IFC/World Bank departments created to enhance coordination of private investments and public policy advice. Standard & Poor's acquires the Emerging Markets Data Base. Compliance adviser/Ombudsman appointed to improve accountability to locally affected communities. Increased focus on new IFC sectors such as health and education. Environmental and social policies strengthened, putting leading-edge principles in place. 1997 Regional hubs established in Moscow and New Delhi. "Extending IFC's Reach" initiative launched, targeting countries where difficult environments hamper investments. First investments in Azerbaijan, Tajikistan, Cambodia, Georgia, FYR Macedonia and Mongolia. Syndications reach record US$4.8 billion. Membership reaches 170 with the addition of St. Kitts & Nevis and BosniaHerzegovina. First investments in Albania, Angola, Croatia, Maldives, Slovak Republic, Vanuatu and Western Samoa. Capital adequacy framework revised, increasing investment capacity. Information disclosure policy strengthened. First environmental training for financial intermediaries initiated. Membership exceeds 150 with the addition of the Czech and Slovak Republics. Infrastructure department created. Environment unit established. Multilateral Fund of the Montreal Protocol and Global Environmental Facility established. INTERNATIONAL FINANCIAL MARKETS
1999
1998
1996

1995 1993

1992

CONCEPTS 1. Distinction between Euro Credit and Euro Bond Market Both Euro bonds and Euro credit (Euro currency) financing have their advantages and disadvantages. For a given company, under specific circumstances, one method of financing may be preferred to the other. The major differences are: 1. Cost of borrowing Euro bonds are issued in both fixed rate and floating rate forms. Fixed rate bonds are an attractive exposure management tool since the known long-term currency
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inflows can be offset by the known long-term outflows in the same currency. In contrast, Euro currency loans carry variable rates. 2. Maturity Euro bonds have longer maturities while the period of borrowing in the Euro currency market has tended to lengthen over time. 3. Size of the issue Earlier, the funds available for lending at any time have been much more in the inter-bank market than in the bond market. But of late, this situation does not hold true. Moreover, although in the past the flotation costs of a Euro currency loan have been much lower than a Euro bond (about 0.5 % of the total loan amount versus about 2.25 % of the face value of a Euro bond issue), compensation has worked to lower Euro bond flotation costs. 4. Flexibility In a Euro bond issue, the funds must be drawn in one sum on a fixed date and repaid according to a fixed schedule, unless the borrower pays a substantial prepayment penalty. By contrast, the drawdown in a floating rate loan can be staggered to suit the borrowers needs and can be repaid in whole or in part at any time, often without penalty. Moreover, a Euro currency loan with a multicurrency clause enables the borrower to switch currencies on any roll-over date, whereas switching the denomination of a Euro bond from currency A to currency B would require a costly, combined, refunding and reissuing operation. 5. Speed Funds can be raised by a known borrower very quickly in the Euro currency market. Often, a period of two to three weeks should suffice. A Euro bond financing generally takes more time, though the difference is becoming less significant. 2. Euro Credit Market Euro credit or Euro Loans are the loans extended for one year or longer. The market that deals in such loans is called Euro Credit Market. The common maturity for euro credit loans is 5 years. Since Euro banks accept short-term deposits and provide long-term loans, it is likely that asset liability mismatch may arise. To avoid this Euro banks often extend floating rate euro credit loans fixed to some market interest rate. The London Inter Bank Offer Rate (LIBOR) is the most commonly used interest rate. It is the rate charged for loans between Euro Banks. Participants in Euro credit Market The major lending banks in the Euro credit market are Euro banks, American, Japanese, British, Swiss, French, German and Asian (specially that of Singapore) banks, Chemical Bank, JP Morgan, Citicorp, Bankers Trust, Chase Manhattan Bank, First National Bank of Chicago, Barclay's Bank, National Westminster, BNP, etc. Among the borrowers, there are banks, multinational groups, public utilities, government agencies, local authorities, etc.
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Dealing in Euro credits When a borrower approaches a bank for Euro credit, a formal document is prepared on behalf of potential borrowers. This document contains the principal terms and conditions of loan, objectives of loan and details of the borrower. Before launching syndication, the approached bank decides primarily, in consultation with the borrower, on a strategy to be adopted, i.e. whether to approach a large market or a restricted number of banks to form the syndicate. Each of the banks in syndicate lends a part of the loan. The duration of this operation is normally about 6 to 8 weeks. Several clauses may be introduced in the contract of Euro-debt: Pari-passu clause that prevents the borrower from contracting new debts that subordinate the interest of lenders; Exchange option clause that allows the withdrawal of a part or totality of loan in another currency; Negative guarantee clause that commits the borrower not to contract other debts that subordinate the interest of lenders. Characteristics of Euro credit A major part (more than 80 %) of the Euro debts is made in US dollars. The second (but far behind) is Pound Sterling followed by Deutsch mark, Japanese yen, Swiss franc and others. Most of the syndicated debts are of the order of $50 million. As far as the upper limits are concerned, amounts involved are of as high magnitude as $5 billion and more. In 1990, Euro tunnel borrowed $6.8 billion. On an average, maturity periods are of about five years (in some cases it is about 20 years). The reimbursement of the loan may take place in one go (bullet) or in several installments. The interest rate on Euro debt is calculated with respect to a rate of reference, increased by a margin (or spread). The rates are available and generally renewable (roll over credit) every six months, fixed with reference to LIBOR. The LIBOR is the rate of money market applicable to short-term credits among the banks of London. The reference rate can equally be PIBOR at Paris and FIBOR at Frankfurt, etc. It is revised regularly. The margin depends on the supply and demand of the capital as also on the degree of the risk of these credits and the rating of borrowers. Financial institutions are in vigorous competition. There is an active secondary market of Euro debts. Numerous techniques allow banks to sell their titles in this market. 3. Euro Bond Market Euro Bond issue is one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. An example is a Dutch borrower issuing DM-denominated bonds to investors in the UK, Switzerland and the Netherlands. The Eurobond market is the largest international bond market, which is said to have originated in 1963 with an issue of Eurodollar bonds by Autostrade, an Italian
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borrower. The market has since grown enormously in size and was worth about $ 428 billion in 1994. Eurobond markets in all currencies except the Japanese Yen are quite free from any regulation by the respective governments. Straight bonds are priced with reference to a benchmark, typically treasury issues. Thus a Eurodollar bond will be priced to a yield a YTM (Yield-to-Maturity) somewhat above the US treasury bonds of similar maturity, the spread depending upon the borrowers ratings and market conditions. Floatation costs of the Eurobond are comparatively higher than costs indicated with syndicated Eurocredits. 4. Euro CPs Commercial paper is a corporate short-term, unsecured promissory note issued on a discount to yield basis. Commercial paper maturities generally do not exceed 270 days. Commercial paper represents a cheap and flexible source of funds While CPs are negotiable, secondary markets tend to be not very active since most investors hold the paper to maturity. The emergence of the Euro Commercial Paper (ECP) is much more recent. It evolved as a natural culmination of the Note Issuance Facility and developed rapidly in an environment of securitisation and disintermediation of traditional banking. CP has also developed in the domestic segments of some European countries offering attractive funding opportunities to resident entities. 5. Euro CDs A Certificate of Deposit (CD) is a negotiable instrument evidencing a deposit with a bank. A CD is a marketable instrument so that the investor can dispose it off in the secondary market whenever cash is needed. The final holder is paid the face value on maturity along with the interest. It is used by the commercial banks as shortterm funding instruments. Euro CDs are mainly issued in London by banks. Interest on CDs with maturity more than a year is paid annually than semi-annually. 6. International Capital Markets International Capital Markets have come into existence to cater to the need of international financing by economies in the form of short, medium or long-term securities or credits. These markets also called Euro markets, are the markets on which Euro currencies, Euro bonds, Euro shares and Euro bills are traded/exchanged. Over the years, there has been a phenomenal growth both in volume and types of financial instruments transacted in these markets. Euro currency deposits are the deposits made in a bank, situated outside the territory of the origin of currency. For example, Euro dollar is a deposit made in US dollars in a bank located outside the USA; likewise, Euro banks are the banks in which Euro currencies are deposited. They have term deposits in Euro currencies and offer credits in a currency other than that of the country in which they are located. A distinctive feature of the financial strategy of multinational companies is the wide range of external services of funds that they use on an ongoing basis. British Telecommunication offers stock in London, New York and Tokyo, while Swiss Bank Corporation-, aided by Italian, Belgian, Canadian and German banks- helps corporations sell Swiss franc bonds in Europe and then swap the proceeds back into US dollars.
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Firms have three general sources of funds available: (i) internally generated cash, (ii) short-term external funds, and (iii) long-term external funds. External investment comes in the form of debt or equity, which are generally negotiable (tradable) instruments. The pattern of financing varies from country to country. Companies in the UK get an average of 60-70% of their funds from internal sources. German companies get about 40-50% of their funds from external suppliers. In 1975, Japanese companies got more than 70% of their money from outside sources, but this pattern has since reversed; major chunks of finances come from internal sources. Another significant aspect of financing behaviour is that debt accounts for the overwhelming share of external finance. Industry sources of external finance also differ widely from country to country. German and Japanese companies have relied heavily on bank borrowing, while the US and British industry raised much more money directly from financial markets by the sale of securities. However, in all countries, bank borrowing is on a decline. There is a growing tendency for corporate borrowing to take the form of negotiable securities issued in the public capital markets rather than in the form of commercial bank loans. This process known as securitisation is most pronounced among the Japanese companies.
7. Petro Dollar During the oil crises of 1973, the Capital markets have played a very important role. They accepted the dollar deposits from oil exporters and channeled the funds to the borrowers in other countries. This is called recycling the petrodollars. 8. Junk Bonds A junk bond is issued by a corporation or municipality with a bad credit rating. In exchange for the risk of lending money to a bond issuer with bad credit, the issuer pays the investor a higher interest rate. "High-yield bond" is a nicer name for junk bond The credit rating of a high yield bond is considered "speculative" grade or below "investment grade". This means that the chance of default with high yield bonds is higher than for other bonds. Their higher credit risk means that "junk" bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk. Junk bonds became a common means for raising business capital in the 1980s, when they were used to help finance the purchase of companies, especially by leveraged buyouts, the sale of junk bonds continued to be used in the 1990s to generate capital 9. Samurai Bonds They are publicly issued yen denominated bonds. They are issued by nonJapanese entities. The Japanese Ministry of Finance lays down the eligibility guidelines for potential foreign borrowers. These specify the minimum rating, size of issue, maturity and so forth. Floatation costs tend to be high. Pricing is done with respect to Long-term Prime Rate.
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Shibosai Bonds They are private placement bonds with distribution limited to banks and institutions. The eligibility criteria are less stringent but the MOF still maintains control. Shogun / Geisha Bonds They are publicly floated bonds in a foreign currency while Geisha are their private counterparts. 10. Yankee Bonds These are dollar denominated bonds issued by foreign borrowers. It is the largest and most active market in the world but potential borrowers must meet very stringent disclosure, dual rating and other listing requirements, options like call and put can be incorporated and there are no restrictions on size of the issue, maturity and so forth. Yankee bonds can be offered under rule 144a of Sec. These issues are exempt from elaborate registration and disclosure requirements but rating, while not mandatory is helpful. Finally low rated or unrated borrowers can make private placements. Higher yields have to be offered and the secondary market is very limited. DESCRIPTIVE 1. Trace the development of the International Capital Markets The financial revolution has been characterized by both a tremendous quantitative expansion and an extraordinary qualitative transformation in the institutions, instruments and regulatory structures. Global financial markets are a relatively recent phenomenon. Prior to 1980, national markets were largely independent of each other and financial intermediaries in each country operated principally in that country. The foreign exchange market and the Eurocurrency and Eurobond markets based in London were the only markets that were truly global in their operations. Financial markets everywhere serve to facilitate transfer of resources from surplus units (savers) to deficit units (borrowers), the former attempting to maximize the return on their savings while the latter looking to minimize their borrowing costs. An efficient financial market thus achieves an optimal allocation of surplus funds between alternative uses. Healthy financial markets also offer the savers a range of instruments enabling them to diversify their portfolios. Globalization of financial markets during the eighties has been driven by two underlying forces. Growing (and continually shifting) imbalance between savings and investment within individual countries, reflected in their current account balances, has necessitated massive cross-border financial flows. For instance, during the late seventies, the massive surpluses of the OPEC countries had to be recycled, i.e. fed back into the economies of oil importing nations. During the eighties, the large current account deficits of the US had to be financed primarily from the mounting surpluses in Japan and Germany. During the nineties, developing countries as a group have experienced huge current account deficits and have also had to resort to international financial markets to bridge the gap
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between incomes and expenditures, as the volume of concessional aid from official bilateral and multilateral sources has fallen far short of their perceived needs. The other motive force is the increasing preference on the part of investors for international diversification of their asset portfolios. This would result in gross cross-border financial flows. Investigators have established that significant risk reduction is possible via global diversification of portfolios. These demand-side forces accompanied by liberalization and geographical integration of financial markets has led to enormous growth in cross-border financial transactions. In virtually all major industrial economies, significant deregulation of the financial markets has already been effected or is under way. Functional and geographic restrictions on financial institutions, restrictions on the kind of securities they can issue and hold in their portfolios, interest rate ceilings, barriers to foreign entities accessing national markets as borrowers and lenders and to foreign financial intermediaries offering various types of financial services have been already dismantled or are being gradually eased away. Finally, the markets themselves have proved to be highly innovative, responding rapidly to changing investor preferences and increasingly complex needs of the borrowers by designing new instruments and highly flexible risk management products. The result of these processes has been the emergence of a vast, seamless global financial market transcending national boundaries. But control and government intervention have not entirely disappeared. E.g. South East Asia- Korea, Taiwan, etc- permit only limited access to foreign investors. However, despite these reservations, the dominant trend is towards globalization of financial markets. International financial markets can develop anywhere, provided that local regulations permit the market and potential users are attracted to it. The most important international financial centers are London, Tokyo and New York. All the major industrial countries have important domestic financial markets as well but only some such as Germany and France are also important international financial centers. On the other hand, even though some countries have relatively unimportant domestic financial markets, they are important world financial centers such as Switzerland, Luxembourg, Singapore and Hong Kong. International Capital Markets, also called Euro markets, are the markets on which Euro currencies; Euro bonds, Euro equity and Euro bills are exchanged. International financing in the form of short-, medium- or long-term securities or credits has become necessary for the international economy. Financing techniques have diversified, volumes dealt have increased and the process is continuing to grow. Notable developments in international capital markets can be traced to the end of 1950s. There are several reasons for their growth. The significant ones are: Transfer of assets of erstwhile Soviet Union to Europe. In the 1950s and early 1960s, the former Soviet Union and Soviet-bloc countries sold gold and commodities to raise hard currency. Because of anti-Soviet sentiment, these Communist countries were afraid of depositing their US dollars in US banks for fear that the deposits could be frozen or taken. Instead they deposited their dollars in a French Bank whose telex address was Euro-Bank. Since that time, dollar deposits
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outside the US have been called Eurodollars and banks accepting Eurocurrency deposits have been called Euro banks. International capital markets subsequently came to be known as Euro markets. Restrictive measures taken by the administration. Several regulatory measures (initiated particularly in the USA) also contributed (in an indirect manner) to the development of International capital markets. The important ones are as follows: Regulation 'Q'. In 1960, Regulation 'Q' in the USA fixed a ceiling on interest rates offered by American banks on term deposits and prohibited them to remunerate the deposits whose term was less than 30 days. Besides, at the end of the 1960s, the Federal Reserve reduced the growth of total monetary mass. The money market rate went up. American banks borrowed on the Euro dollar market, which resulted in: The increase of indebtedness of these banks on the Euro dollar market; The flight of American Capital, attracted by the interest rate on Euro market. Tax of interest equalization. In 1963, tax was imposed on the purchase of foreign securities (portfolio investments) by American residents. The objective was to reduce the deficit of BOP of the USA and to establish equilibrium in international structure of interest rates. In fact, in order to avoid tax payment, some companies launched the issue of dollar bonds outside the USA. This contributed to the growth of Euro dollar market. Realizing its adverse effects, subsequently, the tax was withdrawn in 1974. Program of voluntary restrictions on investments. The USA initiated/imposed various restrictions on its financial system to tackle BOP problems. For instance, banks were directed not to lend or invest in foreign operations beyond the limits of the previous year(s). As a result, the business community felt a scarcity of funds. This in turn led them to take recourse to the Euro dollar market. Differential of American lending and borrowing rates. The interest rate paid by American banks was low, vis--vis, the expected rate from borrowers. European banks availed of this opportunity; they offered higher rates of interest at the cost of contenting themselves with smaller margins than those offered by American banks, to attract investors. They could do so by operating on Euro dollar markets, which were not subject to interest-rate and other regulations. For instance, banks were neither constrained to respect a certain compulsory reserve ratio on their deposits in Euro dollars nor constrained to maintain their interest rates below a certain ceiling. There may be other reasons as well for development of Euro dollars. Globalization of big multinationals has further boosted this development. The financing system practiced hitherto also was not able to respond to capital needs of the international economy. Indian entities began accessing external capital markets towards the end of the seventies as gradually the amount of concessional assistance became inadequate to meet the increasing needs of the economy. The initial forays were low-key. The pace accelerated around mid-eighties, but even the authorities adopted a selective approach and permitted only a few select banks, all India financial institutions and large public and private sector companies to access the market.
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After liberalization, during 1993-94 there was a sharp increase in the amount of funds raised by corporate entities form the global debt and equity markets. Indias borrowings have mainly been by way of syndicated bank loans, buyers credits and lines of credits. Other instruments such as foreign and Euro bonds have been employed less frequently though a number of companies made issues of Euro convertible bonds after 1993. Prior to that only apex financial institutions and the public sector giant ONGC had tapped the German, Swiss, Japanese, and Euro dollar bond markets. Throughout the eighties, there was a steady improvement in the markets perception of the creditworthiness of Indian borrowers (manifested in the steady decline in the spreads they had to pay over LIBOR in the case of Euro loans). The 1990-91 crisis sent Indias sovereign rating below investment grade and the foreign debt markets virtually dried up to be opened up again after 1993. 2. Describe the mechanism of the Euro Bond Market. Euro Bond: issue is one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. An example is a Dutch borrower issuing DM-denominated bonds to investors in the UK, Switzerland and the Netherlands. The Eurobond market is the largest international bond market, which is said to have originated in 1963 with an issue of Eurodollar bonds by Autostrade, an Italian borrower. The market has since grown enormously in size and was worth about $ 428 billion in 1994. Eurobond markets in all currencies except the Japanese Yen are quite free from any regulation by the respective governments. Straight bonds are priced with reference to a benchmark, typically treasury issues. Thus a Eurodollar bond will be priced to a yield a YTM (Yield-to-Maturity) somewhat above the US treasury bonds of similar maturity, the spread depending upon the borrowers ratings and market conditions. Floatation costs of the Eurobond are comparatively higher than costs indicated with syndicated Eurocredits. Primary market: A borrower desiring to raise funds by issuing Euro bonds to the investing public will contact an investment banker and ask it to serve as lead manager of an underwriting syndicate that will bring the bonds to market. The underwriting syndicate is a group of investment banks, merchant banks, and the merchant banking arms of commercial banks that specialize in some phase of public issuance. The lead manager will usually invite co managers to form a managing group to help negotiate terms with the borrower, ascertain market conditions and manage the issuance. The managing group along with other banks, will serve as underwriters for the issue, that is, they will commit their own capital to buy the issue from the borrower at a discount from the issue price, if they are unable to place the bonds with investors. The discount or the underwriting spread is typically in the 2 or 2.5% range. Most of the underwriters along with other banks will be a part of the placement or selling group that sells the bonds to the investing public.
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The total elapsed time from the decision date of the borrower to issue Eurobonds until net proceeds from the sale are received is typically 5 to 6 weeks. The lead manager prepares a preliminary prospectus focusing on economic and financial characteristics of the project and financial standing of the borrower. After having consulted a certain number of banks, the lead manager decides on the interest rate. Subsequently, the issue price is fixed. Clauses of reimbursement before maturity are provided for. After, the issue advertising is done in International Press in the form of tombstone. This tombstone indicates the lead manager, co-lead managers and members of the guarantee syndicate. Secondary Market: Eurobonds purchased in the primary market can be resold before their maturities in the secondary market. The secondary market is an over the counter market with principal trading in London. However, important trading is also done in other major European cities. The bonds are quoted in percentage of their value, without taking into account the coupon already running. The secondary market comprises of market makers and brokers. Market makers stand ready to buy or sell for their own account by quoting a two way bid and ask prices. Market traders trade directly with one another, through a broker, or with retail customers. The bid-ask is their only profit. Brokers accept buy or sell orders from market makers and then attempt to find a matching party for the other side of the trade; they may also trade for their own account. Brokers charge a small commission to the market makers that engaged them. They do not deal directly with retail clients. Extra Information What is a bond? A bond is a loan and you are the lender. The borrower is usually the government, a state, a local municipality or a big company like General Motors. All of these entities need money to operate -- to fund the federal deficit, for instance, or to build roads and finance factories -- so they borrow capital from the public by issuing bonds. When a bond is issued, the price you pay is known as its "face value." Once you buy it, the issuer promises to pay you back on a particular day -- the "maturity date" -- at a predetermined rate of interest -- the "coupon." Say, for instance, you buy a bond with a $1,000 face value, a 5% coupon and a 10-year maturity. You would collect interest payments totaling $50 in each of those 10 years. When the decade was up, you'd get back your $1,000 and walk away. A key difference between stocks and bonds is that stocks make no promises about dividends or returns. General Electric's dividend may be as regular as a heartbeat, but the company is under no obligation to pay it. And while GE stock spends most of its time moving upward, it has been known to spend months -- even years -going the other way. When GE issues a bond, however, the company guarantees to pay back your principal (the face value) plus interest. If you buy the bond and hold it to maturity, you know exactly how much you're going to get back (in most cases, anyway). That's why bonds are also known as "fixed-income" investments -- they assure you
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a steady payout or yearly income. And although they can carry plenty of risk, this regular income is what makes them inherently less volatile than stocks. Global Bond: They have a minimum value of $1 billion and are effected simultaneously in Europe, America and Asia. The salient features of these bonds are that they permit to raise very high amounts. They offer very high liquidity since they are quoted on several exchanges while secondary market functions round the clock, with uniform price all over the world. They are especially used by governments, public enterprises, international organisations and private financial institutions. External Bond Market: The external bond market refers to bond trading activity wherein the bonds are underwritten by an international syndicate, are offered in several countries simultaneously, are issued outside any country's jurisdiction, and are not registered. The Eurobond market is a major external bond market. The external bond market combined with the internal bond market comprises the global bond market. Examples of an external bond are the "global bond," issued by the World Bank, and Eurodollar bonds. Internal Bond Market: The internal bond market refers to all bond trading activity in a given country and is comprised of both a domestic bond market and a foreign bond market. Also referred to as the "national bond market." The internal and external bond markets comprise the global bond market Bulldog Bonds: A sterling denominated foreign bond, priced with reference to the UK gilts. Rembrandt Bond: Denominated in the Dutch guilder. (For more information, please refer to page 504-505 in P G Apte) 3. What are the different international financial markets? The international financial markets consist of the credit market, money market, bond market and equity market. The international credit market, also called Euro credit market, is the market that deals in medium term Euro credit or Euro loans. International banks and their clients comprise the Eurocurrency market and form the core of the international money market. There are several other money market instruments such as the Euro Commercial Paper (ECP) and the Euro Certificate of Deposit (ECD). Foreign bonds and Eurobonds comprise the international bond market. There are several types of bonds such as floating rate bonds, zero coupon bonds, deep discount bonds, etc. The international equity market tells us how ownership in publicly owned corporations is traded throughout the world. This comprises both, the primary sale of new common stock by corporations to initial investors and how previously issued common stock is traded between investors in the secondary markets. International Financial Market- (general- can be used in any) The last two decades have witnessed the emergence of a vast financial market across national boundaries enabling massive cross-border capital flows from those
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who have surplus funds and a search of high returns to those seeking low-cost funding. The degree of mobility of capital, the global dispersal of the finance industry and the enormous diversity of markets and instruments, which a firm seeking funds can tap, is something new. Major OECD (Organization for Economic Co-operation and Development) countries had began deregulating and liberalizing their financial markets towards the end of seventies. While the process was far from smooth, the overall trend was in the direction of relaxation of controls, which till then had compartmentalized the global financial markets. Exchange and capital controls were gradually removed, non-residents were allowed freer access to national capital markets and foreign banks and financial institutions were permitted to establish their presence in the various national markets. While opening up of the domestic markets began only around the end of seventies, a truly international financial market had already been born in the midfifties and gradually grown in size and scope during sixties and seventies. This refers to the Euro currencies Market where borrower (investor) from country A could raise (place) funds from (with) financial institutions located in country B, denominated in the currency of country C. During the eighties and nineties, this market grew further in size, geographical scope and diversity of funding instruments. It is no more a "euro" market but a part of the general category called offshore markets. Alongside liberalization, other qualitative changes have been taking place in the global financial markets. Removal of restrictions has resulted into geographical integration of the major financial markets in the OECD countries. Gradually this trend is spreading to developing countries many of which have opened up their markets-at least partially-to non-resident investors, borrowers and financial institutions. Another noticeable trend is functional integration. The traditional distinctions between different financial institutions-commercial banks, investment banks, finance companies, etc.- are giving way to diversified entities that offer the full range of financial services. The early part of eighties saw the process of disintermediation get underway. Highly rated issuers began approaching investors directly rather than going through the bank loan route. On the other side, debt crisis in the developing countries, adoption of capital adequacy norms and intense competition, forced commercial banks to realize that their traditional business of accepting deposits and making loans was not enough to guarantee their long-term survival and growth. They began looking for new products and markets. Concurrently, the international financial environment was becoming more volatile- there were fluctuations in interest and exchange rates. These forces gave rise to innovative forms of funding instruments and tremendous advances in risk management. The decade saw increasing activity in and sophistication of the derivatives market, which had begun emerging in the seventies. Taken together, these developments have given rise to a globally integrated financial marketplace in which entities in need of short- or long-term funding have a much wider choice than before in terms of market segment, maturity, currency of denomination, interest rate basis, incorporating special features and so forth.
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The same flexibility is available to investors to structure their portfolios in line with their risk-return tradeoffs and expectations regarding interest rates, exchange rates, stock markets and commodity prices. 4. List out the growth and functions of Eurocurrency markets While opening up of the domestic markets began only around the end of seventies, a truly international financial market had already been born in the midfifties and gradually grown in size and scope during sixties and seventies. This refers to the well-known Eurocurrencies Market. It is the largest offshore market. Prior to 1980, Eurocurrencies market was the only truly international financial market of any significance. It is mainly an inter-bank market trading in time deposits and various debt instruments. What matters is the location of the bank neither the ownership of the bank nor ownership of the deposit. The prefix "Euro" is now outdated since such deposits and loans are regularly traded outside Europe. Over the years, these markets have evolved a variety of instruments other than time deposits and short-term loans, e.g. certificates of deposit (CDs), euro commercial paper (ECP), medium- to long- term floating rate loans, eurobonds, floating rate notes and euro medium-term notes (EMTNs). The difference between Euro markets and their domestic counterparts is one of regulation. Eurobonds are free from rating and a disclosure requirement applicable to many domestic issues as well as registration with securities exchange authorities. Emergence of Euro markets: 1. During the 1950s, the erstwhile USSR was earning dollars from the sale of gold and other commodities and wanted to use them to buy grain and other products from the West, mainly from the US. However, they did not want to keep these dollars on deposit with banks in New York, as they were apprehensive that the US government might freeze the deposits if the cold war intensified. They approached banks in Britain and France who accepted these dollar deposits and invested them partly in US. 2. Domestic banks in US (as in many other countries) were subjected to reserve requirements, which meant that a part of their deposits were locked up in relatively low yielding assets. 3. The importance of the dollar as a vehicle currency in international trade and finance increased, so many European corporations had cash flows in dollars and hence temporary dollar surpluses. Due to distance and time zone problems as well as their greater familiarity with European banks, these companies preferred to keep their surplus dollars in European banks, a choice made more attractive by the higher rates offered by Euro banks. The main factors behind the emergence and strong growth of the Eurodollar markets were the regulations on borrowers and lenders imposed by the US authorities which motivated both banks and borrowers to evolve Eurodollar deposits and loans. Added to this are the considerations mentioned above, viz. the ability of Euro banks to offer better rates both to the depositors and the borrowers
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and convenience of dealing with a bank that is closer to home, who is familiar with business culture and practices in Europe. SHORT NOTES 1. Participants in International Project Financing a) Sponsors Lenders b)
Sponsors These are partners in the project who bring in the equity capital or risk capital. Being so, they are keenly interested in the successful completion of the project and shoulder major responsibilities as regards its execution. The fact that they bring in the equity capital is an indication of their interest. Also the amount of equity that they bring has a marked bearing on the extent of debt that can be raised for the project. Sometimes people who bring in the equity capital are just the initiators of the project. Included in this category are multinational firms, future buyers of products or services of the project, the public or private investors, international organisations, development banks etc. Lenders They bring in the debt capital. Financing of a big project necessitates intervention of a banking pool consortium composed of banks, national or international financial institutions, export financing institutions etc. Guarantors Guarantees maybe provided by banks, public financing organisations, international financial institutions, private insurance companies etc. Project Operators An operating company intervenes in the erection of the project. It brings its organisational know-how to manage the project. 2. Risks associated with international projects- financial, political, others 1. Financial risk In general, international projects are prone to greater financial risk as a bulk of finance is in the form of debt. The major factors affecting financial risk are degree of indebtedness, the terms and conditions of repayment of debt and currency used. Some projects will have expenses and revenues that involve several currencies. As a result the exchange rate risk is very high.
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Projects maybe financed with floating rates. In view of the volatility observed on the rates like LIBOR, the interest rate risk is also significant. Therefore it is necessary to plan the coverage of all these risks. Foreign Exchange Risk As corporations expand their international activities, they begin to acquire foreign assets and foreign liabilities. As exchange rates change, the values of these foreign assets and liabilities change accordingly. For a corporation, exchange rate risk is the sensitivity of the value of the corporation when the exchange rates change. Obviously, the change in the corporation value is related to the net change in the values of the foreign assets and foreign liabilities. (E.g. foreign direct investment, foreign exchange loss, sales and income from foreign sources.) 2. Economic Risk Economic risk is risk created by changes in the economy. Typically, it is related to technological changes, the actions of competitors, shifts in consumer preferences, etc. Ideally, a pure domestic firm is affected only by domestic economic conditions - the domestic economic risk. However, in today's integrated world economy, the concept of a pure domestic firm has less practical relevance. Many firms that appear strictly pure domestic confront foreign economic risk indirectly. (E.g.: local restaurant/dept store, real estate agent) 3. Political Risk Political risk is risk created by political changes or instability in a country. These factors include, but are not limited to, nationalization, confiscation, price controls, foreign exchange and capital controls, administrative hurdles, uncertain property rights, discriminative or arbitrary regulations on business practices (hiring, contract negotiation), civil wars, riots, terrorism, etc. Each country in the world presents a different political profile and represents a unique source of political risk that firms must assess and manage when they make foreign investments. In order to minimize this risk, local investors or the local government may be associated with the project. Insurance against political risk is another useful technique recommended for the purpose. What constitutes political risk and how to measure it? The political risk management typically involves: - Identifying political risk and its likely consequences - Developing policies in advance to cope with the possibility of political risk - Strengthening a firm's bargaining position - Devising measures to maximize compensation in the event of expropriation Country Risk: It refers to elements of risk inherent in doing business in the economic, social, and political environment of another country. Counter party Risk - The risk that a counter party will default on a financial obligation. Liquidity Risk -The risk that a financial position cannot be sold quickly at prevailing prices.
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4.
5.
INTERNATIONAL FINANCE 6.
Delivery Risk - The risk that a buyer will not deliver payment of funds after a seller has delivered securities or foreign exchange that were purchased. Rollover Risk - The risk of being closed out from a financial market and unable to renew (or roll over) a short-term contract. 8. Other risks - Other risks relate to the risk of cost overruns and bad management. 3. Financing of MNCs in local or international market
7.
Project financing may be defined as financing of an economic unit, legally independent, created with a view to setting up of a big project, which is commercially profitable and financially viable. Project is considered as a distinct legal entity and is financed, to a marked extent, by debt (65 to 75 percent). Therefore the risk to be borne is substantial. There are two major methods of financing international projects: 1. Financing with total risk borne by lenders where only the future cashflows ensure the reimbursement of the loan. This method of financing was used in petroleum and gas industry in the USA and Canada. Due to increased level of risks, this method of project financing is generally not preferred. 2. In another type of financing, both the lender and the promoter share the risk. The problem sometimes encountered in this method is to decide the proportion in which the risk is to be shared between two parties. Domestic v/s Offshore markets Financial assets and liabilities denominated in a particular currency - say the Swiss Franc - are traded are primarily in the national financial markets of that country. These financial markets are known as Domestic Markets. In case of many convertible currencies they are traded in the financial markets outside the country of that currency. These financial markets are known as Offshore Markets. While it is true that neither both markets will offer both the financing options nor any entity can access all segments of a particular market, it is true generally that a given entity has an access to both the segments of the markets for placing as well as raising funds. There are theories by experts that suggest that there are no two types of financial markets (viz. Domestic and offshore markets) but everything is a part of single Global Financial Market. Similarity Experts suggest that arbitrage will ensure that both these markets will be closely linked together in terms of costs of funding and returns on assets. Differences Both of these markets significantly differ on the Regulatory dimension. Major segments of the domestic markets are subject to strict supervision by the relevant
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authorities such as SEC in US, Ministry of Finance in Japan and the Swiss National Bank in Switzerland. These authorities regulate foreign (non-resident) entities access to the public capital markets in their countries by laying down eligibility criteria, disclosure & accounting norms and registration & rating requirements (similarly for domestic banks, reserve requirements and deposit insurance). The offshore markets on the other hand have minimal regulation and often no registration. Finally it must be noted that though the nature of regulation continues to distinguish Domestic from the offshore markets, there are segments like Private Placements, Unlisted Bonds, Bank loans etc. in domestic markets where regulation tends to be the least. 4. Eurocurrency Markets While opening up of the domestic markets began only around the end of seventies, a truly international financial market had already been born in the midfifties and gradually grown in size and scope during sixties and seventies. This refers to the well-known Eurocurrencies Market. It is the largest offshore market. Prior to 1980, Eurocurrencies market was the only truly international financial market of any significance. It is mainly an inter-bank market trading in time deposits and various debt instruments. What matters is the location of the bank neither the ownership of the bank nor ownership of the deposit. The prefix "Euro" is now outdated since such deposits and loans are regularly traded outside Europe. Over the years, these markets have evolved a variety of instruments other than time deposits and short-term loans, e.g. certificates of deposit (CDs), euro commercial paper (ECP), medium- to long- term floating rate loans, eurobonds, floating rate notes and euro medium-term notes (EMTNs). The main factors behind the emergence and strong growth of the Eurodollar markets were the regulations on borrowers and lenders imposed by the US authorities which motivated both banks and borrowers to evolve Eurodollar deposits and loans. Added to this are the considerations mentioned above, viz. the ability of euro banks to offer better rates both to the depositors and the borrowers and convenience of dealing with a bank that is closer to home, who is familiar with business culture and practices in Europe. 5. External Bond Market The external bond market refers to bond trading activity wherein the bonds are underwritten by an international syndicate, are offered in several countries simultaneously, are issued outside any country's jurisdiction, and are not registered. The Eurobond market is a major external bond market. The external bond market combined with the internal bond market comprises the global bond market. Examples of an external bond are the "global bond," issued by the World Bank, and Eurodollar bonds. The External Bond Market comprises of the : Foreign Bond Market and Euro Bond Market
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Foreign Bond: issue is one offered by a foreign borrower to the investors in a national capital market and denominated in that nations currency. An example is German MNC issuing dollar denominated bonds to the U.S. investors. Euro Bond: issue is one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. An example is a Dutch borrower issuing DM-denominated bonds to investors in the UK, Switzerland and the Netherlands. The Foreign Exchange Market I Conceptual Questions 1. Value Date: The settlement of a transaction takes place by transfers of deposits between two parties. The day on which these transfers are effected is called the Settlement Date or the Value Date. 2. Spot Rate: When the exchange of currencies takes place on the second working day after the date of the deal, it is called spot rate. 3. Forward Transactions: If the exchange of currencies takes place after a certain period from the date of the deal (more than 2 working days), it is called a forward rate. A trader may quote a forward transaction for any future date. It is a binding contract between a customer and dealer for the purchase or sale of a specific quantity of a stated foreign currency at the rate of exchange fixed at the time of making the contract. 4. Swap Transaction: A swap transaction in the foreign exchange market is combination of a spot and a forward in the opposite direction. Thus a bank will buy DEM spot against USD and simultaneously enter into a forward transaction with the same counter party to sell DEM against USD against the mark coupled with a 60- day forward sale of USD against the mark. As the term swap implies, it is a temporary exchange of one currency for another with an obligation to reverse it at a specific future date. 5. Bid Rate: The bid rate denotes the number of units of a currency a bank is willing to pay when it buys another currency. 6. Offer Rate: The offer rate denotes the number of units of a currency a bank will want to be paid when it sells a currency. 7. Bid - Offer Rate: The bid offer Rate is the rate which states both, the price which is the bank is willing to pay to buy other currencies and the price the bank expects when it sells the same currency. Bid and Ask will always be from a banks point of view. Thus (A/B)bid will denote the number of units of A the bank will pay when it buys one unit of B and (A/B)ask will mean the number of units of A the bank will want to be paid in order to sell one unit of B. 8. European Quote: The quotes are given as number of units of a currency per USD. Thus DEM1.5675/USD is a European quote. 9. American Quotes: American quotes are given as number of dollars per unit of a currency. Thus USD0.4575/DEM is an American quote. 10. Direct Quotes: in a country, direct quotes are those that give unit of the currency of that country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote in India. 11. Indirect Quote: Indirect or Reciprocal Quotes are stated as number of units of a foreign currency per unit of the home currency. Thus USD 3.9560/INR 100 is an indirect quote in India.
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12. Arbitrage: Arbitrage may be defined a san operation that consists in deriving a profit without risk from a differential existing between different quoted rates. It may result from 2 currencies, also known as, geographical arbitrage or from 3 currencies, also known as, triangular currencies.
II Descriptive questions 1. What is foreign exchange? In a business setting, there is a fundamental difference between making payment in the domestic market and making payment abroad. In a domestic transaction, only one currency is used while in a foreign transaction, two or more currencies maybe used. Suppose an U.S importer has agreed to purchase a certain quantity of Indian spices and to pay the Indian exporter Rs. 1000000 for it. How would he go about doing this? He would have to pay the amount in dollars, which will be equivalent to its existing rate in rupees at a decided date. That is why the foreign exchange market comes into existence so that such transactions become possible and easier. The special checks and other instruments for making payment abroad are referred to collectively as foreign exchange. In other words, Foreign exchange includes currencies and other instruments of payment denominated in currencies. 2. Elaborate the structure of the foreign exchange market and compare it with the foreign exchange of India The major participants in the foreign exchange markets are commercial banks; foreign exchange brokers and other authorized dealers, and the monetary authorities. It is necessary to understand that the commercial banks operate at retail level for individual exporters and corporations as well as at wholesale levels in the inter bank market. The foreign exchange brokers involve either individual brokers or corporations. Bank dealers often use brokers to stay anonymous since the identity of banks can influence short term quotes. The monetary authorities mainly involve the central banks of various countries, which intervene in order to maintain or influence the exchange rate of their currencies within a certain range and also to execute the orders of the government. It is important to recognize that, although the participants themselves may be based within the individual countries, and countries may have their own trading centers, the market itself is world wide. The trading centers are in close and continuous contact with one another, and participants will deal in more than one market. Primarily, exchange markets function through telephone and telex. Also, it is important to note that currencies with limited convertibility play a minor role in the exchange market. Besides this, only a small number of countries have established their full convertibility of their currencies for full transactions. The foreign exchange market in India consists of 3 segments or tires. The first consists of transactions between the RBI and the authorized dealers. The latter are mostly commercial banks. The second segment is the interbank market
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in which the ADs deal with each other. And the third segment consists of transactions between ADs and their corporate customers. The retail market in currency notes and travelers cheques caters to tourists. In the retail segment in addition to the ADs there are moneychangers, who are allowed to deal in foreign currencies. The Indian market started acquiring some depth and features of well functioning market e.g. active market makers prepared to quote two-way rates only around 1985. Even then 2 - way forward quotes were generally not available. In the interbank market, forward quotes were even in the form of near term swaps mainly for ADs to adjust their positions in various currencies. Apart from the ADs currency brokers engage in the business of matching sellers with buyers. In the interbank market collecting a commission from both. FEDAI rules required that deals between ADs in the same market centers must be effected through accredited brokers. 3. Write a note on Inter bank dealing Primary dealers quote two way prices and are willing to deal either side, i.e. they buy and sell the base currency up to conventional amounts at those prices. However, in interbank markets this is a matter of mutual accommodation. A dealer will be shown a two-way quote only if he / she extends the privilege to fellow dealers when they call for a quote. Communications between dealers tend to be very terse. A typical spot transaction would be dealt as follows: BANK A : Bank A calling. Your price on mark dollar please. BANK B : Forty forty eight. BANK A : Ten dollars mine at forty eight. Bank A dealer identifies and asks himself for Bs DEM/USD. Bank A is dealing at 1.4540/1.4548. The first of these, 1.4540, is bank Bs price for buying USD against DEM or its bid for USD; it will pay DEM 1.4540 for every USD it buys. The second 1.4548, is its selling or offer price for USD, also called ask price; it will charge DEM 1.4548 for very USD it sells. The difference between the two, 0.0008 or 8 points is bank Bs bid offer or bid ask spread. It compensates the bank for costs of performing the market making function including some profit. Between dealers it is assumed that the caller knows the big figure, viz. 1.45. Bank B dealer therefore quotes the last two digits (points) in her bid offer quote viz. 40 48. Bank A dealer whishes to buy dollars against marks and he conveys this in the third line which really means I buy ten million dollars at your offer price of DEM 1.4548per US dollar. Bank B is said to have been hit on its offer side. If the bank A dealer wanted to sell say 5 million dollars, he would instead said Five dollars yours at forty. Bank B would have been hit on its bid side. When a dealer A calls another dealer B and asks for a quote between a pair of currencies, dealer B may or may not wish to take on the resulting position on his books. If he does, he will quote a price based on his information about the current market and the anticipated trends and take the deal on his books. This is known as warehousing the deal. If he does not wish to warehouse the deal, he will immediately call a dealer C, get his quote and show that quote to A. If A does a deal, B will immediately offset it with C. This is known as back-to-back dealing. Normally, back-to-back deals are
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done when the client asks for a quote on a currency, which a dealer does not actively trade. In the interbank market deals are done on the telephone. Suppose bank A wishes to buy the British pound sterling against the USD. A trader in bank A might call his counterpart in bank B and asks for a price quotation. If the price is acceptable they will agree to do the deal and both will enter the details- the amount bought/sold, the price, the identity of the counter party, etc.-in their respective banks computerized record systems and go to the next transaction. Subsequently, written confirmations will be sent containing all the details. On the day of the settlement, bank A will turn over a US dollar deposit to bank B and B will turn over a sterling deposit to A. The traders are out of the picture once the deal is agreed upon and entered in the record systems. This enables them to do deals very rapidly. In a normal two-way market, a trader expects to be hit on both sides of his quote amounts. That is in the pound dollar case above. On a normal business day the trader expects to buy and sell roughly equal amounts of pounds / dollars. The bank margin would then be the bid ask spread. But suppose in the course of trading the trader finds that he is being hit on one side of hiss quote much more often than the other side. In the pound dollar example this means that he is buying many more pounds that he selling or vie versa. This leads to a trader building up a position. If he has sold / bough t more pounds than he has bought/ sold he is said to have a net short position / long position in pounds. Given the variability of exchange rates, maintaining a large net short or long position in pounds of 1000000. The pound suddenly appreciates from say $1.7500 to $1.7520. This implies that the banks liability increases by $2000 ($0.0020 per pound for 1 million pounds. Of course pound depreciation would have resulted in a gain. Similarly a net long position leads to a loss if it has to be covered at a lower price and a gain if at a higher price. (By covering a position we mean undertaking transactions that will reduce the net position to zero. A trader net long in pounds must sell pounds to cover a net short must buy pounds. A potential gain or loss from a position depends upon the size of the position and the variability of exchange rates. Building and carrying such net positions for a long duration would be equivalent to speculation and banks exercise tight control over their traders to prevent such activity. This is done by prescribing the maximum size of net positions a trader can build up during a trading day and how much can be carried overnight. When a trader realizes that he is building up an undesirable net position he will adjust his bid ask quotes in a manner designed to discourage on type of deal and encourage the opposite deal. For instance a trader who has overbought say DEM against USD, will want to discourage further sellers of marks and encourage buyers. If his initial quote was say DEM/USD 1.7500 1.7510 he might move it to 1.7508 1.7518 i.e offer more marks per USD sold to the bank and charge more marks per dollar bought from the bank. Since most of the trading takes place between market making banks, it is a zero sum game, i.e. gains made by one trader are reflected in losses made by another. However when central banks intervene, it is possible for banks as a group to gain or lose at the expense of the central bank. Bulk of the trading of the convertible currencies. Takes place against the US dollar. Thus quotations for Deutschemarks, Swiss Francs, yen, pound sterling etc will be commonly given against the US dollar. If a corporate customer wants to buy or sell yen against the DEM, a cross rate will be worked out from the DEM/USD and JPY/USD quotation. One reason for using a common currency (called the vehicle
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currency) for all quotations is to economize on the number of exchange rates. With 10 currencies 54 two-way quotes will be needed. By using a common currency to quote against, the number is reduced to 9 or in general n 1ss. Also by this means the possibility of triangular arbitrage is minimized. However some banks specialize in giving these so called cross rates. 4. Define the value date and classify the transactions into spot and forward transactions based on value date A settlement of any transaction takes place by transfers of deposits between the two parties. The day on which these transactions are effected is called the settlement date or the value date. To effect the transfers, the banks in the countries of the two currencies involved must be open for business. The relevant countries are called settlement locations. The location of the two banks involved in the trade is dealing locations, which need not be the same as the settlement locations. When we talk about settlements, they are usually of the following types: Cash Tom Spot Forward T+0 T+1 T+2 T+n
Where T represents the current day when trading takes place and n represents number of days, usually after two business days but mostly at least after one month. Cash Cash rate or Ready rate is the rate when the exchange of currencies takes place on the date of the deal itself. There is no delay in payment at all, therefore represented by T + 0. When the delivery is made on the day of the contract is booked, it is called a Telegraphic Transfer or cash or value day deal. Tom It stands for tomorrow rate, which indicates that the exchange of currencies takes place on the next working day after the date of the deal, and therefore represented by T+ 1. Spot When the exchange of currencies takes place on the second day after the date of the deal (T+2), it is called as spot rate. The spot rate is the rate quoted for current foreign currency transactions. It applies to interbank transactions that require delivery on the purchased currency within two business days in exchange for immediate cash payment for that currency. Forward If the exchange of currencies takes place after a certain period after the date of the deal (more than two working days), it is called forward rate. The forward rate is a contractual rate between a foreign exchange trader and the traders client for delivery of foreign currency sometime in the future, after at least two business days but usually after at least one month. Standard forward contract maturities are 1,2,3,6, 9, and 12 months.
5. Define arbitrage and explain the different types of arbitrage.

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Sometimes companies deal in foreign exchange to make a profit, even though the transaction is not connected to any other business purpose, such as trade flows or investment flows. Usually, however, this type of foreign exchange activities is more likely to be persuaded by foreign exchange traders and investors. One type of profit seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) in order to profit from a price discrepancy. Hence, arbitrage may be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates. It may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage). Interest arbitrage involves investing in foreign bearing instruments in foreign exchange in an effort to earn a profit due to interest rates differentials. For example, a trader may invest $ 1000 in the United States for ninety days or convert $1000 into British pounds, invest the money in the United Kingdom for ninety days and then convert the pounds back into dollars. The investor would try to pick the alternative that would be the highest yielding at the end of ninety days. But Speculation is the buying or the selling of the commodity i.e. foreign currency, where the activity contains both the element of risk and the chances of a greater profit. Speculators are important in the foreign exchange market because they spot trends and try to take advantage of them. Thus they can be a valuable source of both supply and demand for a currency. As a protection against risk, foreign exchange transactions can be used to hedge against a potential loss due to an exchange rate change.
Spot Quotations: Arbitraging between Banks: Though one hears the term market rate, it is not true that all banks will have identical quotes for a given pair of currencies at a given point of time. The rates will be close to each other but it may be possible for a corporate customer to save some money by shopping around. Inverse quotes and 2 point arbitrage: The arbitrage transaction that involve buying a currency in one market and selling it at a higher price in another market is called Two point Arbitrage. Foreign exchange markets quickly eliminate two point arbitrage opportunities if and when they arise. Cross rates and 3 point arbitrage: The term three point arbitrage refers to the kind of transaction where one starts with currency A, sell it for B, sell B for C and finally sell C back for A ending up with more A than one began with. Efficient foreign exchange markets do not permit risk - less arbitrage profit of this kind.
Numerical Examples 1. An Arbitrage between two Currencies.

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Suppose two traders A and B are quoting the following rates: Trader A (Paris) Trader B (New York) FFr 5.5012/US$ US $ 0.1817/FFr We assume that the buying and selling rates for these traders are the same. We find out the reciprocal rate of the quote given by the trader B, which is FFr 5.5036 / US $ (= 1/0.1817) .A combiste buys, say, US $ 10,000 from the trader A by paying FFr 55,012. Then he sells these US $ to trader B and receives FFr 55,036. in the process he gains FFr 24 (=55,036 - 55,012). Since, in practice buying and selling rates are likely to be different, so the quotation is likely to be as follows: Trader A Trader B FFr 5.4500/US $ - FFr 5.5012 US $ US $ 0.1785/FFr - US $ 0.1817/ FFr These rates mean that trader A would be willing to buy one unit of US dollar by paying FFr 5.45 while he would sell one US dollar for FFr 5.501. The same holds true for the corresponding figures of trader B. But this process would tend to increase the selling rate at the trader A because of the increase in demand of US dollars and the reverse would happen at the trader B because of increased supply of US dollars. This would lead to an equilibrium after some time. 2.An Arbitrage between three currencies Suppose two traders, both located at New York are quoting as follows: Trader A Trader B $ 0.60/SF $ 0.60/SFr $ 0.51 DM $ 0.52 DM Since three currencies are involved here, we find the cross rates between SFr and DM as well. These are: SFr 0.85/DM (= 0.51/0.60) at the trader A and SFr 0.867/DM (= 0.52/0.60) at the trader B. Thus, the situation looks like as follows: Trader A Trader B $ 0.60/SFr $ 0.60/SFr $ 0.51/DM $ 0.52/DM SFr 0.85/DM SFr 0.867/ DM Hence what are the arbitrage possibilities? There is no arbitrage gain possible between the US $ and the Swiss franc. The following two arbitrages are, however possible.
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Deutschmarks against the US $ is being quoted at the trader B. So buy DMs from the trader A and sell them to trader B. Buy DMs against SFrs from the trader A and sell them to the trader B. 6. Examine clearly the different types of forward transactions and describe discount and premium evaluation in forward quotations. Outright forward quotation: Some of the major currencies quoted in the forward market are Deutschmarks, Pound sterling, Japanese yen, Swiss franc, Canadian dollar etc. they are generally quoted in terms of US dollars. Currencies may be quoted in terms of one, three, six months and one year forward. But enterprises may obtain form banks quotations for different periods.
As mentioned earlier, the spot market is for foreign exchange transactions within two business days. However, some transactions maybe entered into on one day but not completed until after two business days. For example, a French exporter of perfume might sell perfume to an US importer with immediate delivery but payment not required for thirty days. The US importer is obligated to pay in francs in thirty days and may enter into a contract with a trader to deliver francs in thirty days at a forward rate, a rate today for future delivery. Thus the forward rate is the rate quoted by foreign exchange traders for the purchase or sale of foreign exchange in the future. The difference between the spot and the forward rates is known as either the forward discount or the forward premium on the contract. If the domestic currency is quoted on a direct basis and the forward rate is greater than the spot rate, the foreign currency is selling at a premium. It is calculated as follows:
Forward discount/ premium = * 100
Forward mid Spot mid * 12/n
Spot mid Where n indicates the number of months forward. When Fwd rate > Spot rate, it implies premium. Fwd rate < Spot rate, it implies discount. In the case of forward market, the arbitrage operates in the differential of interest rates and the premium or discount on exchange rates. Numerical problems 1. Spot 1-month 3-months 6-months (FFr/US$) 5.2321/2340 25/20 40/32 20/26 In outright terms these quotes would be expressed as below: Maturity Bid/Buy Sell/Offer/Ask Spread
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Spot FFr 5.2321 per US $ FFr 5.2340 per US $ 0.0019 1-month FFr 5.2296 per US $ FFr 5.2320 per US $ 0.0024 3-months FFr 5.2281 per US $ FFr 5.2308 per US $ 0.0027 6-months FFr 5.2341 per US $ FFr 5.2366 per US $ 0.0025 It may be noted that in the forward deals of one month and 3 months, US $ is at discount against the French franc while 6 months forward is at a premium. The first figure is greater than the second both in one month and three months forward quotes. Therefore, these quotes are at a discount and accordingly these points have been subtracted from the spot rates to arrive at outright rates. The reverse is the case for 6 months forward.
2. We take an example of a quotation for the US $ against Rupees, given by a trader in New Delhi. Spot 1-month 3-months 6-months Rs 32.1010-Rs32.1100 225/275 300/350 375/455 Spread 0.0090 0.0050 0.0050 0.0080 The outright rates from these quotations will be as follows: Maturity Bid/Buy Sell/Offer/Ask Spread Spot Rs 32.1010 per US $ Rs 32.1100 per US $ 0.0090 1-month Rs 32.1235 per US $ Rs 32.1375 per US$ 0.0140 3-months Rs 32.1310 per US $ Rs 32.1450 per US $ 0.0140 6-months Rs 32.1385 per US $ Rs 32.1555 per US $ 0.0170 Here we notice that the US $ is at a premium for all three forward periods. Also, it should be noted that the spreads in forward rates are always equal to the sum of the spread of the spot rate and that of the corresponding forward points. Numerical problems and solutions 1.On a particular date the following DEM/$ spot quote is obtained from a bank: -1.6225/35 a) Explain this quotation. Ans. The above quotation shows the bid rate and the ask rate of the currencies in question, the initial figure i.e. 1.6225 being the bid rate and the latter being the ask rate. Also it shows the number of DEM used to buy or sell one US dollar i.e. the bank will pay 1.6225 DEM for each US dollar it buys and will want to be paid 1.6235 DEM for each US dollar it sells. b) Compute implied inverse quote. Ans. When DEM/$ is 1.6225/35, the implied inverse quote is:
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$/DEM becomes 0.6159/63 (1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163) Another bank quoted $/DEM 0.6154/59. Is there an arbitrage? If so how would it work? Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM 0.6159/63. There is no arbitrage opportunity since the main purpose of doing an arbitrage is making a profit without any risk or commitment of capital. This doesnt exist in the given case as a potential buyer would end up buying a DEM at 0.6159 $ from Bank A and would have to sell it to Bank B at the same price since that would be the only way of not making any losses. It is clear form the diagram shows that shows no arbitrage is possible: $/DEM 0.6154 Bank A 59 Bank B 63 c)
2. The following quotes are obtained from the banks: Bank A Bank B FFr/$ spot 4.9570/80 4.9578/90 a) Is there an arbitrage opportunities Ans. There is no arbitrage opportunity in this case. This can represented diagrammatically as: FFr/$ 4.9570 Bank B The quotes are overlapping each other hence preventing an arbitrage. The buyer will go into a loss if he buys from bank A at 4.9580 FFr since he would have to sell it to bank B for 4.9578 FFr undergoing a loss of 0.0002 FFr. b) What kind of market will it result into? Ans. This will result into a one way market. c) What might be the reason for this? Ans. A one way market may be created when a bank wants to either encourage the seller of dollars and discourage buyers or vice versa. In this case, Bank A wants to encourage buyers of dollars and discourage sellers of the same thus creating a net long positioning dollars. At the same time Bank B wants to encourage the sellers of dollars and discourage buyers thus creating a net short position in dollars. Hence the outcome would be that Bank A will be confronted largely with buyers of US dollars and few sellers while for Bank B the reverse case will hold true. Eventually, it would mean that regular clients of Bank B wanting to buy dollars can save some money by going to Bank A and vice versa.
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be
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80
90
Bank A
3. In London a dealer quotes: DEM/ GPB spot 3.5250/55 JPY/ GPB spot 180.0080/181.0030 a) What do you expect the JPY/ DEM rate to be in Frankfurt? Ans. In London: DEM/ GPB spot 3.5250/55 JPY/ GPB spot 180.0080/181.0030 Therefore, JPY/ DEM = B1 A1 [where B1 - 180.0080 A2 B2 A1 181.0030 B2 - 3.5250 A2 3.5255] = 180.0080 181.0030 3.5255 = 51.0588 / 51.3483 JPY/ DEM It is assumed that the JPY/ DEM rate in Frankfurt will also approximately be the same as in London. Therefore, the JPY/ DEM rate in Frankfurt is 51.0588 / 51.3483. b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot 51.1530/ 51.2250. Is there an arbitrage opportunity? Ans. When in London: JPY/ DEM 51.0588 / 51.3483 and In Frankfurt: JPY/ DEM 51.1530/ 51.2250 There is no arbitrage opportunity as the quotes overlap each other and the buyer will stand to make a loss. If he buys in Frankfurt where 1 DEM is 51.2250 JPY and sells it in London for 51.0588 JPY, he makes a loss of 0.1662JPY. Diagrammatically it can be represented as: JPY/ DEM 51.0588 Frankfurt London .1530 .2250 .3483 3.5250
4. The following quotes are obtained in New York: DEM/$ spot 1.5880/ 90 1- month forward 10/ 5 2- month forward 20/ 10 3- month forward 30/ 15 Calculate the outright forward rates. Ans. While observing the forward quotations, it is clear that the US dollar is at discount in the forward market since the points corresponding to the bid price are higher than those corresponding to the ask price. Therefore, the forward points will be subtracted form the spot rate figure. Thus, the outright rates are: DEM/$ spot - 1.5880/ 90
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1 month forward - 1.5870/ 85 2 month forward - 1.5860/ 80 3 month forward - 1.5850/ 75 Text Book Questions The Foreign Exchange Market I. Explain the following terms: 1. Bid rate: The bid rate denotes the number of units of a currency a bank is willing to pay when it buys another currency. 2. Offer rate: The offer rate denotes the number of units of a currency a bank will want to be paid when it sells a currency 3. Bid offer spread: The difference between the ask and bid rates. E.g. [(DEM/USD)ask (DEM/USD)bid] 4. Value date: The settlement of a transaction takes place by transfers of deposits between two parties. The day on which these transfers are effected is called the Settlement Date or the Value Date. 5. Swap transaction: A swap transaction in the foreign exchange market is combination of a spot and a forward in the opposite direction. Thus a bank will buy DEM spot against USD and simultaneously enter into a forward transaction with the same counter party to sell DEM against USD against the mark coupled with a 60- day forward sale of USD against the mark. As the term swap implies, it is a temporary exchange of one currency for another with an obligation to reverse it at a specific future date. II Explain the terms: a) European quotes: The quotes are given as number of units of a currency per USD. Thus DEM1.5675/USD is a European quote. b) American quotes: American quotes are given as number of dollars per unit of a currency. Thus USD0.4575/DEM is an American quote c) Direct quotes: In a country, direct quotes are those that give unit of the currency of that country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote in India. d) Indirect quotes: Indirect or Reciprocal Quotes are stated as number of units of a foreign currency per unit of the home currency. Thus USD 3.9560/INR 100 is an indirect quote in India. e) On a particular day at 11.00 am, the following DEM/$ spot quote is obtained from a bank 1.6225/35. a). Explain this quotation. Ans. The above quotation shows the bid rate and the ask rate of the currencies in question, the initial figure i.e. 1.6225 being the bid rate and the latter being the ask rate. Also it shows the number of DEM used to buy or sell one US dollar i.e.
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the bank will pay 1.6225 DEM for each US dollar it buys and will want to be paid 1.6235 DEM for each US dollar it sells. b) Compute implied inverse quote. Ans. When DEM/$ is 1.6225/35, the implied inverse quote is: $/DEM becomes 0.6159/63 (1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163) c). Another bank quoted $/DEM 0.6154/59. Is there an arbitrage? If so how would it work? Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM 0.6159/63. There is no arbitrage opportunity since the main purpose of doing an arbitrage is making a profit without any risk or commitment of capital. This doesnt exist in the given case as a potential buyer would end up buying a DEM at 0.6159 $ from Bank A and would have to sell it to Bank B at the same price since that would be the only way of not making any losses. It is clear form the diagram shown below that shows no arbitrage is possible: $/DEM 0.6154 59 Bank A 63 Bank B
III. The following quotes are obtained from the banks: FFr/$ spot Bank A 4.9570/80 Bank B 4.9578/90
a) Is there an arbitrage opportunities Ans. There is no arbitrage opportunity in this case. This can be represented diagrammatically as: FFr/$ 4.9570 90 Bank A Bank B The quotes are overlapping each other hence preventing an arbitrage. The buyer will go into a loss if he buys from bank A at 4.9580 FFr since he would have to sell it to bank B for 4.9578 FFr undergoing a loss of 0.0002 FFr. b) What kind of market will it result into? Ans. This will result into a one way market. c) What might be the reason for this? Ans. A one way market may be created when a bank wants to either encourage the seller of dollars and discourage buyers or vice versa. In this case, Bank A wants to encourage buyers of dollars and discourage sellers of the same thus creating a net long positioning dollars. At the same time Bank B wants to encourage the sellers of dollars and discourage buyers thus creating a net short position in dollars. Hence the outcome would be that Bank A will be confronted largely with buyers of US dollars and few sellers while for Bank B the
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78
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reverse case will hold true. Eventually, it would mean that regular clients of Bank B wanting to buy dollars can save some money by going to Bank A and vice versa. IV. The buyer rate for SFr spot in New York is $ 0.5910. A corporate treasurer is going to buy SFr in Zurich at SFr/$ 1.6650 and sell them in New York. Will he make a profit? If yes, then how much? Ans. The steps involved in this process are as follows: i. Buys 1.6650SFr at Zurich by paying 1$ ii. Sells 1.6650 SFr at New York and gets 0.9840$ [0.5910*1.6650] Thus, gives 1$ and gets 0.9840$. Therefore loss inculcated is $0.016. V. In London a dealer quotes: DEM/ GPB spot 3.5250/55 JPY/ GPB spot 180.80/181. 30 a) What do you expect the JPY/ DEM rate to be in Frankfurt? Ans. In London: DEM/ GPB spot 3.5250/55 JPY/ GPB spot 180.80/181.30 Therefore, JPY/ DEM = B1 A1 [where B1 - 180.80 A2 B2 A1 181.30 B2 - 3.5250 A2 3.5255] = 180.80 181.30 3.5255 3.5250 = 51.2835/ 51.4326 JPY/ DEM It is assumed that the JPY/ DEM rate in Frankfurt will also approximately be the same as in London. Therefore, the JPY/ DEM rate in Frankfurt is 51.2835/ 51.4326 b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot 51.1530/ 51.2250. Is there an arbitrage opportunity? Ans. When in London A: JPY/ DEM 51. 2835/ 51.4326 and In Frankfurt B: JPY/ DEM 51.1530/ 51.2250 There exist an arbitrage opportunity, buy from the dealer from Frankfurt at 51.2550JPY and sell it to the dealer in London at 51.2835JPY making a profit of 0.0285JPY/DEM without any risk of commitment of capital. It can be shown as : At B + DEM -51.2550 JPY At A -DEM +51.2835 JPY i. +0.0285JPY Another arbitrage that is possible is shown as under: At A buy DEM i.e. DEM +51.2835 JPY At B +x -51.2550 JPY X = 51.2835/51.2550 = 1.0006 DEM Therefore, arbitrage of 0.0006 DEM is possible. VII. The following quotes are obtained in New York: DEM/$ spot 1.5880/ 90 1- month forward 10/ 5 2- month forward 20/ 10
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3- month forward 30/ 15 Calculate the outright forward rates. Ans. While observing the forward quotations, it is clear that the US dollar is at discount in the forward market since the points corresponding to the bid price are higher than VIII The following quotes are available in Amsterdam: $/DG spot :0.5875/85 1- month fwd :12/18 2-month fwd :15/25 3- month fwd :20/30 Calculate the outright forward. Ans. An observation of the figures indicates that the first figure is lower than the second in all the three forward quotes, implying DG is quoted at premium in the forward market. Thus, the points will be added to the corresponding spot rates. The rates are calculated as shown: $/DG spot :0.5875/58 1-month fwd :0.5887/0.5903 2-month fwd :0.5890/0.5910 3-month fwd :0.5895/0.5915 those corresponding to the ask price. Therefore, the forward points will be subtracted form the spot rate figure. Thus, the outright rates are: DEM/$ spot - 1.5880/ 90 1 month forward - 1.5870/ 85 2 month forward - 1.5860/ 80 3 month forward - 1.5850/ 75
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INTERNATIONAL FINANCE

Bretton Woods System was valid as along as it lasted

Indian Corporate Delivery of ordinary shares or bonds Co-ordinate activities

Lead Manager Co-ordinate activities

Domestic Custodian Bank

Instruction to issue depository receipts or certificates

Overseas Depository Bank

Listing Purchase of Depository receipts

Payment of Interest / Dividend

Foreign aid is allocated on long repayment repayment schedules, at lower interest

schedules or soft terms.

5. Define arbitrage and explain the different types of arbitrage.

Numerical Examples 1. An Arbitrage between two Currencies.

Forward discount/ premium = * 100

Forward mid Spot mid * 12/n

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