Question Paper

International Finance and Trade – I (221) : July 2005

Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.
Quotas are government imposed limits on the __________ of goods trade between countries. < Answer >
1.
(a) Prices (b) Quantity (c) Revenue (d) Costs (e) Tax slabs.
If there are no barriers to trade among the member countries and the external barriers for non-members < Answer >
2.
are also common, then this form of trading block falls under
(a) Free trade area (b) Common Market
(c) Customs Union (d) Economic Union (e) Autarky .
The role of _________ is to direct one nation’s savings into investments of another nation. < Answer >
3.
(a) Merchandise trade flows (b) Services flows
(c) Current account flows (d) Capital flows (e) Both (c) and (d) above.
In balance of payments statement, current account deficits are offset by < Answer >
4.
(a) Merchandise trade deficits (b) Merchandise trade surpluses
(c) Capital account surpluses (d) Capital account deficits (e) Official reserves.
A depreciation of the dollar in US will have its most pronounced impact on imports, if the demand for < Answer >
5.
imports is
(a) Constant (b) Inelastic (c) Elastic
(d) Unitary elastic (e) Zero.
The relationship between the exchange rate and the prices of tradeable goods is known as the < Answer >
6.
(a) Purchasing power parity theory (b) Asset markets theory
(c) Portfolio balance theory (d) Interest rate parity theory
(e) Fisher open condition.
Low real interest rates in the United States tend to < Answer >
7.
(a) Increase the demand for dollars, causing the dollar to depreciate
(b) Decrease the demand for dollars, causing the dollar to appreciate
(c) Decrease the demand for dollars, causing the dollar to depreciate
(d) Increase the demand for dollars, causing the dollar to appreciate
(e) Bring stability in exchange rates.
Which exchange rate system involves “leaning against the Wind” strategy in which short-term < Answer >
8.
fluctuations in exchange rates are reduced without adhering to any particular exchange rate over the
long run?
(a) Pegged exchange rate system (b) Currency board system
(c) Monetary union (d) Freely floating exchange rate system
(e) Managed floating exchange rate system.
An appreciation of a country’s currency < Answer >
9.
(a) Decreases the relative price of its exports and lowers the relative price of its imports
(b) Raises the relative price of its exports and raises the relative price of its imports
(c) Decreases the relative price of its exports and raises the relative price of its imports
(d) Raises the relative price of its exports and lowers the relative price of its imports
(e) Both (a) and (b) above.
< Answer >
10. If U.K. interest rates are higher than Japanese interest rates, the theory of covered interest arbitrage
would suggest that in the £/Yen exchange markets the Yen would be at a forward _________ and the
pound would ___________.
(a) Discount, be at a forward premium
(b) Discount, also be at a forward discount
(c) Premium, also be at a forward premium
(d) Premium, be at a forward discount
(e) Discount, be stable.
< Answer >
11. If a speculator observes that the current 90-day forward rate on Danish Kroner is $0.20 = DKr1 but he

1
 expects that the spot rate in 90 days will be $ 0.30 = DKr 1, then this speculator would now
(a) Buy dollars in the forward market
(b) Buy Danish kroners in the forward market
(c) Sell Danish kroners in the forward market
(d) Buy Danish kroners on the spot market and simultaneously sell Danish kroners on the 90 – day
forward market if the current spot rate is $ 0.25 = DKr 1
(e) Avoid taking any buy or sell position.
If in the time period 1, the equilibrium value of one pound is $ 1.6, but then U.K prices double between < Answer >
12.
time period 1 and 2, while US prices rise by 60% then the relative purchasing power parity theory
would say that the equilibrium value of one pound in time period 2 is
(a) $ 0. 80 (b) $ 1.25 (c) $ 1.28 (d) $ 2.00 (e) $ 3.00.
Consider the information given below < Answer >
13.
Country Tons of steel Air conditioners
Japan 80 40
China 20 20
The opportunity cost of one air conditioner in China is
(a) One ton of steel (b) Two tons of steel (c) Three tons of steel
(d) Four tons of steel (e) Five tons of steel.
A bill of lading in which the consignor is a party other than the seller is called < Answer >
14.
(a) House bill of lading (b) Charter party bill of lading
(c) Clean bill of lading (d) Third party bill of lading
(e) Short form bill of lading.
In which of the following cases of international commercial terms, the seller has to make payment of < Answer >
15.
freight charges for transportation of goods to buyer
(a) Free Alongside Ship (b) Free on Board
(c) Free Carrier (d) Ex-works (e) Delivered Ex-Ship.
Bank of India is having an account with Citi Bank New York. When ICICI Bank refers to this account < Answer >
16.
of Bank of India, while corresponding with Citi Bank New York, it would refer to this as
(a) Nostro account (b) Vostro account (c) Loro account
(d) Mirror account (e) Shadow account.
Which of the following strategies is classified as production strategies to manage the economic < Answer >
17.
exposure?
(a) Market selection (b) Plant location
(c) Product strategy (d) Promotional strategy
(e) Pricing strategy.
Trade in differentiated products is called < Answer >
18.
(a) Trade based on economies of scale
(b) Inter-Industry trade (c) Intra-Industry trade
(d) Trade based on imitation gaps (e) Trade based on product cycles.
Terms of trade for a country are the ratio of ________ to _________ < Answer >
19.
(a) Its currency, other currencies
(b) Export prices, import prices
(c) Its opportunity costs, world opportunity costs
(d) Savings, investment
(e) Foreign exchange earnings, foreign currency borrowings.
Which of the following is true under a currency board system? < Answer >
20.
(a) The interest rates are automatically set by the market mechanism
(b) When there is a higher demand for the anchor currency, the reserves with the currency board gets
enhanced
(c) Lending to either the government or the domestic banks by the currency board is allowed
(d) The board can act as the lender of the last resort
(e) Exchange rates are unstable.
Which of the following is true with respect to irrevocable letter of credit? < Answer >
21.
(a) It cannot be canceled by the issuing bank without the consent of the beneficiary
(b) The applicant in the irrevocable letter of credit is the exporter
(c) It can be canceled by the issuing bank at the request of the applicant
(d) It cannot be confirmed by any bank other than the issuing bank
(e) The credit available to the beneficiary gets reinstated after being utilized once.

2
 < Answer >
22. If there is a strong probability of positive cash flows being generated, the discount rate for calculating
the present value of depreciation tax shield would be
(a) Domestic nominal risk free rate (b) All equity discount rate
(c) Host country nominal risk free rate (d) Competitive borrowing rate in host country
(e) Cost of capital of the parent company.
< Answer >
23. In a swap-out deal, the foreign currency is
(a) Bought both spot and forward (b) Sold both spot and forward
(c) Sold spot and bought forward (d) Sold forward with different maturities
(e) Bought forward with different maturities.
< Answer >
24. The rates available in the market are:
Rs./$ Spot 43.78 / 79
£/$ 0.5285 /86
If an Indian importer requires pounds, the rate quoted to him is
(a) Rs.82.82/£ (b) Rs.82.72/£ (c) Rs.82.79/£ (d) Rs.82.86/£ (e) Rs.82.84/£.
< Answer >
25. Which of the following foreign exchange exposures refers to the impact on the value of firms operations
due to unanticipated changes in the exchange rates?
(a) Transformation exposure (b) Transaction exposure
(c) Translation exposure (d) Currency exposure (e) Economic exposure.
< Answer >
26. An exporter who desires to claim various export incentives has to register with the
(a) RBI
(b) EXIM Bank
(c) Foreign Exchange Dealers Association of India
(d) Export Credit Guarantee Corporation
(e) Export promotion council.
< Answer >
27. Which of the following risks is/are classified by Export Credit Guarantee Corporation as political risk?
(a) Buyer’s failure to accept the goods
(b) Insolvency of the buyer
(c) Cancellation of a valid import licence in buyer’s country
(d) Buyer’s failure to make the payment within the due date
(e) Both (a) and (d) above.
< Answer >
28. The present exchange control regulations require an exporter to submit all the shipping documents
evidencing export to an Authorized dealer within
(a) 3 days from the date of shipment (b) 7 days from the date of shipment
(c) 15 days from the date of shipment (d) 21 days from the date of shipment
(e) 30 days from the date of shipment.
< Answer >
29. Samurai bond is a bond
(a) Denominated in yen and issued outside Japan
(b) Denominated in a currency other than yen and issued to the public in Japan
(c) Denominated in yen and issued under private placement by non-Japanese borrowers in Japan
(d) Denominated in yen and issued by non-Japanese borrowers to the public in Japan
(e) Denominated in yen and issued by Japanese borrowers in US.
< Answer >
30. If interest rate parity holds and the transaction costs are zero, covered foreign financing will result in an
effective borrowing rate that is
(a) Less than domestic interest rate
(b) Greater than domestic interest rate
(c) Equal to domestic interest rate
(d) Less than domestic interest rate if forward rate is in discount
(e) Negative.
END OF SECTION A

Section B : Problems (50 Marks)

This section consists of questions with serial number 1 – 6.
Answer all questions.
Marks are indicated against each question.

3
 Detailed workings should form part of your answer.
Do not spend more than 110 - 120 minutes on Section B.

1. You are given the following information by your banker.

Spot Rs./HK $ : 5.60 / 65
Rupee Interest rates (p.a.)
Six months : 6% / 7%
HK $ Interest rates (p.a.)
Six months : 4% / 5%
You are required to determine the limits for six-month forward rates that would prevent covered interest
arbitrage.
(6 marks) < Answer >
2. A German exporter is expecting to receive $5,00,000 after six months. He has collected the following information.
Spot $/Euro : 1.2800/05
Six-month forward $/Euro : 80/85
Six-month interest rates (p.a.) : $ – 2.4% / 3%
Euro – 2% / 2.6%
You are required to compare the two alternatives of money market and forward market for covering the exposure.
(7 marks) < Answer >
3. Vinod Apparels exported readymade garments to Germany. On April 01, 2005, the company requested its banker
to book a forward contract for Euro 100,000 to deliver on June 30, 2005.
On April 01, 2005 the following rates prevailed in the inter bank market for US dollars in Mumbai:
Rs./$ Spot : 43.10/11
April : 10/9 paise
May : 20/19 paise
June : 30/29 paise

The exchange rates in Singapore market are:

Euro/$ Spot : 0.7806/08
April : 0.7799/02
May : 0.7792/96
June : 0.7785/90

However, the company could not export the readymade garments due to a dispute over the price. Hence, the
company requested its banker to cancel the contract on June 30, 2005.
On June 30, 2005 the following rates prevailed in the inter-bank market for US dollars in Mumbai.
Rs./$ Spot : 43.42/44
1 month forward : 5/6 paise
2 months forward : 10/11 paise

The exchange rates in Singapore market are:

Euro/$ Spot : 0.7786/88

Exchange margin collected by the bank is 0.10% while quoting the rates.

You are required to compute:

a. The forward rate quoted by the bank on July 01, 2005.
b. The cancellation charges, if any, payable by or to the company.
(4 + 6 = 10 marks) < Answer >

4
4. Richmond Pension Fund, an offshore investment company floated by a multinational investment banker in U.S
has invested in a few selected mutual funds in India for a period of one year.
Rs./$ one year ago Rs.44.48/50
Rs./$ now Rs.43.43/45
Unit value of investment Rs.1,00,000
Cash flow at the end of six months Rs.5,000
Cash flow at the end of one year 1,00,500
Reinvestment rate in India 6%
Inflation rate in India 5%
Inflation rate in U.S 3%
You are required to
a. Compute nominal rate of return to the company.
b. Compute the real rate of return to the company.
c. Compute the real rate of return to an Indian Investor who invested in the same mutual fund.
(3 + 4 + 3 = 10 marks) < Answer >
5. Swastik Industries imported drilling machines from Germany under an irrevocable letter of credit. The LC
negotiating bank forwarded all the shipping documents by courier and obtained reimbursement on July 01, 2005.
The bank in Mumbai received the documents on July 08, 2005. The amount of payable was Euro 1,00,000.
Though the importer had funds to settle the payable on July 08, 2005, the importer settled the payable on July 18,
2005 by forecasting that the rupee would appreciate. Bank quoted the exchange rate by loading an exchange
margin of 0.20%. Commission at the rate of 0.15% was recovered on the bill amount. Interest was recovered at
12%.
The spot exchange rates as on July 08, 2005 and July 18, 2005 are given below:
July 08, 2005 July 18, 2005
Mumbai Rs. / $ 43.43 / 45 43.32 / 34
London $/£ 1.8730 / 32 1.8736 / 38
Euro / £ 1.4624 / 26 1.4630 / 32
Note : As per FEDAI rules, sight import bills received under LC are to be retired by the importer on or before 10
days after the date of receipt of the documents by the bank.
You are required to calculate:
a. The effective exchange rate on July 08, 2005.
b. Gain or loss to the importer for settling the amount on July 18, 2005.
c. Actual rupee outflow to the importer on the date of settlement.
(3 + 3 + 4 = 10 marks) < Answer >
6. A US Institutional Investor wants to invest in a Indian security with a beta of 1.23 and standard deviation of 18%.
The return on the market portfolio is 16% and risk-free rate is 5% in India. Indian rupee is expected to depreciate
by 3% in the next one year.
You are required to calculate expected return in dollar if the FII holds the investment for one year.
(7 marks) < Answer >

END OF SECTION B

Section C : Applied Theory (20 Marks)

This section consists of questions with serial number 7 - 8.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.

7. Mr Rohit an exporter of polished diamonds and jewellery has been availing preshipment finance from his bank at

5
 8%. He is of the view that his competitors in other countries are able to access capital at a cheaper rate of interest.
After having explored various alternatives he has zeroed in on the preshipment credit in foreign currency scheme
(PCFC). Explain the PCFC scheme, its benefits and the terms and conditions applicable to such credit
(10 marks) < Answer >
8. Economic exposure is managed through various marketing, production and financial management strategies, as
the traditional hedging tools are not appropriate techniques for managing economic exposure. Discuss different
types of production strategies a firm can adopt to manage economic exposure.
(10 marks) < Answer >
END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
International Finance and Trade – I (221): July 2005
Section A : Basic Concepts
1. Answer : (b) < TOP >

Reason : Quotas are government imposed limits on the quantity of goods trade
between countries.
2. Answer : (c) < TOP >

Reason : If there are no barriers to trade among the member countries and the
external barriers for non-members are also common, then this form of
trading block falls under customs union.
3. Answer : (d) < TOP >

Reason : The role of capital flows is to direct one nations savings into investments
of another nation.
4. Answer : (c) < TOP >

Reason : In balance of payments statement, current account deficits are offset by

capital account surplus.
5. Answer : (c) < TOP >

Reason : A depreciation of the dollar in US will have its most pronounced impact
on imports, if the demand for imports is elastic.
6. Answer : (a) < TOP >

Reason : The relationship between the exchange rate and the prices of tradeable
goods is known as the purchasing power parity theory.
7. Answer : (c) < TOP >

Reason : Low real interest rates in the United States tend to decrease the demand
for dollars, causing the dollar to depreciate.
8. Answer : (e) < TOP >

Reason : Managed floating exchange rate system involves “leaning against the
wind” strategy in which short-term fluctuations in exchange rates are
reduced without adhering to any particular exchange rate over the long
run.
9. Answer : (d) < TOP >

Reason : An appreciation of a country currency raises the relative price of its

exports and lowers the relative price of its imports.
10. Answer : (d) < TOP >

Reason : If U.K interest rates are higher than Japanese interest rates, the theory of
covered interest arbitrage would suggest that in the £/yen exchange
markets, the yen would be at a forward premium and the pound would
6
 be at a forward discount.
11. Answer : (b) < TOP >

Reason : If the speculator expects that the spot rate in 90 days is going to be $
0.30 = DKr1 as against the present 90 days forward rate of DKr 1 =
$0.20, then the speculator would now buy Danish Kroner at DKR 1=
$0.20. This will result in profit for the speculator. Assume that the
speculator purchased DKR 5 for US$1. After 90 days the speculator
sells DKR 5 at $0.30 = DKr1. This will result in inflow of dollars at
(5 x 0.30) = $ 1.50
Profit = 1.50 – 1.00 = $0.50.
12. Answer : (c) < TOP >

Reason : Time period 1 £ 1 = $ 1.6

Prices in UK doubled and in US by 60%. Following PPP
Time period 2 £ 2 = 1.6 x 1.60
2.56
£ 1 = 2.00
= $ 1.28.
13. Answer : (a) < TOP >

Reason : The opportunity cost of one air conditioner in China is one ton of steel
(20/20).
14. Answer : (d) < TOP >

Reason : A bill of lading in which the consignor is a party other than the seller is
called third party bill of lading.
15. Answer : (e) < TOP >

Reason : In the case of delivered ex-ship contract, the seller has to make payment
of freight changes for transportation of goods to buyer. In all other cases
of options a, b, c, and d the buyer has to bear the freight changes.
16. Answer : (c) < TOP >

Reason : Bank of India is having an account with Citi Bank Newyork. When
ICICI Bank refers to this account of Bank of India, while corresponding
with Citi Bank Newyork, it would refer to this as Loro account. Loro
account means “their account with you”.
17. Answer : (b) < TOP >

Reason : Options in a, c, d and e are marketing strategies for management of

economic exposure. Option in b is the production strategy for
management of economic exposure.
18. Answer : (c) < TOP >

Reason : Trade in differentiated products is called Intra-Industry trade.

19. Answer : (b) < TOP >

Reason : Terms of trade for a country are the ratio of export prices to import
prices.
20. Answer : (a) < TOP >

Reason : In the currency board system, the board does not have any discretionary
powers over the monetary policy; the interest rates are automatically set
by the market mechanism. Options (b), (c), (d) and (e) are not true.
21. Answer : (a) < TOP >

Reason : An irrevocable Letter of Credit is one which cannot be canceled by the

issuing bank without the consent of the beneficiary. The applicant in the
irrevocable letter of credit is importer. When any bank other than the
issuing bank does not confirm a letter of credit, it is called an
unconfirmed letter of credit. If the credit available to the beneficiary
gets reinstated after being utilized once, it is called revolving letter of

7
 credit. Hence alternative (a) is the answer.
< TOP >
22. Answer : (a)
Reason : Since the depreciation charge is based on the historical cost of assets
and is hence contractual, the discount rate should be the domestic
nominal rate. If there is a strong probability of positive cash flows being
generated, and hence of the depreciation tax shield being availed, the
risk premium bay be negligible, and the domestic nominal risk free rate
may be used.
< TOP >
23. Answer : (c)
Reason : In a swap-out deal, the foreign currency is sold spot and bought forward.
Options in (a), (b), (d) and (e) are not correct.
24. Answer : (d) < TOP >

Reason : The rate to be quoted to the Importer is the ask rate

= (Rs./$) ask × ($/£) ask
= (Rs./$) ask ×(1/£/$) bid
= 43.79 × (1/0.5285) = Rs.82.86/£
25. Answer : (e) < TOP >

Reason : Economic exposure refers to the impact on the value of firms operations
due to unanticipated changes in the exchange rates.
Transaction exposure arises out of day-to-day activities of a company.
Transaction exposure arises due to the need to translate the foreign
currency values of assets and liabilities into the domestic currency
Currency exposure refers to the currency which is to be received/or
paid.
Correct answer is (e).
26. Answer : (e) < TOP >

Reason : An exporter who desires to claim various export incentives has to

register with Export promotion council. Options in (a), (b), (c) and (d)
are not correct.
27. Answer : (c) < TOP >

Reason : Cancellation of a valid import licence in buyer’s country is considered

as political risk by ECGC. Options in (a), (b) and (d) are considered as
commercial risks.
28. Answer : (d) < TOP >

Reason : An exporter has to submit all the shipping documents evidencing export,
to an Authorized Dealer within 21 days from the date of shipment.
29. Answer : (d) < TOP >

Reason : Samurai bond is a bond denominated in yen and issued by non-Japanese

borrowers to the public in Japan.
30. Answer : (c) < TOP >

Reason : According to the Interest rate parity or the covered interest parity
condition, the cost of borrowing money or the rate of return on financial
investments, when adjusted for the cost of covering foreign exchange
risk is equal across different currencies.

8
 Section B : Problems
1. Let Fb be the forward rate (Rs./HK$)
Suppose we borrow Rs. 100 for 6 months.
Conversion into HK$ and investment for 6 months yields.
Rs. (100/5.65) (1 + 0.04/2) (Fb)
Loan repayment = 100 (1 + 0.07/2)
To prevent arbitrage,
100 (1 + 0.07/2) > (100/5.65) ( 1 + 0.04/2) (Fb)
Or 5.73 > Fb
Or Fb < 5.73
Assume we borrow HK$ 100 for 6 months. Conversion into Rs. And investment for 6 months will yield
HK$ (100) (5.60) (1 + 0.06/2)/Fa
Loan repayment = (100) (1 + 0.05/2)
To prevent arbitrage,
(100) (1 + 0.05/2) > (100) (5.60) (1+0.06/2)/Fa
Or Fa > 5.63
So, to prevent arbitrage, forward rates should be
Fb < Rs. 5.73/HK$
Fa > Rs. 5.63/HK$.
< TOP >
2. Forward Cover :
The exporter can sell $ 5,00, 000 forward.
Euro obtained = 5,00,000 / 1.2890
= Euro 3,87,897.60
Money Market cover :
The exporter can borrow today:
$ (5,00,000)/(1 + 0.03/2) = $ 4,92,610.84
4, 92, 610.84
This can be converted into Euro at 1.2805 = 1.2805
= Euro 3,84,701.95
If this amount is invested we will receive 3,84,701.95 (1 + 0.02 / 2) = Euro 3,88,548.97
So, the money market cover generates more revenues in this case.
< TOP >

3. a. US dollar is at discount. Discount is to be taken for June 05.

Rs /$ Spot bid rate 43.10
Deduct discount for June 0.30
42.80
Less exchange margin at 0.10% 0.043
Forward buying rate for dollar 42.757
US dollar is at discount. Since selling rate is to be considered, earlier delivery ask rate of 0.7796 is to be
taken.

42.757
Forward bid rate of Euro = 0.7796
= Rs.54.84.
b. On June 30, 2004 the contract is to be cancelled at the T.T. selling rate
Rs./$ spot ask rate = 43.44

9
 0.043
Add Exchange margin at 0.10% = 43.483
Euro/$ spot buying rate 0.7786

43.483
T.T selling rate for Rs./Euro = 0.7786
= 55.847
Say Rs.55.85
Cancellation charges
Euro 1,00,000 sold to the company at Rs.55.85 = Rs.55,85,000
Euro 1,00,000 bought from the company at Rs.54.84 = Rs.54,84,000
Exchange difference payable by the company = Rs. 1,01,000
The company has to pay Rs.1,01,100 including Rs.100/- towards cancellation charges.
< TOP >

4. a. Nominal rate of return to Jupiter Pension Fund

1, 00,500 5, 000  0.06  100000

+ 1 + = (1 + r )
43.45 43.45  2  44.48
2,313.00 + 118.53 = 2,248.20 (1 + r)
2,431.53 = 2,248.20 ( 1+ r )
r = 0.0815
r = 8.15%
b. Real rate of return to Richmond pension fund.
Here the inflation should be adjusted. The inflation in U.S should be considered to compute the real rate of
return.

2,313.00 118.53
+ = 2, 248.20(1 + r)
That is 1 + 0.03 1 + 0.03
2,245.63 + 115.08 = 2,248.20 (1 + r)
2,360.71 = 2,248.20 (1 + r)
r = 0.0500
or r = 5%
c. Real rate of return for an Indian investor
Here the exchange rates need not be considered because the amount is invested in India itself. Inflation in
India should be considered while computing the real rate of return.

 0.06 
1 + 
Cash flow invested will grow by the end of the year to 5,000  2  = Rs.5150
Total inflow at the end of the year = 100500 + 5150
= Rs.1,05,650

1, 05, 650 − 1, 00, 000

Nominal return = 1, 00, 000 = 5.65%

1.0565
−1
Real return = 1.05 = 0.62%
< TOP >

10
5. a. The importer has to buy Euro from the bank. Hence the relevant rate is Rs. / Euro ask rate.
The effective exchange rate on July 08, 2005.
Rs. / Euro ask rate = (Rs. / $)ask × ($ / £ )ask × (£ / Euro)ask

1
= (Rs. / $)ask × ($ / £ )ask × (Euro / £) bid

1
43.45 ×1.8732 ×
= 1.4624
= 55.6555
Effective rate offered by the bank = 55.6555 (1 + 0.002)
= 55.7668 Say Rs.55.77
b. Actual rupee / Euro ask rate on July 18, 2005

1
43.34 × 1.8738 ×
Rs. / Euro ask rate = 1.4630
Effective rate offered by the bank = 55.5096 (1 + 0.002)
= 55.6206 Say Rs.55.62
Gain to the customer = 1,00,000 (55.77 – 55.62)
= Rs.15,000
c. Actual rupee outflow to the importer
Bill amount (1,00,000 × 55.62) = 55,62,000
Commission at 0.15% = 8,343
Interest at 12% for 17 days
(July 01, 2005 to July 18, 2005) = 31,086
= Rs.56,01,429
< TOP >

6. Expected return = Rf + β (Rm – Rf)

= 0.05 + 1.23 (0.16 – 0.05)
= 18.53%
Suppose the FII buy Rs.100 worth of stock.
Value of the investment after one year
= 100 (1.1853)
= Rs.118.53
If spot $/Rs. rate is x at the time of investment, it will $/Rs.0.97x after one year

118.53 × 0.97 x − 100 x

∴ Dollar return on investment = 100 x
= 14.97%.
< TOP >

Section C: Applied Theory

7. Exports often complain about the high cost of capital vis-à-vis their competitors from other countries. In order to
make their prices competitive and thereby give a boost to exports, the Government of India made available yet
another mode of financing – financing exporters in foreign currency at internationally competitive interest rates.
Pre – shipment Credit in Foreign (PCFC) is made available to cover both the domestic as well as imported inputs

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 of the exported goods. It is available only for cash exports. It can also be extended in a convertible currency other
than the currency in which the export order is invoiced. An exporter who avails of credit under this scheme will
not be eligible to avail of post-shipment finance in Indian rupees. He will necessarily have to avail of post-
shipment finance in foreign currency only.
PCFC will initially be available for a maximum period of 180 days. Any extension beyond this time limit will be
subject to the same terms and conditions as rupee packing credit and it will also have an additional interest cost of
2% above the rate for the initial period of 180 days prevailing at the time of extension. Any extension beyond 270
days will be subject tot eh terms and conditions fixed by the authorized dealer concerned and if no export takes
place within 360 days, the PCFC will be adjusted at the TT selling rate of the currency concerned. In such cases
authorized dealers (ADs) can arrange to remit foreign exchange to repay the loan or line of credit raised abroad
and interest thereon without prior permission of RBI.
Liquidation of Credit
The credit will be self liquidating in nature and accordingly after the shipment of goods, the credit will be
liquidated by submission of export documents for discounting/rediscounting under the Rediscounting of export
bills abroad scheme. PCFC should not be liquidated with foreign exchange acquired from other sources. The
benefit such as credit by a part of export proceeds to EEFC account, etc. will accrue only after realization of the
export proceeds or when the resultant export bills are rediscounted ‘without recourse’ basis and not at the stage of
conversion of pre-shipment credit to post=shipment credit.
In case of cancellation of export order or where the export takes place after 360 days, the PCFC may be liquidated
by selling equivalent amount of foreign exchange (principal plus interest) at the T.T selling rate prevailing on the
principal amount at the rate of “Export credit not otherwise specified” plus a penal rate of 2 percent from the date
of advance after adjustment of interest of PCFC already recovered. Banks may extend PCFC to such exporters
subsequently only after ensuring that the earlier cancellation of PCFC was due to genuine reasons and not for
speculative purposes.
Rates of Interest Applicable under PCFC
Period between date of Interest rate Current Rate
extending pre-shipment Chargeable
credit till the date the
export takes place
Up to 180 days L + 200 to 250 bp
181-360 days 2% over the rate charged up to 180 LIBOR based
days
Export does not take place PCFC is adjusted at selling rate LIBOR based
within 360 days
Interest will be charged on the Rupee Not more than 20%
equivalent of the principal amount at
“Export Credit not otherwise
specified” + 2% after adjustment of
the interest of PCFC already
recovered.
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8. The following strategies would be available to the production manager:

• Input mix
• Product sourcing
• Plant location
• Raising productivity
Input Mix
The pressures on the profits of an exporting firm caused by an appreciating domestic currency can be countered by
buying more inputs in the international markets than in the domestic market. This would reduce the costs at the
time of reducing revenues, thus protecting the profits, at least to a certain extent. Another way of achieving the
same objective is to outsource the intermediated inputs, either from producers in the country where the firm is
selling its final product, or from producers of a country whose currency is closely linked to that of the country in
which it markets its products. At the same time, it would create pressure on the domestic producers of the
intermediate inputs and force them to become more competitive, thus proving advantageous to the exporting firm.
Product Sourcing
One of the ways of countering exposure is to shift production among different production centers. This strategy
presupposes the presence of production facilities in more than one country. As a response to exchange rate
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movements, the firm can reallocate production to increase the quantity produced in the country whose currency
has depreciated, and reducing production in countries whose currency has appreciated. Due to this flexibility, an
MNC faces less economic exposure than a company having production facilities in only one country.
Plant Location
Companies which do not have multiple production facilities may be forced to set up such facilities abroad as a
response to exchange rate movements which change the relative cost advantages of countries. Firms may even
decide to set up production facilities in third-world countries for labor-intensive products due to the low labor cost
there, without there being any specific advantage due to exchange rate movements.
Such decisions have to be taken after giving due consideration to the duration for which such production facilities
are likely to enjoy cost advantages. Since these commitments are long-term in nature, the benefits should be
expected to continue for a substantially long period, for such investment to be justified. The underlying economic
factors of the country where the setting up of production facilities is being contemplated, need to be evaluated
thoroughly before the decision is made. Sometimes the root cause of the depreciation of that currency (which
gives the country its cost advantage) may be such as to make the cost advantage last only for a short-term (e.g.
inflation). In such cases it may be advisable not to make the investment.
Raising Productivity
An appreciation of the domestic currency results in increasing the costs of an exporting firm in terms of the
foreign currency, thus making the product uncompetitive in the international market, forcing the firm either to bear
a cut in the profit margin or to lose market share. This problem may be resolved by the firm making an effort to
reduce the domestic currency cost of its product in the wake of a domestic currency appreciation. While this may
happen automatically in case imported raw materials or intermediate inputs being used. When this is not the case
the firm may have to resort to other measures like attempting to increase the productivity of the various factors of
production. It may entail modernizing the machinery and the technology, renegotiating wage agreements, closing
inefficient plants, pruning the product line etc.
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