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INTERNATIONAL FINANCE AND TRADE

WORKBOOK

The ICFAI University 52, Nagarjuna Hills, Hyderabad - 500 082

Contents

SECTION I: INTERNATIONAL FINANCE

Brief Summaries of Chapters 1

Part I : Questions and Answers on Basic Concepts (with Explanatory Notes) 20

Part II : Problems and Solutions 79

Part III : Applied Theory: Questions and Answers 181

Part IV : Case Studies: Problems and Solutions 215

Part V : Caselets: Questions and Answers 241

SECTION II: INTERNATIONAL TRADE

Part I : Questions and Answers on Basic Concepts (with Explanatory Notes) 261

Part II : Problems and Solutions 307

Part III : Applied Theory: Questions and Answers 316

Part IV : Case Studies: Problems and Solutions 338

Part V : Caselets: Questions and Answers 346

Part VI : Model Question Papers (with Suggested Answers) 357

Preface The ICFAI University has been upgrading the study material so that it is amenable for self study by the Distance Learning Students. ICFAI University is delighted to publish a Workbook for the benefit of the students preparing for the examinations. The workbook is divided into two sections (International Finance and International Trade). Each section consists five parts. Part VI (Model Question Papers) is common to both the sections. Brief Summaries of Chapters A brief summary of all the chapters in the textbook are given here for easy recollection of the topics studied. Part I: Questions on Basic Concept (with Explanatory Notes) Students are advised to go through the relevant textbook carefully and understand the subject thoroughly before attempting Part I. Under no circumstances the students should attempt Part I without fully grasping the material included in the textbook. Part II: Problems and Solutions The students should attempt Part II only after carefully going through all the solved illustrations in the textbook. A few repetitive problems are provided for the students to have sufficient practice. Part III: Applied Theory Questions and Answers All theory questions are applied in nature. Having understood the basics in the textbook, the students are expected to apply their knowledge to certain real life situations and develop relevant answers. To be able to answer the applied theory questions satisfactorily all the students are advised to follow regularly the Analyst magazine, business magazines and financial dailies. Part IV: Case Studies Problems and Solutions A case study attempts to test the cognitive skills of the student in integrating various concepts covered in the subject with focus on quantitative aspects. Hence, students should attempt them only after they are thorough with the entire subject. Part V: Caselets Questions and Answers A caselet also tests the cognitive skills of the student in integrating various concepts but with focus on qualitative aspects. Students are advised to try to answer the questions given at the end of the articles in the ICFAI Reader to develop their skills further. The caselets given in this part also help students gain the adequate exposure on how current events of interest can be analyzed and interpreted. Part VI: Model Question Papers (with Suggested Answers) The students should attempt all model question papers under simulated examination conditions. They should self score their answers by comparing them with the model answers. Please remember that the ICFAI University examinations are quite rigorous and demanding. The student has to prepare well for each examination. There are no short-cuts to success. We hope that the students will find this workbook useful in preparing for the ICFAI University examinations. Work Hard. Work Smart. Work Regularly. You have a good chance to succeed. All the best.

Brief Summaries of Chapters SECTION I: INTERNATIONAL FINANCE Introduction to International Finance 1. Globalization has led to the integration of both financial and commodity markets. This has

increased the need to study international finance. 2. Studying international finance helps a finance manager to understand the complexities of

the various economies and also various activities that affect the operations of his firm. It helps him to identify and exploit opportunities and also to prevent harmful effects of the international events. Thus he can maximize his profits and minimize his losses.

3. The market players try to profit from the arbitrage opportunities in the international markets and so the events affecting one market also affect other markets directly or indirectly.

4. Integration of markets involves freedom and opportunity to raise funds from and to invest anywhere in the world through any type of instrument. Therefore control over these markets is significantly reduced.

5. Because of the freedom, any event affecting the financial market in one part of the world automatically and quickly affects other part of the world also. This is called “Transmission Effect”.

6. Development of technology, new financial instruments, liberalization of regulations governing the financial markets, and increased cross penetration of foreign ownership are some factors, which contributed to the process of globalization.

7. Integration of markets leads to efficient allocation of capital and a better working financial system, smoother consumption patterns enjoyed by all the countries over a period of time and also give benefits of diversification.

8. Currency risk denotes the risk of the value of an investment denominated in some other country’s currency, coming down in terms of the domestic currency. It also denotes the risk of the value of a foreign liability increasing in terms of the domestic currency.

9. Currency risk is the risk of not being able to disinvest at will due to countries suddenly changing their attitude towards foreign investment or due to some other factors like war, revolution, etc.

Theories of International Trade 1. Adam Smith proposed the theory of Absolute Advantage in 1776. The theory states that –

international trade takes place because one country may be more efficient in producing a particular good than another country, and that other country may be capable of producing some other good more efficiently than the first one.

2. According to the theory of Comparative Advantage, propounded by the English economist David Ricardo in 1817, trade is possible as long as the country experiencing the disadvantage is not equally less efficient in producing all the products, i.e., both the countries enjoy comparative advantage in at least one of the products. The theory states that each country should produce that good, in which it has a comparative advantage.

3. According to the Heckscher-Ohlin model, developed by Eli Heckscher and Bertil Ohlin, there are two types of products – labor intensive and capital intensive. The model says that two countries operate at the same level of efficiency, and trade between themselves due to the differences in their factor endowments. The labor-rich country is more likely to produce labor-intensive goods and the country rich in capital will most probably produce capital-intensive goods.

4. According to the Imitation Gap theory, propounded by Posner, improvement in technology is a continuous process and the resulting inventions and innovations in existing products give rise to trade between such countries.

2

5. Demand lag is the difference between the time a new product is introduced in one country, and the time when consumers in the other country start demanding it.

6. Imitation lag is the difference between the time of introduction of the product in one country, and the time when the producers in country start producing it.

7. According to the international Product Life cycle theory, innovations are generally concentrated in the richer, more developed countries.

International Trade Finance in India 1. International trade is important for all countries as it increases the overall efficiencies of

world production. 2. Financing of international trade takes two forms – financing imports and financing exports. 3. The major way through imports are financed is through Letters of Credit. A letter of credit

is “an arrangement by means of which a bank acting at the request of a customer, undertakes to pay to a third party a predetermined amount by a given date, according to agreed stipulations and against presentation of stipulated documents”.

4. Applicant, issuing bank, beneficiary and advising bank are the parties to a letter of credit. 5. Revocable letter of credit, irrevocable letter of credit, confirmed letter of credit, deferred

payment letter of credit, unconfirmed letter of credit, revolving letter of credit, transferable letter of credit, back-to-back letter of credit and anticipatory letter of credit are different types of letters of credit.

6. Export credit sanctioned is classified into two categories depending on the timing of the credit – pre-shipment credit and post-shipment credit.

7. The purpose of the pre-shipment credit is to provide the necessary funds to the exporter to procure raw material and meet the costs involved in manufacturing the goods. This credit is initially extended without security and it is known as extended packing credit. It is extended to a maximum period of 180 days.

8. Usually there is a time lag between the time of export and the receipt of payment from the importer. The banks extend credit during this period, which is known as post-shipment credit.

9. Turnkey projects are those requiring the rendering of services like civil construction, design, erection, and commissioning of plants, supervision thereof and supply of equipment for the plant.

10. The EXIM bank was set up to finance and promote foreign trade. It extends finance to exporters of capital and manufactured goods, exporters of software and consultancy services and to overseas joint ventures and turnkey/construction projects abroad.

11. The functions of the EXIM bank are lending, guaranteeing, promotional services and advisory services.

12. Exchange controls were introduced in India in 1939, during the World War II, to conserve foreign exchange and to ensure its effective utilization.

13. Right now, the foreign exchange regulations in India are governed by the Foreign Exchange Management Act, 1999.

Balance of Payments 1. The BoP Account is the summary of the flow of economic transactions between the

residents of a country and the Rest of the World (ROW) during a given time period. 2. BoP of a country measures the flow of international payments and receipts. As it measures

flows and not stocks, it records only the changes in the levels (and not the absolute level) of international assets and liabilities.

3. The BoP account records various transactions like exports/imports of goods, and services, payment of dividend/interest, investment in assets, etc. The transactions are broadly classified into current and capital account.

3

4. The IMF Manual recommends the following principles to be followed for valuation of transactions entering the BoP Account: • The transactions should be valued at market prices. • Both exports and imports should be valued at f.o.b. basis (i.e., free on board basis). • Any transaction denominated in a foreign currency should be converted into the

domestic currency at the exchange rates prevailing in the market at the time the transaction takes place.

5. The BoP Account has three components: the current account, the capital account and official account.

6. The current account records all the income-related flows. These flows could arise on account of trade in goods and services and transfer payments among the countries. A net inflow on account of merchandize trade results in a trade surplus while a net outflow results in a trade deficit. A net inflow after taking all entries in the current account into consideration is referred to as the current account surplus and a net outflow as current account deficit.

7. The capital account records movements on account of international purchase or sale of assets. The excess of credits over debits in the capital account over a particular period is referred to as the capital account surplus. The excess of debits over credits is known as capital account surplus.

8. Official Reserves include gold, reserves of convertible foreign currencies, SDRs and balances with the IMF, which are the means of international payment. The official reserves account reflects the amount of these ‘means of international payment’ acquired or lost during the period for which the BoP account is constructed.

9. If there is net surplus in the current account and the capital account taken together (generally referred to as BoP surplus), there will be an increase in the official reserves as the inflows will exceed the outflows. This will appear as a debit entry in the BoP account. A BoP deficit will appear as a credit entry due to its effect on the official reserves.

10. The BoP account has to balance because of the double-entry system, but an imbalance may creep into the BoP account, which can be removed by adding the heading “Errors and Omissions” to it.

11. Exports of goods and services, imports of goods and services income on investments, transfer payments are some of the factors that affect the components of BoP account.

International Monetary System 1. The exchange rate is formally defined as the value of one currency in terms of another. 2. Exchange rates may be fixed, floating, or with limited flexibility. 3. Under a fixed (or pegged) exchange rate system the value of a currency in terms of another

is fixed. These rates are determined by governments or the central banks of the respective countries. The fixed exchange rates result from countries pegging their currencies to either some common commodity or to some particular currency.

4. Under a currency board system, a country fixes the rate of its domestic currency in terms of a foreign currency, and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged.

5. The biggest advantage of a currency board system is that it offers stable exchange rates, which acts as an incentive for international trade and investment.

6. Among the drawbacks, the foremost is the loss of control over interest rates. The equilibrium in the forex markets is established at the point where the domestic interest rates in the economy are in accordance with the underlying economic fundamentals of the domestic and the anchor currency economy and the fixed exchange rate.

7. A good example of a currency board is that of Hong Kong.

4

8. A group of countries sometimes get together, and agree to maintain the exchange rates between their currencies within a certain band around fixed central exchange rates. This system is called a target zone arrangement.

9. Monetary union is the next logical step of target zone arrangement. Under this system, a group of countries agree to use a common currency, instead of their individual currencies. This eliminates the variability of exchange rates and the attendant inefficiencies completely.

10. Under this system, the exchange rates between currencies are variable. These rates are determined by the demand and supply for the currencies in the international market.

11. The exchange rate is said to be freely floating when its movements are totally determined by the market. There is no intervention at all either by the government or by the central bank.

12. When the central banks generally intervene in the currency markets to smoothen the fluctuations, such a system is referred to as a managed float or a dirty float.

13. A crawling peg system 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 itself keeps changing in accordance with the underlying economic fundamentals, thus letting the market forces play a role in the determination of the exchange rate.

14. The exchange rate between two currencies was determined on the basis of the rates at which the respective currencies could be converted into gold, i.e. the price of gold in the two countries.

15. Process of correction of imbalance in international receipts and payments is known as the price-specie-flow mechanism.

16. Under the system of the gold-exchange standard, 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. Instead of holding gold as a reserve asset, they started holding reserves of that currency.

17. Sterilization, or neutralization, is the policy of not letting a change in the reserves have any effect on the money supply. This may be done either by directly breaking the link between the reserves and the notes printed, or by increasing or reducing the ability of banks to create money.

18. In 1944, representatives of 44 countries met in Bretton Woods, New Hampshire, USA, and signed an agreement to establish a new monetary system which would address all these needs. This system came to be known as the Bretton Woods System.

19. Two new institutions were established, namely, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD, also called the World Bank).

20. A system (which came to be known as the adjustable peg system) was established which fixed the exchange rates, with the provision of changing them if the necessity arose. 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 the US dollar.

21. According to Triffin Paradox, it was necessary for the US to run BoP deficit in order to supply the world with the additional dollar reserves needed for increased international trade. Yet, as its deficit increased and the volume of dollar reserves held by other countries grew without a simultaneous increase in US’s gold reserves, its ability to honor its commitment (of converting dollars into gold) would decrease. Such a situation would result in decreased confidence in the system, and since the system was running on the member countries’ confidence, it would result in the system breaking down.

22. The idea of creating a monetarily stable zone started taking shape in 1978, which resulted in the creation of the European Monetary System in 1979. The system was quite similar to the Bretton Woods System, with the exception that instead of the currencies being pegged to the currency of one of the participating nations, a new currency was created for the purpose.

5

23. The new currency was named the European Currency Unit (ECU) and was defined as a weighted average of the various European currencies.

24. The main functions of the ECB are to • determine the monetary policy and to implement it • support the member countries in implementing their economic policies, if that does

not entail • going against its main aim of maintaining price stability • help the member countries in managing their forex reserves and to conduct forex

operations • ensure a smoothly operating interbank payments system.

The Foreign Exchange Markets 1. The main players in the foreign exchange market are large commercial banks, forex

brokers, large corporations and the central banks. 2. Large commercial banks act as the market makers in the forex markets i.e., they stand ready

to buy or sell various currencies at specific prices at all points of time. 3. The foreign exchange brokers do not actually buy or sell any currency. They bring buyers

and sellers together. 4. The market in which the commercial banks deal with their customers (both individuals and

corporates) is called the retail market, while that in which the banks deal with each other is called the wholesale or the interbank market.

5. Nostro account is the overseas account held by a domestic bank with a foreign bank or with its own foreign branch, in that foreign country’s currency. The same account is called vostro account from the point of view of the holding bank.

6. A currency’s settlement always takes place in the country of origin of the currency. The term “currency” includes coins, bank notes, postal notes, postal orders and money orders.

7. An exchange rate quotation is the price of a currency stated in terms of another. 8. A quote can be classified as European or American if one of the currencies is dollar. An

American quote is the number of dollars expressed per unit of any other currency, while a European quote is the number of units of any other currency expressed per dollar.

9. A direct quote is the quote where the exchange rate is expressed in terms of number of units of the domestic currency per unit of foreign currency.

10. An indirect quote is where the exchange rate is expressed in terms of number of units of the foreign currency for a fixed number of units of the domestic currency.

11. The rate at which a bank is ready to buy a currency is called bid rate and the rate at which a bank is ready to sell a currency is called ask rate. The difference between the bid rate and the ask rate is called the bid-ask spread. The bid rate is always lower than the ask rate.

12. Merchant quote is the quote given by a bank to its retail customers. Interbank quote is the quote given by one bank to another.

13. For every quote (A/B) between two currencies, there exists an inverse quote (B/A), where currency A is bought and sold, with its price expressed in terms of currency B.

Implied inverse (B/A) quote = bidask (A/B)

1/

(A/B)

1

14. The arbitrage activity involving buying and selling in another is termed as two-way arbitrage.

15. Synthetic inverse rate is always different from the actual rate because of the presence of transaction costs as a difference between the bid and ask rates.

6

16. In the foreign exchange markets, it is a practice to quote most of the currencies against the dollar, and to calculate the exchange rates between other currencies with the dollar as the intermediate currency. The rate thus calculated is called cross rate or synthetic cross rate.

Synthetic (A/C)bid = (A/B)bid x (B/C)bid

Synthetic (A/C)ask = (A/B)ask x (B/C)ask 17. The synthetic cross rates can also be calculated if the inverse quotes are available for any of

the required rates. Synthetic (A/C)bid = (A/B)bid x 1/(C/B)ask

Synthetic (A/C)ask = (A/B)ask x 1/(C/B)bid

18. If the synthetic rate is less than the actual bid rate, then arbitrageurs have a chance to make a profit by three-point arbitrage.

19. Spot transactions are those, which are settled after two business days from the date of the contract.

20. Forward contract (also called an outright forward) is one where the parties to the transaction agree to buy or sell a currency at a predetermined future date at a particular price.

21. A currency is said to be in premium against other currency if it is more expensive in the forward market than in the spot market. A currency is said to be discount if it is cheaper in the forward market than in the spot market.

22. The difference between the spot rates and the forward rates can be expressed in terms of swap points. The bid side swap points are to be added to or subtracted from the spot bid depending upon whether the currency is at premium or at discount to arrive at the forward bid rate. Similarly, the ask side swap points should be added to or subtracted from the spot ask rate to give the forward ask rate.

23. A broken-date contract is a forward contract for maturity, which is not a whole month. The rate for a broken date contract is calculated by interpolating between the available quotes for the preceding and succeeding maturities.

24. Option forward contracts can be used when the customer knows the estimated time when the need to deal in a foreign currency may arise, but may not be sure about the exact timing.

• When the bank is buying a currency, it will add on the minimum premium possible and deduct the maximum discount possible from the spot rate, resulting in the bank quoting the rate applicable to the beginning of the option period when the currency is at premium, and the rate applicable to the end of the option period when the currency is at a discount.

• When the bank is selling a currency, it will add on the maximum premium possible and deduct the minimum discount possible from the spot rate, resulting in the bank quoting the rate applicable to the end of the option period when the currency is at premium, and the rate applicable to the beginning of the option period when the currency is at a discount.

25. A transaction whereby two currencies are exchanged by the parties involved, only to be exchanged back is called a currency swap.

26. The settlement date for a spot transaction is the second business day from the date of the transaction.

27. In cases of contracts where the settlement date is less than two business days after the date of transaction are referred to as short-date transactions.

7

28. In India, the foreign exchange markets are regulated by the Foreign Exchange Management Act. The FEDAI provides for the early delivery/extension/cancellation of forward exchange contracts.

Exchange Rate Determination 1. According to the Purchasing-Power Parity (PPP) theorem, the price levels in different

countries determine the exchange rates of these countries’ currencies. The theory assumes that the exchange rates between various currencies reflect the purchasing power of these currencies.

2. According to the law of one price, in equilibrium conditions, the price of a commodity has to be equal across the world.

3. According to the Absolute form of PPP, the exchange rate between two countries’ currencies is determined by the respective price levels in the two countries.

B

A

P

PS(A/B)=

4. The relative form of PPP, links the changes in spot rates and in price levels over a period of time. According to it, changes in spot rates over a period of time reflect the changes in the price levels over a period of time reflect the changes in the price levels over the same period in he concerned economies. The equation for the relative form of PPP states that the percentage change in the spot rate (A/B) equals the difference in the inflation rates divided by 1 plus inflation rate in country B.

~P1

~P~P(A/B)~S

A

BA

+

−=

5. According to the expected form of PPP, change in the spot rate is equal to the difference in the expected inflation rates in the two countries. It is also called efficient form of PPP.

S* (A/B) = * *A BP P−

6. According to the Interest Rate Parity theorem, the cost of money (i.e., 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.

7. The investors prefer to invest in securities denominated in currency A rather than in currency B, if

A BF(A/B)(1 r ) x (1 r )S(A/B)

+ > +

Where rA and rB are interest rates in countries A and B respectively. 8. The investors prefer to invest in securities denominated in currency B rather than in

currency A, if

A BF(A/B)(1 r ) x (1 r )S(A/B)

+ < +

Where rA and rB are interest rates in countries A and B respectively. 9. The investors would be indifferent as to the choice of currency only if,

)r(1xS(A/B)

F(A/B))r(1 BA +=+

Also,

A B(F(A/B) S(A/B)r r

S(A/B)−

= +

10. The investment choice can also be made for less than one year. 11. For borrowing currencies, converse of the points (7) and (8) should be used. If the borrower

is indifferent then use the formula given in (9).

8

12. According to the uncovered interest rate parity or the International Fisher Effect, the expected percentage change in the spot rate should be approximately equal to the interest differential.

rA – rB = S*(A/B) 13. The Fisher Open Condition states that real interest rates are equal across countries. rA – P*

A = rB – P*BB

Exchange Rate Forecasting 1. Forecasting of exchange rates is important for players in the international markets, as the

exchange rates have a great impact on their operations. The forecasting of exchange rates help the speculators to undertake speculative activities, when their expectations are against those of the market.

2. Forward rate is expected to be an unbiased predictor of future exchange rate.

3. A forecasting tool is said to be accurate if the forecast generated proves to be in accordance with the actual future values of the concerned variable, with minor errors.

4. An unbiased estimate is, where the probability of an overestimate is same as the probability of an underestimate.

5. According to the Demand-Supply approach, changes in exchange rates can be forecasted by analyzing the factors that affect the demand and supply of a currency. Some factors, which affect the demand and supply of currency are trade-in services, income flows, transfer payments, foreign investments, foreign investments, relative price levels in the respective countries, changes in National Income and money supply in respective countries, etc.

6. According to the J-curve effect, when both imports and exports are price inelastic in the short-run but elastic in the long-run, volume of exports and imports do not immediately respond to the change in relative prices of exports and imports, caused by a depreciation of home currency.

7. The Marshall-Lerner condition says that in order to avoid exchange rate instability, the elasticities of exports and imports should together be greater than one.

8. According to the Monetary Approach, the effect on exchange rates is immediate rather than happening after an event takes place.

9. Dornbusch Sticky-Price Theory explains the overshooting of the exchange rates. It says that exchange rates change more than that required by a change in economic variable and later come back to the new equilibrium.

10. According to the Asset Approach, whatever changes are expected to occur in the value of a currency in future gets reflected in the exchange rates immediately. That is an expected change gets absorbed immediately. Hence the current exchange rate is the reflection of the expectations of the market as a whole.

11. According to the Portfolio Balance Approach, the value of a currency is determined by relative demand and supply of money and relative demand and supply of bonds. According to this approach, people can hold assets across different countries, denominated in different currencies. Hence any change in exchange rates changes the wealth of the holders of these assets, which becomes an instrument for maintaining equilibrium in money and bond markets.

Introduction to Exchange Risk 1. Foreign Exchange exposure results in foreign exchange risk due to the unanticipated

variability in exchange rates.

2. Foreign Exchange exposure is defined as “the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates.

9

3. Exposure can be measured in terms of (i) foreign currency assets and liabilities which have fixed foreign-currency values (ii) foreign currency assets and liabilities with foreign-currency values that change with an unexpected change in the exchange rate. (iii) domestic currency assets and liabilities (iv) operating incomes.

4. Foreign Exchange Risk is defined as “the variance of the domestic-currency value of an asset, liability, or operating income that is attributable to unanticipated changes in exchange rates”.

5. Exposure can be classified as Transaction Exposure, Translation Exposure and Operating Exposure.

6. Transaction exposure is the exposure that arises from foreign currency denominated transactions, which an entity is committed to complete. It arises from contractual, foreign currency, future cash flows.

7. Translation exposure is the exposure that arises from the need to convert values of assets and liabilities denominated in a foreign currency into domestic currency.

8. Operating exposure is the extent to which the value of the firm stands exposed to exchange rate movements, the firm’s value being measured by the present value of its expected cash flows. It is a result of economic consequences. Therefore it is also called economic exposure.

Management of Exchange Risk 1. Management of exchange risk essentially means reduction or elimination of exchange rate

risk through hedging. It involves taking a position in the forex and/or the money market, which cancels out the outstanding position.

2. Exchange risk can be managed using internal and external hedging techniques. Internal techniques are those, which are part of day-to-day operations of a company, while the external techniques are the ones, which are not part of the day-to-day activities and are specially undertaken for the purpose of hedging exchange risk.

3. Exposure Netting involves creating exposures in the normal course of business, which offset the existing exposures. It can be achieved by creating an opposite exposure in the same currency or a currency, which moves in tandem with the currency of original exposure.

4. Leading involves advancing a payment and Lagging involves postponing a payment. A company can lead payments required to be made in a currency that is likely to appreciate, and lag payments that it needs to make in a currency that is likely to depreciate.

5. Transaction and Translation exposures can be hedged by invoicing all receivables and payables in the domestic currency. But only one party can hedge itself in this manner. It will still leave the other party exposed, as it will be dealing in a foreign currency.

6. Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials in the same currency in which it sells its products.

7. In order to hedge the transaction exposure, a company having a long position in a currency (having a receivable) will sell the currency in the forward market, and a company having a short position in the currency (having a payable) will buy the currency forward. The cost of a forward hedge can be measured by the opportunity cost, which depends on the expected spot rate at which the currency needs to be bought or sold in the absence of the forward contract.

8. The company can also hedge through the futures market. Hedging through the futures market has a similar effect of hedging through forward market. The gain/loss on the futures contract gets cancelled by the loss/gain on the underlying transaction and therefore the exposure gets eliminated completely.

9. Transaction and Translation exposure can also be hedged using options. A firm having a foreign currency receivable can buy a put option on the currency, having the same maturity as the receivable. Conversely, a firm having a foreign currency payable can buy a call option on the currency with the same maturity.

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10. Money markets can also be used to hedge foreign currency receivables or payables. 11. Economic exposure cannot be managed by the traditional hedging techniques due to the

unpredictability of the changes in the cash flows. It requires various marketing, production and financial management strategies to cope with the risks.

12. Market selection, pricing strategy, promotional strategy and product strategy can be used by a marketing manager to manage the exposure.

13. Input mix, product sourcing, plant location and raising productivity are some of the production strategies available.

14. The major financial strategy is to create liabilities in the currency to which a firm’s earnings are earnings are exposed to a large extent, thus creating a natural hedge.

International Project Appraisal 1. Foreign Direct Investment (FDI) is the investment made in physical assets like plant and

machinery in a foreign country, with the management control being retained by the domestic investor.

2. FDI results in managerial control over the operations of the foreign entity. 3. FDI can be done either by establishing a new corporate in the foreign country or by making

further investments in an existing foreign entity or by acquiring an existing foreign business enterprise or by purchasing assets.

4. Companies invest in foreign physical assets for a number of reasons. The important ones are: economies of scale, need to get around trade barriers, comparative advantage, vertical diversification, general diversification benefits, attacking foreign competition, extension of existing international operations, product life cycle, non-transferable knowledge, brand equity, and protection of brand equity.

5. The economic viability of a home country project can be measured using various tools like NPV, IRR, payback period, accounting rate of return etc.,

6. Certain issues like blocked funds, effect on the cash flows of other divisions, restrictions on repatriation, taxability of cash flows, exchange rate movements and subsidized loans by the foreign government affect both the cash flows and the discount rate.

7. The adjusted present value of a foreign project is given by:

* * *n t t t

o o o Tt 1 e

(S C E )(1 T)APV S (C A )

(1 k )=

+ −= − + ∑

+

n nt ot tt 1 t 1d b

D T rB T(1 k ) (1 k )= =

+ +∑ ∑+ +

*n n

t to o t tt 1t 1 e p

R P TS CL

(1 k ) (1 k )==

⎡ ⎤⎢ ⎥+ +∑ ∑⎢ ⎥+ +⎣ ⎦

n ttt 1 i

I(1 k )=

+ ∑+

APV = Adjusted present value.

So = Current exchange rate.

Co = Initial cash outlay in foreign currency terms

Ao = Activated funds.

*tS = Expected exchange rate at time ‘t’.

n = Life of the project.

*tC = Expected cash flow at time ‘t’, in foreign currency terms.

*tE = Expected effect on the cash flows of other divisions at time ‘t’, expressed in

domestic currency terms; can be either positive or negative.

T = Domestic or foreign tax rate, whichever is higher.

11

Dt = Depreciation in home currency terms at time ‘t’. (If the depreciation is not allowed to be set off by the parent company against its own profits, it needs to be defined in foreign currency terms with its present value being converted at So into domestic currency terms).

BBo = Contribution of the project to borrowing capacity of the parent firm.

R = Domestic interest rate.

CLo = Amount of concessional loan received in foreign currency.

Rt = Repayment of concessional loan at time ‘t’.

*tP = Expected savings at time ‘t’ from inter-subsidiary transfer pricing.

It = Illegally repatriated cash flows at time ‘t’. ke = All-equity discount rate, reflecting all systematic risks, including country

risk and exchange-rate risk. kd = Discount rate for depreciation allowances. kb = Discount rate for tax savings from generation of borrowing capacity. kc = Discount rate for savings due to concessionary loans, generally the interest

rate in the absence of concessionary loans. kp = Discount rate for savings through transfer pricing. ki = Discount rate for illegal transfers.

8. The economic, political, and financial aspects of a country in which the project is based are very crucial for the profitability of a project.

International Financial Markets and Instruments 1. The Indian companies have many opportunities to raise funds in the international equity

markets for the right kind of usage. 2. There are various types of instruments in the international markets like: Yankee bonds,

Samurai bonds, Bulldog bonds, Eurobonds, etc. as well as ADR/GDR/IDRs for equity issues.

3. The major players in the international markets are: borrowers/issuers, lenders/investors and intermediaries. The institutional investors can be classified as: market specific investors, time specific investors and industry specific investors.

4. Intermediaries are mainly: lead and co-managers, underwriters, agents and trustees, lawyers and auditors, listing agents and stock exchanges, depository banks, custodians and lastly, printers.

5. Resource mobilization depends on the following factors: currency requirements, pricing of the issue, investment, depth of the market, international positioning, regulatory aspects, disclosure requirements and investment climate.

6. The issuance of GDRs requires the following steps: approval of the shareholders, appointment of lead manager, finalization of the structure, documentation (prospectus, depository agreement, underwriting agreement, subscription agreement, custodian agreement, trust deed, paying and conversion agreement, listing agreement), the launching of the GDR, marketing and road shows, pricing and finally closing.

7. Eurodollars are liabilities denominated in U.S. dollars, but not subject to U.S. banking regulations. Mostly banks located outside the U.S. issue Eurodollar deposits.

8. There are various advantages of Eurodollar deposits, the main being, lesser regulatory impediments, lower cost of deposit intermediation and less intense supervisory scrutiny by the authorities.

9. The main instruments in the Eurodollar market are: Eurodollar Certificate of Deposits (CDs), Eurodollar Floating Rate CDs (FRCDs), Eurodollar Floating Rate Notes (FRNs), Note Issuance Facilities (NIFs) and Eurocommercial Papers (CPs).

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10. The three basic risks with Eurodollar deposits are: chances of interference of transfer of funds by the host country government, potential jurisdiction of international disputes and soundness of deposits of banking offices of foreign countries with relation to the U.S.

11. Most of the Euroloans are today sourced through a syndicate of banks or lenders. The process is almost similar to the process of syndication of loans from internal sources.

12. The advantages of syndicated loans are: size of the loan, speed and certainty of funds, maturity profile of the loan, flexibility in repayment, lower cost of funds, diversity of currency, simpler banking relationships and possibility of renegotiation.

International Equity Investments 1. Investment in foreign securities offers the same diversification benefits, as investment in a

diversified domestic portfolio does. 2. The returns on a foreign security would be denominated in the foreign currency. The rate at

which the realizations from the security are converted into the domestic currency is most likely to be different from the rate at which currency conversion takes place at the time of investment, due to the volatile nature of the forex markets.

3. Investments in foreign securities carry some additional risks when compared to domestic investments. These risks stem from the uncertainties related to the conversion of the realization proceeds into the domestic currency which can be broadly classified as country risk (also known as political risk) and currency (or exchange) risk.

4. Country risk is the uncertainty as to whether the investor would be able to convert the realization proceeds into the domestic currency. This risk arises due to the possibility of the foreign government preventing the conversion of its currency for various reasons.

5. Currency risk is the uncertainty as to the rate at which the realization proceeds would be converted into the domestic currency. As this rate would not be known in advance, there would be the risk of a loss due to an unfavorable movement of the exchange rate.

6. While it is not possible to measure the political risk, currency risk can be measured and factored into the risk of foreign investment.

7. Variance of domestic currency returns on foreign investment = Var(rf) + Var(S~) + 2 cov (rf, S~) 8. The risk on foreign investment consists of three elements: the variability of the returns on

the foreign security, the variability of the exchange rate, and the covariance between the exchange rate and the returns on the foreign security. Thus exchange rates increase the riskiness of a foreign investment by being volatile, and more so if they are positively correlated with the foreign security returns.

9. The CAPM states that the investors in a security are compensated only for the systematic risk of the security, and the unsystematic risk can be diversified.

10. The systematic risk of the security is measured by the sensitivity of the security returns to a change in the market returns, given by the beta of the security.

11. International CAPM extends the same logic to the world security markets as a whole. According to this theory, the market portfolio consists of all the securities available in any of the countries, and the beta of a security measures the sensitivity of the security returns to a change in the returns on this extended market portfolio. Hence, restricting one’s investments to the domestic market would imply being below the efficiency frontier.

12. According to international CAPM, the return on a security is given by ri = rf (r

wβ w – rf)

where rf = World risk-free rate of return

= World beta of the security = wβ i w

w

cov(r , r )ˆVar(r )

rw = Return on the world-market portfolio

13

13. Segmentation of non-integration of the markets can be because of the regulations restricting foreign investments, non-convertibility of currencies, home-country bias and indirect barriers.

Short-term Financial Management 1. The objective of cash management is (i) to maximize the return by proper allocation of

short-term investments and (ii) to minimize the cost borrowing in different money markets. 2. Certain situations warrant proper cash management systems. Therefore most of the MNCs

resort to centralized cash management systems. Netting, management of currency exposure, and pooling of cash are some of the advantages of the centralized cash management systems.

International Accounting and Taxation 1. The foreign currency transactions of firm can be divided into (i) transactions in a foreign

currency that need to be stated in domestic currency terms and (ii) the presence of foreign operations whose financial statements need to be translated into the domestic currency.

2. Foreign operations can be Integral Foreign Operations and Independent Foreign Operations.

3. In India, reporting of foreign currency transactions is governed by Accounting Standard – 11 prescribed by the Institute of Chartered Accountants of India.

4. A foreign currency transaction may result in a receivable or payable. 5. The exchange gain/loss arising because of the differences in the spot rates can be covered

using forward contracts, or other hedging tools. 6. The difference between the contract rate and the spot rate as on the date of the transaction

should be recognised as income or expenditure, spread over the life of the contract. Also any profit/loss arising due to cancellation/extension of a forward contract should be accounted for as income or expenditure for the period in which it arises.

7. There are four methods, which guide the translation of the financial statements of a foreign entity, whether independent or integrated. They are (i) Current/Non-current method (ii) Monetary/Non-monetary method (iii) Temporal method and (iv) Current rate method.

8. Historical exchange is the rate at which a transaction was actually settled. 9. Current or closing exchange rate is the rate prevailing on the date of translation of accounts. 10. Average rate: It is the average of the rates prevailing over a certain period of time. 11. An entity operating in more than one country faces multiplicity of rules. One of the major

factors acting as an impediment to international trade is the possibility of double taxation. The income earned by an entity in a foreign country may be taxed twice, once in the country in which it has been earned and the second time in the country in which the entity is based.

SECTION II: INTERNATIONAL TRADE Trade Blocks 1. GATT has come into existence in the year 1947 by 23 countries to ensure fair and foreign

trade. The membership of GATT has increased over the years to 125 countries in 1995. The GATT lays down the rules for the conduct of international trade and provides a platform for trade and negotiations through which trade liberalization can be made.

2. WTO has emerged as the new multilateral trade body replacing GATT from January 1st 1995. It serves as a permanent forum for trade negotiations.

3. US has an Act – Section 301, according to which policies and practices of any country reconsidered to be discriminatory if they deny most favored nation status to US goods, services or investments.

4. The challenges faced by WTO include the evolvement of regionalism which has led to favor members of their trading blocks, implications of the post-GATT order and balancing the domestic and international trade concerns.

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5. The problem to be addressed by the WTO in the coming years – Multilateral Investment Agreement (MIA). The aim of this agreement is to allow foreign investment in almost all sectors of the economy.

6. In Europe in 1957, six countries signed an agreement to make trading blocks. It was formed to bring closer integration through economic co-operation among member countries. European Community accounts for 1/3rd of the world trade making the EC the largest and most important trading block. The vision of the EC is the removal of all barriers to facilitate the free movements of factors of production i.e., goods, services, capital and people.

7. In 1992 US, Canada and Mexico signed an agreement for the North American Free Trade blocks. NAFTA proposes to bring down tariffs, liberalize trade in finance services by year 2000.

8. In Asia there are two major trade blocks ASEAN countries and SAPTA. 9. European Economic and Monetary Union (EMU) is a single market, which will have the

face movements of goods, persons, services and capital between the member states. The creation of this common market had to be accompanied by a common economic and monetary policy.

Export Import Policy 1. The exim policy 1997-2002 basically aims at imparting operational flexibility to the

exporters. The changes brought about will enable exporters to tap new markets and help them improve exports both in terms of quality and quantity.

2. FEMA defines ‘import’ as bringing into India, any goods or services. Imports to India can be classified into two categories: OGL and Negative List.

3. Freely importable items or the Open General License (OGL): The OGL includes those items which are freely importable and do not require import licenses.

4. The negative list: Import of those items which are not regulated by the OGL fall under the negative list category. This category of items are broadly grouped under 3 heads: Prohibited, Restricted and Canalized.

5. Import license means a license granted specifically for import of goods which are subject to import control.

6. Regular License: These are licenses issued for the import of goods which fall under the normal import policy. These can be issued to anybody entitled for issuance as per the policy provision.

7. Advance License: Advance licenses are issued under the duty exemption scheme. Under advance licenses, duty free imports of inputs are permitted on fulfillment of value addition and export obligation within a certain time-frame. Advance Licenses are broadly divided into value based advance license and quantity based license.

8. Certain licenses are issued with a rider, like ‘export obligation’ which means importers of capital goods are required to export to a place outside India, a certain proportion of goods manufactured by the use of imported capital goods. In case of importers rendering services, export obligation means receiving payments in freely convertible foreign currency for services, rendered through the use of such capital goods.

9. A Special Import License (SIL) may be used to import, among other items, certain consumer goods. The SIL is like an import permit and is traded in the market, at a premium on its value. It is issued to Indian exporters as an export incentive, and its value is tied to export earnings.

10. When the import license is so endorsed, the license holder may transfer the license in full in case he has not made any imports or where imports have already been made, the license may be transferred in part excluding the value and quantity of imports already made or the materials or the balance already imported.

11. The objective of Duty Entitlement Passbook Scheme is to neutralize the incidence of Customs duty on the import content of the export product. The neutralization shall be provided by way of grant of duty credit against the export product.

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12. Under the Duty Entitlement Passbook Scheme (DEPB), an exporter may apply for credit, as a specified percentage of FOB value of exports, made in freely convertible currency.

13. The DEPB on pre-export basis shall be non-transferable and items imported against it shall be subject to actual user condition even after offsetting their obligation against such DEPB.

14. The exim policy 2000-2001 has done away with the DEPB scheme on pre-export basis as very few exporters were availing of the scheme.

15. To give a boost to exports of diamond, gem and jewelry for which India enjoys a special advantage of skilled labor, exporters under these sectors have been offered two special schemes viz: • Replenishment (REP) licenses, and • Diamond Imprest Licenses.

16. Bank Guarantee and Legal Undertaking The licensee is required to execute a bank guarantee/legal undertaking before the first

consignment of import is cleared. However, this requirement will be waived in case the export obligation is fulfilled before any imports are made.

17. The Licensing Authority will allow extension in export obligation period for a period of four months against one or more consignment/sight on payment of penalty of 1% on the unfulfilled FoB value of export obligation with reference to CIF value of the imports made for which extension is being sought.

18. FEMA defines ‘export’ as the taking or sending out of goods by land, sea or air, on consignment or by way of sale, lease, hire purchase, or under any other arrangement by whatever name called, and in the case of software, also includes transmission through any electronic media.

(Exports may be of different types. They could be cash exports; project exports and deemed exports.)

19. A decade ago, various tariff and non-tariff trade barriers were imposed by different countries. With the liberalization and globalization, countries have done away with the quotas and embargoes towards the positive and growth oriented economic policies.

20. In India, for many years the accent of trade policies was on maintaining the level of imports within the available foreign exchange in order to protect the domestic industry and to achieve price stability.

21. The import export policy of 1985 was the first bold and dynamic policy in the direction of export promotion, import substitution and technological upgradation.

22. The Liberalized Exchange Rate Management System (LERMS) was in March 1992. The success of the scheme led to the introduction of Unified Exchange Rate System in 1993. Since then, all foreign exchange transactions are being put through by authorized dealers at market-determined rates.

23. As a sequence, the government of India introduced significant changes in the import export policy also. An attempt was made to align India’s international trade policies and practices in the 1992-97 Export-Import policy. This particular export-import policy saw numerous changes and modifications.

24. The major objectives of the new exim policy: accelerating country’s transition to a globally oriented vibrant economy, stimulating sustained economic growth, enhancing the technological strength and encouraging the attainment of internationally accepted standards of quality and providing consumers with good quality products at reasonable prices.

Documentary Credits 1. A documentary/letter of credit may be defined as “an arrangement by means of which a

bank (Issuing Bank) acting at the request of a customer (Applicant), undertakes to pay to third party (Beneficiary) a predetermined amount by a given date according to agreed stipulations and against presentation of stipulated documents”.

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2. The principal parties to a letter of credit are – The Applicant (Opener of the LC/Importer) – The Issuing Bank (The bank which opens the LC) – The Beneficiary (Who is the Seller/ Exporter) of the underlying LC – The Advising Bank – Confirming Bank – Nominated Bank – Reimbursement Bank. 3. The applicant of an LC is normally the buyer of the goods who is to make payment to the

seller. 4. The Issuing bank is the bank, which opens the LC in favor of the beneficiary. 5. The Beneficiary is the seller of goods who is to receive payment from the buyer. 6. The Advising Bank advises the credit to the beneficiary. 7. The advising bank or any other bank so authorized by the issuing bank may assume the role

of a confirming bank and add its confirmation to the LC opened by an issuing bank. 8. Nominated bank is the bank that is nominated and authorized by the issuing bank to

• Pay if the LC is a payment LC • Incur a deferred payment undertaking • Accept drafts, if the credit stipulates so • Negotiate.

9. Reimbursement bank is the bank, which is authorized to honor the reimbursement claim in settlement of negotiation/acceptance/payment lodged with it by the paying, negotiating or accepting bank.

10. In order to make payment to the overseas supplier, the buyer of goods approaches his bank for opening a letter of credit in favor of the supplier.

11. LCs may be categorized based on the scope for cancellation, mode of payment, tenor and availability style.

12. Revocable Letter of Credit, Irrevocable L.C., confirmed L.C., payment credit, Acceptance credit, Negation credit, Sight credit, Usance credit, Revolving credit, Installment credit, Deferred credit, transit credit, and anticipatory credit are different types of credit available.

13. In case of shipment under Letter of Credit, the supplier should prepare documents strictly in accordance with the terms and conditions of the Letter of Credit and submit them to his bank for negotiation. The negotiating bank will examine these documents and if found in order, negotiate the same.

14. The documents to be submitted by the exporter to his banker would include a commercial invoice, transport document which is usually the bill of lading (or seaway bill or airway bill), insurance document, certificate of inspection, packing list and in some cases a certificate of origin of goods as well.

15. A commercial invoice is prima facie evidence of the contract of sale and purchase. It is a document made by the exporter on the importer indicating details like description of the goods consigned, consignor’s name, consignee’s name, name of the steamer, number and date of bill of lading, country of origin, price, terms of payment, amount of freight, etc.

16. A bill of lading is a document issued by the shipping company or its agent, acknowledging the receipt of goods for carriage which are deliverable to the consignee or his assignee in the same condition as they were received.

17. In international trade, when goods are in transit they are exposed to marine perils. Insurance is effected to protect the insured against risk of loss or damage to goods due to marine perils. Therefore, Insurance documents should be issued and signed only by insurance companies or underwriters or their agents.

17

18. A letter of credit may also call for additional documents like bill of exchange, health certificate, pre-shipment inspection certificate, packing list, shipping company’s certificate, beneficiary’s declaration/undertaking, etc.

19. Certificate of origin is an important document in case of imports into India to determine the origin of goods for methods of payment purpose as required by the Exchange Control Authorities.

20. Incoterms – An acronym for International Commercial Terms – are a series of 13 trade terms used in international sales contracts to clearly divide the risks and responsibilities of buyers and sellers with regard to the movement of goods between both parties.

Export Finance and Exchange Control Regulations Governing Exports 1. Export finance can be categorized into pre-shipment finance and post-shipment finance

depending at what stage of export activity, finance is extended. 2. Pre-shipment finance is basically a short-term finance (inventory finance) extended to

exporters in anticipation of export of goods. This finance enables exporters to procure raw materials, process, manufacture, warehouses, ship the goods meant for export.

3. Pre-shipment finance can be classified as a. Packing credit b. Advance against incentives receivable from Government covered by ECGC

Guarantee c. Advance against cheques/drafts received as advance payment. 4. Pre-shipment finance being a need based finance, banks have the freedom to determine the

margin that is to be brought in by the exporters. 5. Margins serve three important purposes: a. To ensure that the exporter has a stake in the business b. To take care of erosion in the value of goods charged to the banker c. To ensure that bank finance is not extended to cover exporters profit margin. 6. Banks are permitted to grant pre-shipment advances without insisting on immediate

lodgement of letters of credit/firm export orders under “Running Account” facility. 7. Pre-shipment Credit in Foreign Currency (PCFC) is made available to cover both the

domestic as well as imported inputs of the exported goods. It is available only for cash exports.

8. PCFC will initially be available for a maximum period of 180 days. 9. 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.

10. Advances against Incentives receivable from Government of India granted at post-shipment stage.

11. Where the value of material to be procured for export is more than the FOB value of the contract and considering the availability of receivables from Government of India, advances are granted for a maximum period of 90 days for more than the FOB value. These advances are liquidated by negotiation of export bills and out of proceeds of receivables from Government of India.

12. Pre-shipment finance can also be extended against duty drawback entitlements provisionally certified by the Customs. The loans so extended will be adjusted when the final assessment is made by customs and duties are refunded by them.

13. Certain formalities have to be fulfilled for clearance of exports by the customs authorities. The exporter is required to submit necessary documents for this purpose.

14. Post-shipment finance is defined as “any loan or advance granted or any other credit provided by an institution to an exporter from India from the date of extending the credit after shipment of the goods to the date of realization of the export proceeds”.

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15. Post-shipment finance can be classified as under:

– Negotiation/Payment/Acceptance of export documents under letter of credit

– Purchase/discount of export documents under confirmed orders/export contracts, etc.

– Advances against export bills sent on collection basis

– Advances against exports on consignment basis

– Advances against undrawn balance on exports

– Advances against receivables from the Government of India

– Advances against retention money relating to exports

– Advances against approved deemed exports. 16. Post-shipment finance is extended to the actual exporter or to an exporter in whose names

the export documents are transferred. In case of deemed exports, finance is extended to the deemed exporters. In case of cash exports, exporters should submit GR/PP/VP/SOFTEX forms, as applicable along with the shipping documents for negotiation.

17. Post-shipment finance can be extended up to 100% of the invoice value of the goods.

18. Post-shipment finance may be availed of either in Indian rupees or by using the rediscounting of export bills abroad scheme.

19. Rediscounting of Export Bills Abroad was introduced by the Reserve Bank of India on 6th October, 1993. It serves as an additional window for early realization of export proceeds. Under this scheme, authorized dealers in India and exporters can have an access to the overseas market for rediscounting of export bills.

20. Authorized dealers can utilize the foreign exchange resources available with them in Exchange Earners Foreign Currency Accounts (EEFC), Resident Foreign Currency Accounts (RFC), Foreign Currency (Non-Resident) Accounts (Banks) Scheme and Escrow Accounts to discount usance bills and retain them in their portfolio without resorting to rediscounting.

21. Exchange control regulations in India are issued and administered by the Reserve Bank of India. Some of the aspects covered by these regulations include the method of realization of proceeds of exports, purchase and sale of foreign exchange, maintenance of balance at foreign centers, etc. The Reserve Bank of India, ensures strict compliance of these regulations in order to conserve foreign exchange reserves.

22. As per FEMA, every person/firm engaged in the business of exports (with the exception of exports to Nepal and Bhutan) is required to make a declaration giving the full value of the exported goods on an export declaration form.

23. Export declaration forms are of different types depending on the mode of export.

Mode Form

Exports made otherwise

than by post GR form

Exports by post PP form

Exports by post (proceeds VP/COD form

realized through postal

channels ‘value

payable’ basis)

Export of computer software SOFTEX form

19

Import Finance and Exchange Regulations Relating to Import Finance 1. Bank lending activities under import financing are mainly concentrated on activities like

• Import of consumable inputs and channelized items • Import of plant and machinery • Imports made under short-term credit facility extended by overseas seller.

2. Whenever an importer approaches a bank for opening an import LC, banks usually subject the request for scrutiny under the premises of

a. Trade Control Requirements b. Exchange Control Requirements c. Credit Norms of R.B.I d. U.C.P.D.C Provisions and FEDAI e. Bank’s Internal Procedures 3. According to the exchange control guidelines banks are required to open letters of credit for

their own customers known to be participating in the trade. The opening of a letter of credit involves two stages wherein the importer is first required to make an application in the required format to the bank for opening the LC. Along with the application the applicant is also required to submit certain important documents.

4. The importer should be in possession of an importer exporter code issued by the Director General of Foreign Trade.

As the exchange control copy of the import license should be submitted to the authorized dealer, the import license should follow certain rules.

5. If the Letter of Credit application is found to be in order after scrutiny from all angles, the bank will open the LC in favor of the supplier of goods.

6. FEMA places restriction on the purchase and sale of foreign currency. As per this Act, only authorized dealers or those generally or specially permitted by the RBI can purchase or sell foreign currency. Any foreign exchange that is required for import payment can be acquired only from an authorized dealer.

7. FEMA also lays down that any person who acquires foreign exchange for importing goods into India but does not import the goods or does not import goods of value or kind or quality or quantity indicated while acquiring the foreign exchange, will be presumed to have been unable to use the foreign exchange for the purpose for which it was acquired or as the case may be, to have used the foreign exchange for a purpose other than the one for which it was acquired.

8. In a situation of adverse balance of payments, and where it is necessary to import certain goods, the Government/RBI may obtain a line of credit from the Central Bank of the overseas suppliers country. In such a case, payment may be made either by the Letter of commitment method or the reimbursement method.

9. Under the Letter of commitment method, payment is made directly by the loan agency (i.e. the Central Bank of the supplier) to the supplier of goods. The importer needs to make payment in Indian rupees only to the Government of India.

10. Under the reimbursement method, payment is first made through normal banking channels (by the Government/RBI to the overseas supplier) and reimbursement is subsequently claimed by the Government/RBI from the credit agency (i.e. the Central Bank of the overseas supplier).

Part I: Questions on Basic Concepts SECTION I: INTERNATIONAL FINANCE Introduction to International Finance 1. The benefit(s) of globalization is (are) a. Efficient allocation of capital b. Better working financial system c. Smoother consumption patterns enjoyed by all countries d. All of the above e. Both (a) and (b) above. 2. The costs associated with diversification are a. Country risk b. Currency risk c. Transmission risk d. All of the above e. Both (a) and (b) above. 3. The factors responsible for integration of financial markets are a. Increased cross penetration of foreign ownership b. Liberalization of regulations governing the financial markets c. The development of new financial instruments d. All of the above e. Both (a) and (c) above. 4. Deregulation and globalization of the financial markets increase the volatility in a. Interest rates b. Exchange rates c. Prices of financial assets d. All of the above e. Both (a) and (b) above.

Theories of International Trade 5. If country ‘A’ is efficient in producing one product and country ‘B’ is efficient in

producing the second product, then country ‘A’ will specialize in the production of 1st product and country ‘B’ in the 2nd product. Which theory of international trade is this?

a. Theory of absolute advantage. b. Theory of comparative advantage. c. Heckscher-Ohlin model. d. Imitation gap theory. e. International product life cycle theory. 6. According to the ______, improvement in technology is a continuous process and the

resulting innovations give rise to trade between such countries. a. Theory of absolute advantage b. Theory of comparative advantage c. Heckscher-Ohlin model d. Imitation gap theory e. International product life cycle theory.

Part I

21

7. The ______ uses two types of products – labor intensive and capital intensive, to explain its point. a. Imitation gap theory b. Heckscher-Ohlin model c. International product life cycle theory d. Theory of absolute advantage e. Theory of comparative advantage.

8. The assumptions made by theory of comparative advantage are a. Full employment b. Mobility of labor within the country c. Constant returns to scale d. All of the above e. Both (a) and (b) above.

9. The important principles of international product life cycle theory are a. Technical innovation b. Perfect competition c. Market structure d. All of the above e. Both (a) and (c) above.

10. The reasons for intra industry trade taking place are a. Transportation costs b. Seasonal differences c. Product differentiation d. All of the above e. Only (a) or (b) above.

11. Some minor factors affecting international trade are a. Currency value b. Economies of scale c. High re-entry costs d. Consumer tastes and imperfect competition e. All of the above.

12. Which of the following theories of international trade explains the trade between two countries having similar factor endowments and consumer tastes?

a. Theory of absolute advantage. b. Theory of comparative advantage. c. Heckscher-Ohlin model. d. Imitation gap theory. e. International product life cycle theory.

13. Which of the following trade theories focuses on factor endowments of the trading nations? a. The theory of absolute advantage. b. The theory of comparative advantage. c. The Heckscher-Ohlin model. d. The Imitation gap theory. e. The International product life cycle theory.

International Finance and Trade

22

14. Part of the growth of multinational business over time is due to the realization, that specialization by countries can increase production efficiency, making trade essential when they focus on the products they produce best. This is according to the

a. Product life cycle theory b. Competitive advantage theory c. Imitation gap theory d. Comparative advantage theory e. Absolute advantage theory. 15. If we know that American agriculture is the most efficient in the world, we may say that a. If America is also more efficient in the production of all other goods, there could be

no gains from trade b. It would never pay America to import food c. It would always pay America to import food d. America might or might not be a food importer e. America clearly never exports food. 16. If the cost of production of items A and B in France and Germany are as given below,

which statement will hold good?

Germany France A 15 20 B 12 24

a. France will import A and B from Germany b. France will import A from Germany c. France will import B from Germany d. Germany will import A from France e. France will export A to Germany and import B from Germany.

Balance of Payments 17. Which of the following items would be a debit in India’s Balance of Payments? a. A foreign MNC charters an Indian ship. b. An Indian exporter ships garments to Europe. c. An Indian exporter receives payment against earlier shipments. d. An Indian software company executes a project in Australia. e. An FII invests in Infosys stocks. 18. Of the following items, which represents a credit entry in India’s balance of payments? a. Inflow of gold. b. Repatriation of dividends by an MNC. c. Investment by an Indian mutual fund on Luxembourg Stock Exchange. d. Revenue earned by MMTC against exports. e. Remittance to USA by an American executive based in Mumbai.

19. When a country has a massive current account deficit, the chances are that a. It is funded by gold b. It is funded by citizens staying abroad who repatriate earnings c. It is funded by a change in central bank reserves d. Restrictions exist on capital flows e. It is funded by heavy borrowings from foreigners.

Part I

23

20. Which of the following is a capital account transaction in a country’s Balance of Payments account?

a. Import of cosmetics.

b. Import of automobiles.

c. Payment of interest on External Commercial Borrowings (ECBs).

d. Import of computers.

e. IMF borrowings.

21. Current account deficit for a country indicates that

a. Gross domestic investment is greater than gross domestic savings

b. Gross domestic savings are greater than gross domestic investment

c. Foreign exchange reserves of the country decline

d. Both (a) and (c) above

e. Both (b) and (c) above.

22. The changes in foreign exchange reserves and reserves of monetary gold held by the monetary authority will be recorded in ___________ account of the BoP statement.

a. Current

b. Capital

c. Errors and omissions

d. Official reserves

e. None of the above.

23. The investment income from abroad appears under ________ head of BoP statement.

a. Merchandize account

b. Capital account

c. Official reserve account

d. Invisibles account

e. Unilateral transfer account.

24. International transfers from abroad means transferring of

a. Goods produced by the developed countries to underdeveloped countries without consideration

b. Goods from one country to another due to bilateral agreement

c. Transfer of assets from one country to another country without consideration

d. Both (a) and (c) above

e. All of (a), (b) and (c) above.

25. If the balance on current and capital account of Balance of Payments taken together is negative, then it is a case of

a. BoP surplus

b. BoP where the official reserve account is in surplus

c. BoP deficit

d. BoP disequilibrium

e. None of the above.

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26. A decline in the foreign exchange reserves of a country, other things remaining the same will

a. Cause a capital inflow into the country b. Cause a contraction of money supply in the country c. Force the country to borrow from foreign countries d. Increase the prices of imported goods e. None of the above. 27. Which of the following is not a current account item in India’s balance of payment? a. Receipts in foreign exchange from foreign travelers. b. Deposits of NRIs with banks. c. Profit remitted by the foreign branch of an Indian company to the parent. d. Premium on all kinds of insurance provided by Indian insurance companies to non-

resident clients. e. Non-monetary gold imports. 28. Under a flexible exchange rate system, Balance of Payments disequilibrium is likely to be

corrected by a. Expansion of money supply in the domestic economy b. Higher rate of inflation in the domestic economy c. Higher rate of interest in the domestic economy d. Depreciation of home currency e. Decline in the forex reserves of the country. 29. Factor income represents income received by investors on foreign investments in financial

assets (securities). This transaction is recorded under a. Capital account b. Current account c. Trade account d. Invisibles account e. None of the above. 30. In the context of balance of payments, official reserves include a. Assets denominated in foreign currencies b. Special drawing rights c. Reserve position with IMF d. Both (b) and (c) above e. All of (a), (b) and (c) above. 31. Which of the following statements is/are true regarding balance of payments? a. An increase in the foreign liabilities is a debit entry because it is a source of foreign

exchange. b. A decrease in foreign assets is a source of foreign exchange and is a debit entry. c. A decrease in foreign assets is a source of foreign exchange and is a credit entry. d. An increase in the foreign liabilities is a use of funds and is a debit entry. e. None of the above. 32. Which of the following statements is/are false regarding Balance of Payments? a. Premium on insurance services provided to non-residents by Indian companies is an

‘invisible’. b. Exports and imports form part of the merchandize account. c. A deficit in the current account indicates that the country is living beyond its means. d. Imports and exports of capital goods are shown in the capital account. e. None of the above.

Part I

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33. Which of the following statements is false? a. An overvalued currency will lead to a Balance of Payments deficit. b. Governments try to finance BoP deficits by borrowing abroad. c. The threat of capital control by government is likely to improve the country’s BoP. d. Foreign borrowing is a temporary solution to a persistent BoP deficit. e. None of the above.

34. Which of the following is not a current account item in the Indian Balance of Payments statement?

a. Receipts in foreign exchange from foreign travelers. b. Premium on all kinds of insurance provided by Indian insurance companies to non-

resident clients. c. Profits remitted by the foreign branch of an Indian company to the parent. d. Deposits in NRE accounts and FCNR accounts. e. None of the above.

35. The main difference between depreciation and devaluation of a nation’s currency is that a. Devaluation occurs in the foreign exchange market, depreciation occurs in trade b. Depreciation occurs in foreign trade, devaluation within the economy c. Depreciation takes place in developed countries and devaluation in developing countries d. Devaluation deals with capital account and depreciation with current account e. Devaluation is associated with official announcements and depreciation with market

forces. 36. A country’s capital account balance is expected to a. Decrease if its home currency is expected to weaken, other things being equal b. Increase if its home currency is expected to weaken, other things being equal c. Increase if interest rates decrease in that country and increase in other countries d. Both (a) and (c) above e. None of the above.

37. The main difference between depreciation and devaluation is a. Depreciation occurs due to inflation and devaluation occurs due to increase in

demand for foreign currency b. Depreciation occurs in developing countries and devaluation occurs in under

developed countries c. Devaluation is related to capital account and depreciation is related to current

account d. Devaluation occurs due to changes in stock whereas depreciation occurs due to

changes in flows e. Depreciation is due to market forces and devaluation is due to an official

announcement.

38. If India runs a current account deficit, it means a. Indian government’s expenditure exceeds its tax revenues b. India’s forex reserves are decreasing c. The balance of payments is not zero d. There are heavy capital inflows e. None of the above.

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39. For a country which does not intervene in the forex markets, the current account deficit would be

a. Equal to the capital account surplus b. Less than the capital account surplus c. More than the capital account surplus d. Equal to the capital account deficit adjusted for changes in reserves e. None of the above. 40. A country has forex reserves of $35 billion at the beginning of 1997. During 1997, it incurs

a current account deficit of $10 billion. At the end of 1997, reserves increase to $40 billion. Which of the following is correct?

a. Capital account surplus in 1997 is $10 billion. b. Capital account deficit in 1997 is $ 10 billion. c. There is a net capital inflow of $10 billion during 1997. d. There is a net capital inflow of $15 billion during 1997. e. None of the above. 41. Which of the statements is valid? a. Running a current account deficit is bad. b. Running a current account surplus is good. c. Running a capital account deficit is bad. d. Running a capital account surplus is good. e. None of the above. 42. For the US, the sale of US treasury bonds by a French man shows up as a. A credit on the capital account b. A debit on the trade account c. A credit on the official reserves account d. A debit on the official reserves account e. None of the above. 43. Tourism shows up on the a. Merchandize account b. Current account c. Capital account d. Both (a) and (c) above e. None of the above. 44. If a foreigner purchases Indian Treasury bills, a. The supply of rupees increases b. India’s budget deficit decreases c. Demand for rupees increases d. India’s money supply increases e. None of the above. 45. Gains from international capital flows arise only if a. Flows across borders are controlled b. Flows across borders are freely allowed for all c. Flows across borders are permitted freely for Government sector d. Flows across borders are permitted only for genuine foreign direct investment e. Inflows are freely permitted when reserves are short and prohibited when reserves

are bulging.

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27

International Monetary System 46. In a flexible exchange rate regime, a current account deficit is likely to be corrected by: a. Drawing down on forex reserves b. Depreciation of home currency c. Appreciation of home currency d. Higher inflation e. Expansion of domestic money supply.

47. Which of the following statements is not true? a. Devaluation is a quick remedy for macroeconomic instability. b. Devaluation can often result in inflation. c. Devaluation can boost the long-term competitiveness of an economy. d. Devaluation is often followed by the J-curve effect. e. Devaluation is likely to reduce current account deficit.

48. The J-curve effect arises because a. Supply of exports tends to be inelastic in the short run b. Demand for imports tends to be inelastic in the short run c. Long run elasticity tends to be more for both supply and demand d. All of the above e. Both (a) and (b) above.

49. Which of the following system’s collapse is related to Triffin Paradox? a. Gold standard. b. Bretton Woods. c. Exchange rate mechanism in 1992. d. Both (a) and (b) above. e. None of the above.

50. In general, a currency crisis tends to occur when a. Economic fundamentals are weak b. Currency of a country whose economic fundamentals are weak appreciates c. Economic fundamentals are strong d. Currency depreciates e. None of the above.

51. Which is the most important currency in the world after the collapse of Bretton Woods? a. DM. b. Yen. c. Sterling. d. FF. e. US Dollar.

52. Which of the following countries follows the Currency Board system of exchange rate management?

a. India. b. Pakistan. c. Brazil. d. Argentina. e. Singapore.

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53. The common currency in Europe is a. ECU b. DM c. SDR d. Euro e. None of the above.

54. The tenability of a fixed exchange rate system depends on a. The size of the country b. Quantum of exports made by the country c. Quantum of imports made by the country d. Monetary discipline e. The country’s ability to borrow on a regular basis from foreigners’.

55. Which country’s exchange rate system closely resembles the erstwhile gold standard? a. USA. b. France. c. Hong Kong. d. India. e. UK.

56. Exchange rate movement of which of the following currency will not affect the value of SDR? a. Euro. b. Sterling. c. Swiss franc. d. Yen. e. None of the above.

57. If imports from a particular country are totally banned by the home country, it is called a Anti-dumping duty b. Compound duty c. Quota d. Embargo e. Exchange control.

58. ‘Triffin Paradox’ is associated with a. Interest rate parity b. Collapse of Bretton Wood System c. Purchasing power parity d. Forecasting of exchange rates e. Computation of trade deficit.

59. Which of the following institutions has international monetary cooperation as its primary concern?

a. World Bank. b. Bank for International Settlements. c. International Monetary Fund. d. International Development Association. e. International Finance Corporation.

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60. The value of Special Drawing Rights (SDRs) fluctuates in accordance with value of all of the following currencies except

a. The Japanese yen b. The Swiss franc c. The British pound d. The U.S. dollar e. None of the above.

61. Which exchange rate system is best described as an exchange rate system where a home currency’s value is fixed to a foreign currency but moves in line with that foreign currency against other currencies?

a. Fixed. b. Freely floating. c. Managed float. d. Pegged. e. None of the above.

62. Which of the following statements is false? a. SDR transactions involve no exchange of currencies but only book entries. b. SDR is defined in terms of certain gold equivalent. c. Issue of SDRs to a member country is in proportion to its quota in IMF. d. SDR is a composite currency unit. e. None of the above.

63. Exchange rate system where the central bank intervenes to smoothen out exchange rate fluctuations is known as

a. Free float b. Clean float c. Dirty float d. Fixed rate system e. Floating rate system.

64. Fiat money is the money a. Whose face value is less than its intrinsic value b. That is backed only by faith in the monetary authorities c. Which has wide acceptability the world over d. Which can be readily converted into an equivalent amount of gold e. None of the above.

65. A Central Bank trying to defend its home currency may a. Increase money supply b. Decrease money supply c. Increase interest rates d. Decrease interest rates e. Both (b) and (c) above.

66. Which of the following countries did not adopt the Euro as its currency in 1999? a. Finland. b. Austria. c. Netherlands. d. Spain. e. Greece.

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67. Which is an example of a pegged currency? a. Sterling. b. Malaysian Ringitt. c. Australian Dollar. d. Argentine Peso. e. Singapore Dollar.

68. During the days of the gold standard, the leading currency of the world was a. Dollar b. Sterling c. Yen d. DM e. FF.

69. Which of the following countries has been worst affected by the Asian currency crisis? a. Indonesia. b. Taiwan. c. Malaysia. d. Thailand. e. Philippines.

70. A Currency Board maintains a fixed exchange rate by a. Buying and selling home currency for foreign currency b. Changing domestic money supply c. Regulating the interest rates d. Both (b) and (c) above e. None of the above.

71. Under the gold standard, a. Price levels rose dramatically b. Price levels stayed constant over time c. The long run stability of the price level included alternating periods of inflation and

deflation d. The price level fell gradually e. None of the above.

72. The reserve currency under the Bretton Woods system was a. Sterling b. Dollar c. SDR d. Gold e. Deutschemark.

73. The Asian currency crisis was a result of a. Pegged exchange rates b. Inefficient use of funds c. Wrong pricing of capital d. (a), (b) and (c) above e. Efficient use of funds.

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74. Which of the following is not a determinant of the value of SDRs?

a. Pound sterling.

b. Yen.

c. Swiss Franc.

d. Euro.

e. None of the above.

75. Devaluation of a currency means

a. Government refixing the value of the local currency lower under the fixed exchange system

b. Market forces refixing the value of the local currency under the fixed exchange system

c. Market forces refixing the value of a local currency under the flexible exchange system

d. Government refixing the value of the local currency lower

e. Both (b) and (c) above.

The Foreign Exchange Markets 76. Which of the following foreign exchange transaction does not involve credit risk?

a. Spot transaction.

b. Forward contract.

c. Option forward contract.

d. Futures contract.

e. Swap deal.

77. Rs./$ 46.10/46.20 Rs./Euro 55.00/55.60

If an Indian exporter requires Euro for $, the rate quoted to him is

a. $/Euro 1.1905

b. $/Euro 1.1931

c. $/Euro 1.2035

d. $/Euro 1.2061

e. None of the above.

78. Which of the following statements is false?

a. Authorized dealers are market makers in the foreign exchange market.

b. Foreign currency broker acts as a middleman between two market makers.

c. The counterparty in the foreign exchange market is another bank.

d. Banks buy and sell for their own account and carry ‘inventory’ of currencies.

e. Foreign exchange brokers buy or sell foreign currencies for their customers.

79. The value date in one month forward contract is arrived at by

a. Adding one calendar month to the transaction date

b. Adding one calendar month to the spot settlement date

c. Adding 30 days to the transaction date

d. Adding 30 days to the spot value date

e. None of the above.

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80. Consider the following rates: Spot Rs./$ 44.60/65 $/Euro 0.9562/65

An Indian importer requires euro. The rate quoted to him is a. Rs.42.65/$ b. Rs.42.66/$ c. Rs.42.69/$ d. Rs.42.71/$ e. None of the above.

81. Option-forward is a a. Forward contract entered along with buying a call option b. Forward contract entered along with writing a put option c. Forward contract entered for buying or selling at a future date d. Forward contract entered for buying or selling over a period of time e. An undertaking given to write a call option on a future date.

82. Assume that the spot rate of the Swiss Franc is $0.90 and the expected spot rate one year from now is $0.85. This change reflects

a. A 5.56% appreciation of the Swiss Franc b. A 5.56% depreciation of the Swiss Franc c. A 5.88% appreciation of the Swiss Franc d. A 5.88% depreciation of the Swiss Franc e. None of the above.

83. A Bank located at Madras keeps a Euro account with Dresner Bank, Frankfurt. That account is referred by the Chennai based Bank as

a. Vostro account b. Nostro account c. Loro account d. Mirror account e. Shadow account.

84. You purchased a one month forward dollar from a bank in New York on April 09, 2003, Friday. The one month forward settlement date is

a. May 10, 2003 b. May 11, 2003 c. May 12, 2003 d. May 13, 2003 e. Either (b) or (c) of the above.

85. Which of the following is true if the spot $/Euro is 0.9775/0.9780 and if the swap points are 20/25 for 1-m and 35/25 for 2-m?

a. $ is at premium for 1-m but at a discount for 2-m. b. Euro is at premium for both 1-m and 2-m. c. $ is at premium for both 1-m and 2-m. d. Euro is at discount for 1-m but at premium for 2-m. e. Euro is at premium for 1-m but at discount for 2-m.

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86. The full-fledged money changers in India a. Can only buy foreign currency b. Can buy and sell foreign currency c. Can buy and sell trade related documents d. Can only sell foreign currency e. Can only sell foreign currency in limited amounts.

87. A London based Bank sells Deutschemarks against US dollar to a Paris based Bank. Which of the following statements regarding the transaction is/are true?

i. The dealing locations are London and US. ii. The dealing locations are London and Paris. iii. The settlement locations may be New York and Frankfurt. a. Only (i) above. b. Only (ii) above. c. Only (iii) above. d. Both (i) and (ii) above. e. Both (ii) and (iii) above.

88. Consider the following quotation: Rs./$ Spot 43.39/42 3-m forward 60/65

The outright forward rates are a. 42.74/82 b. 42.79/84 c. 43.99/07 d. 44.01/07 e. None of the above.

89. Which of the following is a condition necessary to ensure that there is no three point arbitrage?

a. ask

1(A/B)

x (C/B)bid x (A/C)bid >1.

b. (B/A)ask x (C/B)bid x (A/C)bid <1. c. (A/B)ask x (B/C)ask x (C/A)ask >1.

d. ask

ask

/B)(A/C)(A

< (C/B)bid.

e. None of the above.

90. Rs./Euro 46.50/55 1-m 5/10 2-m 10/15 3-m 20/15 Which of the following statements is correct? a. Rs. is at a premium for 1 month. b. Euro is at a discount for 2 months. c. Euro is at a premium for 3 months. d. Rs. is at a premium for 3 months. e. Rs. is at a premium for both 1 and 2 months.

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91. Which of the following statements is true?

If the exchange rate is expressed as (A/B)

a. When swap points are in the high/low order currency B is at a premium.

b. When swap points are in the high/low order currency A is at a discount.

c. When swap points are in the low/high order currency A is at a premium.

d. The bid-ask spreads for forward quotes generally widen with increase in maturity.

e. The bid rate for a currency is sometimes less than the ask rate.

92. The settlement date for a spot transaction done on 13th June, 2003, a Friday is

a. 13th June, 2003

b. 14th June, 2003

c. 15th June, 2003

d. 16th June, 2003

e. 17th June, 2003.

93. Spot Rs./$ 42.55/60

1-m 42.80/85

2-m 43.00/10

If an Indian exporter wants an option forward on the dollar with option over the second month, then the bank will quote

a. 43.00

b. 43.10

c. 42.83

d. 42.80

e. None of the above.

94. A dealer in Singapore asks for a two month forward $-quote from another dealer in Tokyo and strikes the deal on Wednesday, January 28. If January 29 happens to be a holiday in Singapore, the delivery date for the above deal would be

(Assume no other holidays in Singapore, Tokyo, London and New York except for Saturdays and Sundays and it is not a leap year.)

a. March, 30

b. March, 31

c. April, 2

d. April, 1

e. March, 27.

95. A Samurai bond is

a. A Yen denominated bond issued by a Japanese resident to non-Japanese investors

b. A Yen denominated bond issued in Japan by a non-Japanese entity

c. A Yen denominated bond issued for global market by Japanese residents

d. All of the above

e. None of the above.

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96. Value date for a one month forward deal done on February 2, 2004, Monday is

a. February 28, 2004

b. February 29, 2004

c. March 1, 2004

d. March 2, 2004

e. March 4, 2004.

97. The observed rates of $/£ are:

Spot : 1.7120/25

3-month forward margin : 25/20

1 month forward margin : 15/20

Which of the following is true?

a. £ is at discount for 1-month but at premium for 3-months.

b. £ is at premium for 1-month as well as for 3-months.

c. $ is at discount for 1-month as well as for 3-months.

d. $ is at discount for 1-month but at premium for 3-months.

e. $ is at premium for 1-month and for 3-months.

98. Three month forward deal is done on November 27, 2003. The value date for it is

a. March 1, 2004

b. February 28, 2004

c. February 27, 2004

d. February 26, 2004

e. None of the above.

99. Which of the following statements is true, in case of a direct quote?

a. Exchange margin is to be deducted from the bid rate.

b. Exchange margin is to be added to the ask rate.

c. Exchange margin is to be added to bid rate.

d. Exchange margin is to be deducted from the ask rate.

e. Exchange margin is to be deducted from bid rate and added to ask rate.

100. The Market rates are as under:

Rs./$ Spot 43.50/75

1-m forward 20/30

2-m forward 25/35

If a bank has to quote for purchase of US$ and delivery option is second month, the quote will be

a. 43.50

b. 43.70

c. 43.75

d. 44.05

e. 44.10.

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101. If the forward rate is 43.75/44.00 and the relevant swap points are 10/15, then the spot rate is a. 43.85/44.15 b. 43.60/44.10 c. 43.65/43.85 d. 43.90/44.10 e. 43.65/43.90.

102. The spot and forward rates are as under:

$/£ $/SFr

Spot 1.7380 0.6642

Forward 1.7308 0.6620

The implied spot and forward rate for SFr/£ a. 2.6254 and 2.6058 b. 1.1544 and 1.1458 c. 2.6167 and 2.6145 d. 1.1496 and 1.1506 e. 1.1820 and 1.6935.

103. Which country’s currency is the peso? a. Malaysia. b. Thailand. c. Indonesia. d. Philippines. e. Brunei.

104. When there is heavy forex inflow into the country, the RBI’s immediate worry is a. Repayment of foreign debt b. Depreciation of the rupee c. Appreciation of the rupee d. Threat of recession e. Rise in interest rates.

105. If the spot rate is 39.00/39.50 and the swap points are 150/200, what is the forward quote? a. 38.85/39.25. b. 39.15/39.75. c. 38.85/39.75. d. 39.15/39.25. e. 40.50/41.50.

106. Which of the following statements is true in case of an “option forward”? a. Forward sale contract is entered into along with purchase of call option. b. Forward purchase contract is entered into along with purchase of put option. c. Forward purchase contract is entered into along with sale of call option. d. Forward sale contract is entered into along with sale of put option. e. Forward contract is entered into at the time of delivery is not definite.

Part I

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107. If A/B Spot : 1.62/1.63 3-m Forward : 1.60/1.61 4-m Forward : 1.59/1.58 then a. A is at a discount for 3-m and 6-m b. B is at a discount for 3-m and 6-m c. A is at a discount for 3-m and at premium for 6-m d. B is at a discount for 3-m and at premium for 6-m e. None of the above. 108. Suppose the Mexican Peso devalues by 75% against the US dollar, what is the percentage

appreciation of the US dollar against the Peso? a. 3%. b. 25%. c. 75%. d. 300%. e. None of the above. 109. If the bid-offer spread on ∈ is 0.30 and the middle rate is Rs./∈ : 55.60, then the bid-offer

rate is a. 55.15/55.20 b. 55.25/55.45 c. 55.40/55.70 d. 55.45/55.75 e. 55.55/55.85. 110. Which type of structure do the Global Forex Markets closely resemble? a. Oligopoly. b. Monopoly. c. Perfect competition. d. Duopoly. e. Monopolistic competition. 111. If the Rs./Pound quote is 80/81 and the Rs./$ quote is 45/46 we can purchase with $/£? a. $1.70. b. $1.74. c. $1.80. d. $1.82. e. $1.85. 112. An Exchange Dealer of a Bank in India quotes Spot USD 1 = Rs.45.60 – 45.90 He has been “hit” successively on one side of the quote. As a result he is presently $4

million long. He wants to return to a square or near square position. His new quotes will be a. 45.30/45.60 b. 45.45/45.75 c. 45.45/46.05 d. 45.75/46.05 e. None of the above.

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113. On 23-1-2003 a Bank in India contacts a Bank in London and sells spot Rs.5,00,000 against USD. 26-1-2003 is a holiday in India but not in London. The value date is

a. 24-1-2003 b. 25-1-2003 c. 26-1-2003 d. 27-1-2003 e. 28-1-2003. 114. When a Bank in India is called upon to quote forward exchange rates to merchants they go

by a. Adding premium to buying and selling rates b. Adding the discount to the buying and selling rates c. Adding premium to the buying rate and deducting the same from the selling rate d. Adding the discount to the buying rate e. None of the above. 115. Transactions costs are relatively a. More for spot transactions b. Less for forward transactions c. Less for spot transactions d. Same for spot and forward transactions e. None of the above.

Exchange Rate Determination 116. If US inflation is persistently more than German inflation, which of the following is likely

to hold good over a period of time? a. The dollar will appreciate against the euro. b. The dollar will depreciate against other currencies. c. The Euro will appreciate against the dollar. d. The Euro will appreciate against other currencies. e. None of the above. 117. The inflation in Germany is 3% and that in UK is 4%. The sterling can be expected to

depreciate against the euro over a period of one year by a. 0.96% b. 0.97% c. 0.98% d. 0.99% e. 1%. 118. The inflation in India is 9% and that in USA is 4%. If the spot rate is Rs.39.00/$ what

would be the spot rate after one year? a. 40.56. b. 40.75. c. 40.88. d. 40.95. e. 42.51.

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119. An Indian company is planning to invest in the US. The rates of inflation are 8% in India and 3% in USA. If the spot rate is currently Rs.39/$, what spot rate can you expect after 5 years?

a. Rs.48.6/$. b. Rs.48.8/$. c. Rs.49.0/$. d. Rs.49.2/$. e. Rs.49.4/$.

120. Interest rate in Holland is 7% and that in UK is 6%. Inflation rates are 4% in Holland and 3.5% in UK. If PPP holds, it makes sense to

a. Borrow Sterlings b. Borrow Euro c. Invest in Sterlings d. Invest in Euro e. Both (a) and (d) above.

121. I am expecting to receive $1 million after three months. If I am an Indian exporter, I should hedge in the money market by

a. Borrowing dollars b. Investing dollars c. Borrowing rupees d. Investing rupees e. Both (a) and (d) above.

122. Choose the correct alternative from the following. a. When covered interest arbitrage is possible then one-way arbitrage is also possible b. When covered interest arbitrage is possible then one-way arbitrage will not be

possible c. When covered interest arbitrage is possible then one-way arbitrage may or may not

be possible d. One-way arbitrage involves the spot market, forward market and two deposit

markets whereas covered interest arbitrage involves three of the above markets only e. Both (a) and (b) above.

123. When the Sterling offers higher interest rates than US dollar, Forward rate for Sterling against dollar will be

a. Higher than spot rate b. Lower than spot rate c. Lower than the spot rate but not in proportion to the difference between Sterling

yields and US yields d. Higher than the spot rate but in proportion to the difference between Sterling yields

and US yields e. Same as that of spot rate.

124. Which of the following is likely to happen when currency of Country X goes from forward discount to a forward premium against currency of Country Y?

a. Interest rate of Country X might have decreased. b. Interest rate of Country X might have increased. c. Money supply in Country X might have increased. d. Country X must have a deficit on current account. e. Both (a) and (d) above.

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125. An appreciation of the dollar relative to the rupee would be expected to have which of the following effects?

a. Increase American exports to India. b. Increase American imports from India. c. Raise the cost to Americans of Indian imports. d. Create Balance of Payments surplus for India. e. Create Balance of Payments surplus for USA.

126. Which of the following statements is not true in respect of choice of invoicing currency? a. If the home currency is prone to high level of domestic inflation, then exporter will

prefer foreign currency. b. If the home currency is expected to appreciate, then the exporter will prefer home

currency. c. If bid-ask spread in the forward markets are very large then the exporter will prefer

home currency. d. If foreign country interest rates are higher than domestic interest rate then the

importer will prefer foreign currency. e. If the home currency is expected to depreciate, then the importer will prefer home

currency.

127. On 13th June 2000, Spot Rs./$ 44.72 CPI in India 350, CPI in US 240 If relative PPP is holding good, then the real exchange rate is (Assume that both indices

have the same base year) a. 20.50 b. 30.67 c. 44.72 d. 65.22 e. None of the above.

128. A Canadian investor will prefer to invest in securities denominated in dollar than in C$, if

a. C$

$

1+i1+i

< F(C$/$)S(S$/$)

b. C$

$

1+i1+i

> F(C$/$)S(S$/$)

c. C$

$

i1+i1+

= F(C$/$)S(S$/$)

d. $

C$

1+i1+i

< F(C$/$)S(S$/$)

e. $

C$

1+i1+i

> F(C$/$)S(S$/$)

.

129. Which of the following is not an underlying assumption of Purchasing Power Parity?

a. Goods can move freely across the globe.

b. Capital can move freely across the globe.

c. There are no tariffs on goods.

d. There are no transaction costs in buying and selling goods.

e. None of the above.

Part I

41

130. There are various forms of Purchasing Power Parity (PPP) theory. Which form of PPP is also known as the “law of one price”?

a. Numerical form.

b. Relative form.

c. Accounting form.

d. Absolute form.

e. Expectations form.

131. Which of the following is not a reason for departure from Interest rate parity?

a. Transaction costs.

b. Political risks.

c. Taxes.

d. Capital controls.

e. None of the above.

132. A borrower will prefer to borrow in a Currency B instead of borrowing in Currency A, when

a. n

A

F (B/A) (1+i )(1+i )

B > S(A/B)

b. n

A

F (A/B) (1+i )(1+i )

B > S(A/B)

c. n

B

F (A/B) (1+i )(1+i )

A > S(A/B)

d. n

B

F (A/B) (1+i )(1+i )

A < S(A/B)

e. n B

A

(A/B) (1+i )(1+i )

F < S(A/B).

133. The spot Rs./$ rate is 43.75. If the one year interest rates in India and the US are 11% and 4% respectively, then the one year forward Rs./$ rate should be

a. 39.41

b. 40.51

c. 42.06

d. 46.69

e. None of the above.

134. If the price of a commodity is Rs.43.50 in India and $1 in the US, then the Rs./$ exchange rate should be 43.50. This is according to

a. Fisher open condition

b. Interest rate parity

c. Absolute purchasing power parity

d. Relative purchasing power parity

e. None of the above.

International Finance and Trade

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135. Which of the following is not an assumption of the Current Account Monetary Model for exchange rate determination?

a. Domestic money is held only by domestic residents and foreign money by foreign residents.

b. Purchasing Power Parity holds good.

c. Uncovered interest parity and Fisher open condition hold good.

d. There is a stable demand for money function.

e. Balance of Payments condition is always in a state of equilibrium due to flexible exchange rates.

136. If interest parity holds and the transaction costs are zero, covered foreign financing will result in an effective borrowing rate that is

a. Less than the domestic interest rate

b. Greater than the domestic interest rate

c. Equal to the domestic interest rate

d. Greater than the domestic interest rate, if the forward rate exhibits a premium and less than the domestic interest rate, if the forward rate exhibits a discount

e. None of the above.

137. Which of the following is true if the current spot rate is Rs./$ 42.60 and if CPI in India and in US with reference to the same base stands at 230 and 150 respectively?

a. Real exchange rate is Rs.27.78.

b. Real exchange rate is Rs.65.32.

c. Rs. has depreciated in real terms.

d. Both (b) and (c) above.

e. Both (a) and (c) above.

138. If PIND is the inflation in India and PUS is the inflation in US and if PIND < PUS then

a. Rupee appreciates with respect to US dollar exactly by the inflation differential

b. Rupee depreciates with respect to US dollar exactly by the inflation differential

c. Rupee appreciates with respect to US dollar by less than the inflation differential

d. Rupee depreciates with respect to US dollar by less than the inflation differential

e. None of the above.

139. US UKr rF(S/£)1+ > 1+4 S($/£) 4

⎛ ⎞ ⎛ ⎞⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠

implies

a. Borrow US$ and invest in £

b. Borrow £ and invest in US$

c. Selection of currency is irrelevant, since there is no scope for arbitrage

d. Data is insufficient to evaluate arbitrage opportunities

e. None of the above.

Part I

43

140. The current interest rates are as under:

Year 1 2 3

Interest Rate 10% 11% 12%

The expected 1 year rate after 2 years is r12 and expected 2 years rate after 1 year is r21, then which of the following is true?

a. r12 = 10.5%; r21 = 11.5%.

b. r12 = 11%; r21 = 11%.

c. r12 = 12%; r21 = 11%.

d. r12 = 13%; r21 = 14%.

e. r12 = 14%; r21 = 13%.

141. According to the Purchasing Power Parity theory,

a. Goods should move from low inflation to high inflation countries

b. Goods should move from low interest rate to high interest rate countries

c. Goods should move from poor to rich countries

d. Goods should move from capital surplus to capital deficit countries

e. Goods should move from labor surplus to labor deficit countries.

142. The forward premium on a currency with high interest rate vis-á-vis another with a low interest rate is likely to be

a. Positive b. Negative c. Determined by the regulatory framework in place d. Positive, if free capital flows are allowed e. None of the above.

143. If the Interest rate of a currency is decreased it will

a. Appreciate

b. Depreciate

c. Remain unchanged

d. Appreciate/depreciate depending on the specific circumstances

e. None of the above.

144. The Dollar is trading at euro 1.8000 today. Interest rates prevailing in Germany and USA are 5% and 6% respectively. What is the three month forward quote (euro) likely to be?

a. 1.7950. b. 1.7956. c. 1.7962. d. 1.7968. e. 1.7974.

145. The Sterling is trading at $1.6100 today. Inflation in UK is 4% and that in USA is 3%. What could be the spot rate ($/£) after 2 years?

a. 1.5792. b. 1.5892. c. 1.5992. d. 1.5939. e. 1.5780.

International Finance and Trade

44

146. If interest parity holds and the transaction costs are zero, covered foreign financing will result in an effective borrowing rate that is

a. Less than the domestic interest rate

b. Greater than the domestic interest rate

c. Equal to the domestic interest rate

d. Greater than the domestic interest rate if the forward rate exhibits a premium and less than the domestic interest rate if the forward rate exhibits a discount

e. None of the above.

147. If the dollar is quoting Yen 145 today and inflation rates are 2% in Japan and 4% in USA, what should be the exchange rate after a year?

a. 140.2.

b. 142.2.

c. 143.6.

d. 145.7.

e. 147.8.

148. If the∈quoting $0.560 today and the interest rates are 3% in Germany and 5% in USA, what should be the quote after three months?

a. 0.557.

b. 0.562.

c. 0.563.

d. 0.564.

e. 0.565.

Exchange Rate Forecasting 149. Rs./$ : 44/44.25 3-month swap points : 30/25 6-month swap points : 15/20 What are the 3-month and 6-month outright forward rates? a. 3-month 44.30/44.50 6-month 43.85/44.05 b. 3-month 44.30/44.50 6-month 44.15/44.45 c. 3-month 43.70/44.00 6-month 44.15/44.45 d. 3-month 43.70/44.00 6-month 43.85/44.05 e. None of the above. 150. In exchange rate forecasting _______ is also known as the balance of payment approach. a. Monetary approach b. Demand-supply approach c. Portfolio balance approach d. Asset approach e. None of the above.

Part I

45

151. Exchange rate overshooting is explained by

a. Triffin Paradox

b. Dornbusch Sticky-Price theory

c. Efficient market theory

d. Marshall-Lerner condition

e. None of the above.

152. Despite a depreciation in the home currency, the current account balance continues to worsen. This results in an instability in the exchange market. This phenomenon is called as the

a. Marshall-Lerner condition

b. J-curve effect

c. Exchange rate volatility

d. Dornbusch Sticky-Price theory

e. None of the above.

153. _________ approach assumes that the purchasing power parity holds good.

a. Monetary

b. Demand-supply

c. Portfolio balance

d. Asset

e. None of the above.

154. The predictions of the monetary approach are

a. An increase in the real GNP of a country causes its currency to appreciate

b. An increase in the real money demand makes the currency appreciate

c. An increase in the money supply causes the currency to depreciate

d. An increase in nominal interest rates causes the currency to depreciate

e. All of the above.

155 According to the _________ approach, whatever changes are expected to occur in the value of a currency in future, gets reflected in the exchange rates immediately.

a. Monetary

b. Demand-supply

c. Asset

d. Portfolio balance

e. None of the above.

156. The ________ approach states that the value of a currency is determined by two factors – the relative demand and supply of money and the relative demand and supply of bonds.

a. Monetary

b. Demand-supply

c. Asset

d. Portfolio-balance

e. None of the above.

International Finance and Trade

46

157. Which of the following is not a method of exchange rate forecasting?

a. Monetary approach.

b. Asset approach.

c. Portfolio balance approach.

d. Demand-supply approach.

e. None of the above.

158. The phenomenon of exchange rates changing more than the required for a given change in an economic variable and latter coming back to the new equilibrium is explained by

a. Efficient Market Hypothesis

b. Dornbusch Sticky-Price Theory

c. Demand-Supply Approach

d. Imitation-Gap Theory

e. None of the above.

159. J-curve effect is the phenomenon of

a. Improving and subsequent worsening of trade balance after currency depreciation

b. Worsening and subsequent improvement of trade balance after currency depreciation

c. Improving and subsequent worsening of trade balance after currency appreciation

d. Worsening and subsequent improvement of trade balance after currency appreciation

e. None of the above.

160. Which of the following is not a corporate function that makes exchange rate forecasting necessary?

a. Hedging decisions.

b. Capital budgeting decisions.

c. Earnings assessments.

d. Short-term investment decisions.

e. None of the above.

161. Which of the following is/are an Asset Market Model for forecasting the Exchange Rates?

a. Current Account Monetary Model.

b. Capital Account Monetary Model.

c. Portfolio Balance Model.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

162. International Asset Pricing Model is based on the premise that

a. International capital markets are perfectly integrated

b. Purchasing power parity holds good

c. International capital markets are not perfectly integrated

d. Both (a) and (b) above

e. Both (b) and (c) above.

Part I

47

163. Capital account monetary model is an improvement over current account monetary model. Which of the following assumptions of the latter is/are relaxed by the forrmer?

i. There may be departures from PPP in the short run.

ii. The increase in domestic interest rates will always lead to depreciation of domestic currency.

iii. There is a stable demand-for-money function in each country.

a. Only (i) above

b. Both (i) and (iii) above

c. Both (i) and (ii) above

d. Both (ii) and (iii) above

e. All of (i), (ii) and (iii) above.

164. J-curve occurs because,

a. Elasticity of demand for imports is greater for long run than for short run

b. Elasticity of supply for exports is greater for long run than for short run

c. Long run and short run trade elasticities are equal

d. All of the above

e. Both (a) and (b) above.

165. The J curve is linked to the concept of

a. Purchasing power parity

b. Interest parity

c. Fischer open condition

d. Capital asset pricing model

e. Elasticity.

Introduction to Exchange Risk 166. The aim of foreign exchange risk management is

a. To maximize profits

b. To minimize losses

c. To earn a minimum level of profits

d. To know with certainty the quantum of future cash flows

e. All of the above.

167. Foreign Exchange Risk is defined as

a. Variance of the domestic currency value of an asset, liability or operating income that is attributable to unanticipated changes in exchange rates

b. Variance of the foreign currency value of an asset, liability or operating income that is attributable to unanticipated changes in exchange rates

c. Variance of the domestic currency value of an asset, liability or operating income that is attributable to anticipated changes in exchange rates

d. Variance of the foreign currency value of an asset, liability or operating income that is attributable to anticipated changes in exchange rates

e. Sensitivity of changes in the real domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates.

International Finance and Trade

48

168. Foreign Exchange exposure is defined as

a. Variance of the domestic currency value of an asset, liability or operating income that is attributable to unanticipated changes in exchange rates

b. Sensitivity of changes in the real domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates

c. Sensitivity of changes in the nominal domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates

d. Sensitivity of changes in the real foreign currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates

e. Sensitivity of changes in the real domestic currency value of assets, liabilities, or operating incomes to anticipated changes in exchange rates.

169. The firm producing and selling in domestic market may face following risk when the economy is opened

a. Transaction risk

b. Translation risk

c. Operating risk

d. Both (a) and (b) above

e. Firm does not face any risk.

170. Which of the following is true in case of foreign exchange risk?

a. Variance in the value of assets and liabilities and operating income due to unanticipated changes in exchange rates.

b. Variance in the operating income due to expected changes in exchange rates.

c. Variance in the operating income, value of the assets and liabilities due to unfavorable movement of exchange rates.

d. The possibility of loss a firm may sustain due to changes in the exchange rates.

e. The actual and potential loss suffered due to changes in exchange rates.

Management of Exchange Risk 171. An Indian company’s cost of production is Rs.20/unit while its export price is $1/ unit. If

the $ appreciates by 10% and the spot rate today is Rs.40/$, what is the impact of transaction exposure?

a. Increase in profit by Rs.4 per unit.

b. Decrease in profit by Rs.4 per unit.

c. No change in profit.

d. Insufficient data.

e. None of the above.

172. Hedging through ‘currency of invoicing’ results in

a. The exporter covering forex exposure

b. The importer covering forex exposure

c. Both exporter and importer covering forex exposure

d. Either exporter or importer covering forex exposure

e. None of the above.

Part I

49

173. Which of the following is an internal hedging technique? a. Leading b. Netting c. Swap d. Both (a) and (b) above e. None of the above.

174. Hedge ratio is the a. Ratio of futures to a spot position that achieves an objective such as minimizing risk b. Ratio of spot position to futures position that achieves an objective such as

minimizing risk c. Ratio of spot position to option position that achieves an objective such as

minimizing risk d. Ratio of basis to a spot position that achieves an objective such as minimizing risk e. Both (b) and (c) above.

175. Which of the following is not an appropriate hedging strategy for a likely devaluation of a currency?

a. Reduce the level of cash. b. Tighten credit term to decrease account receivables. c. Reduce borrowing in the currency. d. Delay account payables. e. Sell the currency forward.

176. Which of the following is not a suitable strategy to hedge economic exposure? a. Plant location. b. Pricing of the product. c. Market selection. d. Product mix. e. Currency swap.

177. Which of the following actions will help in overcoming an undesirable long position built-up by a dealer?

a. Increase both bid and ask rates. b. Reduce both bid and ask rates. c. Increase bid rate above market rate and reduce the ask rate. d. Reduce the ask rate below the market rate and keep bid rate unchanged. e. Keep both bid and ask quotes unchanged.

178. Which of the following statements is false? a. Offsetting a long position in one currency with a short position in the same currency

is known as ‘netting’. b. Risk arising from an exposure in one currency can be reduced with an exposure in

another currency. c. A firm can offset a long position in a currency with a short position in the same

currency. d. If the exchange rate movements of two currencies are negatively correlated, then a

firm can offset the risk arising from a long position in one currency with a short position in other currency.

e. If the currency movements are negatively correlated, then long positions in both the currencies will give rise to risk which is less than the risk arising from a long position in any one currency.

International Finance and Trade

50

179. Which of the following is not an external hedging technique?

a. Forwards.

b. Currency of invoicing.

c. Futures.

d. Options.

e. Currency swap.

180. The operating exposure of a firm can be reduced by

a. Covering through forward market

b. Covering through futures market

c. Covering through money market

d. Covering through options market

e. Altering the firm’s operations.

181. Consolidation of financial statements of an MNC gives rise to

a. Economic exposure

b. Translation exposure

c. Transaction exposure

d. Both (b) and (c) above

e. None of the above.

182. Which of the following factor(s) influence the extent of translation exposure faced by a multinational company?

a. Accounting methods used.

b. Locations of foreign subsidiaries.

c. Degree of foreign involvement by foreign subsidiaries.

d. All of (a), (b) and (c) above.

e. None of the above.

183. A US multinational wants to hedge a payable in Swiss Francs that is due in 6 months. Which of the following money market hedges should it adopt?

a. Borrow dollars, convert to francs, lend in francs for 6 months.

b. Borrow dollars, convert to francs, sell the francs forward 6 months.

c. Borrow francs, convert to dollars, lend the dollars.

d. Borrow francs, convert to dollars, sell the dollars forward 6 months.

e. None of the above.

184. A treasury manager normally tries to cover the forex exposure, because

a. It helps in earning more profits

b. It helps in reducing known losses

c. It helps in reducing the uncertainty of cash flows

d. It helps in reducing the cost of borrowing

e. Both (a) and (b) above.

Part I

51

185. An Italian company has to pay Japanese yen for an import transaction in a few days from now. To hedge this, the company will

a. Sell Japanese yen for Italian Lira forward b. Buy Japanese Yen with Italian Lira forward c. Buy USD with Italian Lira forward d. Sell Japanese Yen for Italian Lira spot e. Buy Japanese Yen spot against Italian Lira. 186. Netting helps in a. Reducing cash requirements b. Reducing interest costs c. Better control of subsidiaries d. Reducing transaction costs e. None of the above. 187. An Indian exporter who invoices in US$ is benefitted most a. By realizing the export proceeds immediately if US $ is at a discount b. By delaying the realization of export proceeds if US $ is at a premium c. By delaying the realization of exports proceeds if US $ is at a discount d. By entering into a forward contract covering receivables e. Both (a) and (b) above. 188. Which of the following statements is/are true? a. Changes in the values of assets, liabilities and operating incomes due to anticipated

changes in exchange rates do not give rise to exposure. b. Exposure is defined with respect to changes in real values of assets, liabilities and

operating incomes. c. Exposure arises only if the firm possesses assets or liabilities or both denominated in

foreign currency. d. Exposure is measured by the standard deviation or variance of the changes in values

of assets denominated in foreign currency. e. Both (a) and (b) above. 189. A speculator buys US dollar at 43.50 and expects to make a profit by keeping open position

for one month. He expects that a. The spot ask rate after one month will be less than the current spot bid rate b. The spot bid rate after one month will be less than the current spot ask rate c. The spot ask rate after one month will be more than the current spot ask rate d. The spot bid rate after one month will be less than the current spot bid rate e. The spot bid rate after one month will be more than the current spot ask rate. 190. A firm has a 90-day receivable of $5000. The firm expects the Rs./$ rate, which is 43.50

now, to be 43.60 by the time of realization. But, the Rs./$ rate actually turns out to be 43.65. The risk faced by the firm from the receivable is

a. Zero b. Rs.250 c. $250 d. Rs.1,00,000 e. None of the above.

International Finance and Trade

52

191. Alpha Impex Ltd. has receivables denominated in Euro and payables denominated in Yen. If the Rupee is expected to depreciate against the Euro and appreciate against the Yen, then the company should

a. Lead the receivable, lag the payable b. Lead both receivable and payable c. Lag the receivable, lead the payable d. Lag both receivable and payable e. None of the above.

192. Which of the following statements is/are true? a. Transaction exposure is also called the profit and loss account exposure. b. Transaction exposure is of two types – contingent exposure and economic exposure. c. Transaction exposure arises only when assets or liabilities are liquidated. d. Transaction exposure is also known as contractual exposure. e. Both (c) and (d) above.

193. Which of the following situations will result in profit? a. Long on Euro and Euro depreciates against Rupee. b. Short on Euro and Euro depreciates against Rupee. c. Short on Euro and Euro appreciates against Rupee. d. Short on Euro and Rupee depreciates against Euro. e. None of the above.

194. If the amount and timing of a foreign currency outflow are both uncertain, then the best hedging technique will be to

a. Buy a put option b. Buy a call option c. Sell a call option d. Buy a forward contract e. None of the above.

195. Which of the following is not a suitable strategy for an exposure in a currency which is likely to appreciate?

a. Realize the investments. b. Postpone the receivables. c. Reduce the local borrowing. d. Postpone collection of payables. e. None of the above.

196. Conversion effect of operating exposure refers to a. Changes in nominal exchange rate in line with relative PPP b. Changes in home currency value of a given foreign currency cash flow c. Changes in real exchange rate d. Changes in prices and quantities of output due to the impact of changes in exchange

rate e. None of the above.

Part I

53

197. State which one of the following is not an internal hedging technique? a. Netting. b. Matching. c. Leading and Lagging. d. Offsetting. e. Entering into forward exchange contract.

198. Hedging through currency invoicing results in a. The exporter and importer covering the exposure b. The exporter covering the exposure c. The importer covering the exposure d. Either exporter or importer covering the exposure e. Neither the exporter nor the importer covering the exposure.

199. The market $/Euro spot rate is 1.0955/65. A dealer finds himself with a long position in Euro exceeding his limit. He should

a. Increase his bid rate above market and reduce his offer rate b. Reduce his bid rate and increase his offer rate c. Increase the bid rate and reduce the offer rate d. Increase both bid rate and offer rate e. Reduce both bid rate and offer rate.

200. Hedging aims to a. Increase profits b. Reduce losses c. Reduce costs d. Minimize risk e. Maximize profits.

201. Which of the following statements is/are false? i. Transaction exposure is a real exposure. ii. Translation exposure does not affect the income of the firm. iii. By restricting its operation in the domestic market a firm can insulate from exchange

risk. a. Only (i) above b. Only (ii) above c. Only (iii) above d. Both (i) and (ii) above e. Both (ii) and (iii) above.

202. An exporter exporting to US is benefited most a. By realizing the export proceeds immediately if US $ is at discount b. By delaying the realization of export proceeds if US $ is at a premium c. By delaying the realization of exports proceeds if US $ is at a discount d. By entering into a forward contract covering receivables e. Both (a) and (b) above.

International Finance and Trade

54

203. In the case of forward cover, the cost of hedging is a. The annualized forward premium b. The difference between the forward rate and expected spot rate c. The difference between the forward rate and current spot rate d. The difference between the forward rate and actual spot rate prevailing on the date

of maturity e. Zero since it does not involve any payment on the date of contract. 204. Netting can do all of the following except a. Reduce foreign exchange risk b. Reduce foreign exchange costs c. Reduce float d. Reduce cable charges e. None of the above. 205. If you were trying to hedge foreign currency receivables you would a. Sell foreign currency futures b. Buy foreign currency futures c. Sell home currency futures d. Both (b) and (c) above e. None of the above. 206. An Italian company has to pay Japanese Yen for an import transaction in a few days from

now. To hedge this the company will a. Sell Japanese yen for Italian Lira forward b. Buy Japanese Yen with Italian Lira forward c. Buy USD with Italian Lira forward d. Sell Japanese Yen for Italian Lira spot e. Buy Japanese Yen spot against Italian Lira.

International Project Appraisal 207. If blocked funds which cannot be repatriated from the host country can be utilized for

a project, and the applicable tax rate is 50%, a. The full value should be added to the cost of the project b. 50% of the value of blocked funds should be added to the cost of the project c. Value of the blocked funds depends on the prevailing exchange rate d. It is at the discretion of the appraiser e. None of the above. 208. The host country’s Governments offers a loan equivalent to Rs.10 million at zero interest.

The loan involves bullet repayment at the end of 5 years. If the competitive rate of borrowing in the home country is 10%, the benefit due to the loan is

a. 0 b. Rs.9 million c. Rs.10 million d. Rs.3.79 million e. None of the above.

Part I

55

209. A project adds $10 million to a company’s borrowing capacity. If the competitive rate of borrowing is 10% and the applicable tax rate is 40%, the benefit available annually is

a. $1 million

b. $0.8 million

c. $0.6 million

d. $0.4 million

e. $0.2 million.

210. Appraising international project using conventional NPV methods increases difficulties due to

i. Activation of blocked funds.

ii. Loss of export sales.

iii. Increases financing.

iv. Differences in taxation.

v. Restriction on profit repatriation.

a. (i), (ii) and (iii) above

b. (ii), (iii) and (iv) above

c. (iii), (iv) and (v) above

d. All of (i), (ii), (iii) and (iv) above

e. All of (i), (ii), (iii), (iv) and (v) above.

211. Uncertainty surrounding payment from abroad or assets held abroad due to the possibility of war, revolution, asset seizure, or other similar political, social, or economic event is known as

a. Political risk

b. Sovereign risk

c. Country risk

d. Credit risk

e. All of (a), (b), and (c) above.

212. The adjusted present value framework is based on the _________ principle.

a. NPV

b. IRR

c Net value added

d. Value additivity

e. None of the above.

213. In the APV method, the discount rate used for calculating the value of concessional loan is

a. The risk-free interest rate in the home country

b. The risk-free interest rate in the host country

c. Competitive borrowing rate in the home country

d. Competitive borrowing rate in the host country

e. None of the above.

International Finance and Trade

56

214. Discount rate used in APV for calculating present value of interest tax shields on incremental debt is

a. Home country risk-free rate b. Host country risk-free rate c. Home country market borrowing rate d. Host country market borrowing rate e. Host country concessional rate of interest.

215. In the APV method, the discount rate used to calculate the benefit due to increased borrowing capacity is

a. Market rate of interest in home country b. Market rate of interest in host country c. Nominal risk-free rate of interest in home country d. Nominal risk-free rate of interest in host country e. Cost of capital for the parent company.

216. Suppose the parent company projects the currency of the subsidiary to appreciate over the life of the capital budgeting project. Which of the following would best apply?

a. Capital budgeting projects would look better from the parent company’s point of view. b. Capital budgeting projects would look worse from the parent company’s point of

view. c. Capital budgeting projects would look worse from the subsidiary’s point of view. d. Both (a) and (c) above. e. None of the above.

217. While appraising projects using the adjusted present value technique, cash outflows due to repayment of a concessional loan are discounted with

a. The risk-free rate of discount b. The rate of interest on the loan c. The all-equity discount rate d. The market rate of interest on the loan e. None of the above.

218. While appraising international projects using the adjusted present value technique, contractual cash flows are discounted at

a. The risk-free rate of discount b. The all-equity cost of capital c. The pre-tax cost of debt d. The weighted average cost of capital e. None of the above.

219. While computing the Adjusted Present Value, the depreciation allowance is discounted by a. Subjective rate to be decided by the management b. The cost of equity capital c. The post-tax cost of debt capital d. The risk-free rate of return e. The pre-tax cost of debt capital.

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220. The discount rate used for Depreciation Tax Shields in APV approach, should be

a. Nominal risk-free rate of return of the country proposing the project

b. Nominal risk-free rate of return of the country where the project is proposed

c. Cost of equity

d. Weighted average cost of capital of the organization proposing the project

e. None of the above.

221. The discount rate used in the APV method for interest tax shield is

a. The weighted average cost of capital

b. Nominal foreign currency interest rate

c. Nominal borrowing rate of the country where borrowing capacity is said to augment

d. All equity cost reflecting the project’s systematic risk

e. Higher of the nominal borrowing rates of the countries involved in the project.

222. In the APV method, the discount rate used to estimate the benefit arising out of depreciation tax shields is

a. Market rate of interest in home country

b. Market rate of interest in host country

c. Risk-free rate of interest in home country

d. Risk-free rate of interest in host country

e. The cost of capital for the parent company.

223. While taking up an overseas project, a company has to take into account

a. Political risk

b. Sovereign risk

c. Inflation risk

d. Currency risk

e. All of the above.

224. When evaluating international project cash flows, which of the following factors are relevant?

a. Future inflation

b. Blockage of funds

c. Remittance provisions

d. Both (a) and (b) above

e. All of the above.

225. Adjusted present value is

a. Used only in International Project Appraisal

b. Superior to Net Present Value, conceptually

c. Inferior to Net Present Value, conceptually

d. A more flexible technique than NPV

e. None of the above.

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International Financial Markets and Instruments 226. The reasons for the international markets to view India in a different perspective are a. Improved performance of Indian companies b. Improved export performance c. Improved confidence of the FIIs in the economy d. Improved forex reserves position e. All of the above.

227. Which of the following bonds are denominated in Yen? a. Yankee. b. Samurai. c. Bulldog. d. Shibosai. e. Both (b) and (d) above.

228. __________ are underwritten and have a maturity of up to one year. a. Note issuance facilities b. Medium-term notes c. Commercial paper d. ADRs e. None of the above.

229. __________ are non-underwritten and have a maturity of more than one year. a. Note issuance facilities b. Medium-term notes c. Commercial paper d. GDRs e. None of the above.

230. __________ is a private arrangement between lending banks and a borrower. a. Club loan b. Multiple component facility c. Syndicated Euro credit d. All of the above e. Both (a) and (c) above.

231. Capital market segmentation means that a. Real interest rate are fixed by the central banks b. Real interest rates are determined by the local credit conditions c. Real interest rates are determined by international supply and demand for funds d. Governments impose restrictions on foreign investments in the country’s capital

market e. None of the above.

232. Expropriation refers to a. Government restraining repatriation of profits b. Government taking over without paying compensation c. Government taking over by paying compensation d. Government treating a country as enemy country e. Government restraining future investments by foreign investors in home country.

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233. Which of the following statements is/are true?

a. Private placement issues in Japanese Bond Market are known as Shibosai Bonds.

b. Foreign issues in the domestic sterling market are called Bulldog Bonds.

c. Bonds issued in domestic dollar market by foreign borrowers are called Yankee Bonds.

d. Both (b) and (c) above.

e. All of (a), (b) and (c) above.

234. A Yankee bond is

a. A dollar dominated bond issued for global market by a non-US entity

b. A dollar denominated bond issued in the US by a non-US entity

c. A dollar denominated bond issued by a US resident to a non-US investor

d. A dollar denominated bond issued in US by a US resident

e. Either (a) or (b) above.

235. Shibosai bond is a bond

a. Denominated in ¥ and issued outside Japan

b. Denominate in a currency other than ¥ and issued in Japan

c. Denominated in Japanese ¥ and issued under private placement in Japan

d. Denominated in ¥ and issued by a overseas corporate to the public in Japan

e. None of the above.

236. A Bull-dog bond is

a. Issued in UK market by UK borrower.

b. Issued in UK market in Sterling by a non-UK borrower under private placement system and unlisted.

c. Issued in UK in Sterling by non-UK borrower and listed

d. Issued outside UK by a UK borrower and listed

e. Issued by a non-UK borrower in non-sterling currency.

237. A drop-lock is generally referred to

a. Box in which collection cheques are deposited and cleared by Banks periodically

b. Facility where the borrower agrees for a minimum interest rate

c. Facility where a non-bank holder of forward contract agrees for amendment of rates under certain conditions

d. Facility under which floating rates are locked at the lowest rate during a period

e. None of the above.

International Equity Investments 238. International diversification will be useful only when

a. Foreign country interest rate is more than domestic interest rates

b. When inflation is less in both domestic country and foreign country

c. When volatility in interest rates is less

d. When volatility in exchange rate is less

e. Stock returns compensate more than foreign exchange risk.

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239. International Asset Pricing Model is based on the premise that a. International capital markets are perfectly integrated b. Purchasing power parity holds good c. International capital markets are not perfectly integrated d. Both (a) and (b) above e. Both (b) and (c) above.

Short-term Financial Management 240. The key issue in international cash management is a. Giving sufficient independence to individual subsidiaries b. Centralizing and minimizing independence of subsidiaries c. Deciding whether hedging is required or not d. Striking the right balance between decentralization and centralization e. None of the above.

241. Netting is a. Facilitated by centralized cash management b. An internal hedging technique c. A tool for management of forex risk d. Applicable only to large companies e. All of the above.

242. Which of the following are the basic objectives of working capital management in an international environment?

a. To allocate short-term investments and cash-balance holdings between currencies and countries to maximize overall returns.

b. To borrow in different money markets to achieve the minimum cost. c. To net the cash inflows and outflows from abroad. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

243. Leading and lagging are used for i. Hedging. ii. Speculating. iii. Reducing taxes. a. Only (i) b. Only (iii) c. Both (i) and (ii) above d. Both (i) and (iii) above e. All of (i), (ii) and (iii) above.

244. Which of the following are the internal techniques for managing foreign exchange exposure?

a. Netting. b. Futures. c. Options. d. Leading and lagging. e. Both (a) and (d) above.

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245. Functional currency of a firm is a. The currency in which most of the assets and liabilities are held b. The currency in which most of the receivables and payables are held c. The currency in which the financial statements are published d. The currency in which the extra commercial borrowings are denominated. e. Both (a) and (c) above.

246. If interest rate parity holds good a. Centralized cash management is better than decentralized cash management b. Decentralized cash management is better than centralized cash management c. It is immaterial whether the cash management is centralized or decentralized d. Interest parity has no relation with cash management e. None of the above.

247. Reporting currency of a firm is a. The currency in which most of the assets and liabilities are held b. The currency in which most of the receivables and payables are held c. The currency in which the financial statements are published d. The currency in which the external commercial borrowings are denominated e. Both (a) and (c) above.

248. Which of the following statements is false in respect of choice of currency of invoicing? a. If the home currency is prone to high levels of inflation, the exporter may prefer

foreign currency. b. If the home currency does not have a well groomed forward market then the

exporter may prefer home currency. c. If the bid-ask spread in the forward markets are very large then the exporter may

prefer home currency. d. If the foreign currency interest rates are higher than domestic interest rates then the

importer may prefer foreign currency. e. If the home currency is expected to depreciate, the importer may prefer the home

currency.

249. The functional currency of a firm can be best defined as a. The currency in which the firm prepares its financial statements b. The currency of the primary economic environment in which the firm operates c. The currency in which the firm reports its financial performance to the international

shareholder d. The currency of that country where the parent firm is situated e. None of the above.

250. A company sells its exports receivables to a firm that takes responsibility for collecting payment from the importer. It has used

a. Accounts receivable financing b. Factoring c. Forfaiting d. Letter of credit e. None of the above.

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International Accounting and Taxation 251. According to AS-II, a transaction in a foreign currency should be translated at the _______

as on the date of the transaction. a. 1-month forward rate b. 3-month forward rate c. Spot rate d. Inflation adjusted rate e. Rate depending on case by case basis.

252. _______ advocates the conversion of all current assets and liabilities at the closing rate and all non-current assets and liabilities at the historical rate.

a. Current rate method b. Current/Non-current method c. Monetary/Non-monetary method d. Temporal method e. Either (b) or (c) above.

253. _______ method classifies items on the basis of whether they are valued at historical basis or market price basis.

a. Current rate b. Current/Non-current c. Monetary/Non-monetary d. Temporal e. Both (a) and (b) above.

254. A ______ is given by way of reduction in the tax payable by the entity on an international transaction by the amount it has paid as withholding taxes.

a. Tax relief b. Tax concession c. Tax credit d. Tax exemption e. Tax deduction.

255. The method of translating financial statements in which items are classified based on whether they are valued at historical basis or on market price basis is known as

a. Current/non-current method b. Monetary/non-monetary method c. Temporal method d. Current rate method e. Average rate method.

256. Current assets and current liabilities are translated at the current exchange rate while all other assets and liabilities are translated at historical rates according to the

a. Current rate method b. Temporal method c. Monetary – Non-monetary method d. Current – Non-current method e. None of the above.

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257. If the rate of income tax and capital gains tax are equal and the interest parity holds good, then investors would

a. Benefit if they invest in a currency that is likely to appreciate b. Benefit if they invest in a currency that is likely to depreciate c. Benefit if they invest in a currency that remains fairly stable d. Realize the same gains irrespective of the currency in which they invest. e. Cannot be inferred from the above.

258. Which of the following is/are translated at current rate under temporal method? a. Cash. b. Receivables. c. Inventory carried at net realizable value. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

Part I: Answers to Questions on Basic Concepts SECTION I: INTERNATIONAL FINANCE Introduction to International Finance 1. (d) Globalization involves the various markets getting integrated across geographical

boundaries. All the above are benefits associated with globalization.

2. (d) Integration of financial markets or diversification also involves taking additional risks. A currency risk denotes the risk of value of an investment in some other country’s currency, coming down in terms of the domestic currency. Country risk is the risk of not being able to disinvest at will due to countries suddenly changing their attitude towards foreign investment, or due to some other factors like war, revolution etc. Transmission risk is the risk of markets going down together in times of a downturn in an economy or in case of any panic among investors.

3. (d) Integration of financial markets involves the freedom and opportunity to raise funds from and to invest anywhere in the world, through any type of instrument. All the above factors are responsible for integration of financial markets.

4. (d) Interest rates, exchange rates or prices of financial assets, all of them change quite frequently in response to various changes taking place in different segments of the financial markets all over the world.

Theories of International Trade 5. (a) According to the theory of absolute advantage proposed by Adam Smith, International

trade takes place because one country may be more efficient in producing a particular good than another country, and that other country may be capable of producing some other good more efficiently than the first one.

6. (d) According to the Imitation-Gap theory given by Posner, improvement in technology is a continuous process and the resulting inventions and innovations in existing products give rise to trade between such countries.

7. (b) According to the Heckscher-Ohlin model there are two types of products – labor intensive and capital intensive. The reason for two countries benefiting from the trade is the differences in their factor endowments.

8. (d) According to the theory of Comparative advantage, each country should produce that good in which it has comparative advantage. In explaining the theory David Ricardo made all the implicit assumptions.

9. (e) The important principles of International product life cycle theory are (i) new products are developed as a result of technological innovations. (ii) trade patterns are determined by the market structure and the phase in a new product’s life.

10. (d) The phenomenon of a particular country simultaneously importing and exporting the same product is called intra-industry trade. All the reasons given can be attributed to such trade.

11. (e) All the above are minor factors affecting international trade.

12. (d) According to the Imitation-Gap theory given by Posner, improvement in technology is a continuous process and the resulting inventions and innovations in existing products give rise to trade between such countries.

13. (c) According to the Heckscher-Ohlin model, there are two types of products – labor intensive and capital intensive. The reason for two countries benefiting from the trade is the differences in their factor endowments.

14. (d) According to the theory of comparative advantage, each country should produce that good, in which it has a comparative advantage.

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15. (d) America has a comparative advantage in food production, hence it may or may not import food.

16. (e) France has absolute advantage in producing A and Germany has absolute advantage in producing B. Hence France will export A to Germany and import B from Germany.

Balance of Payments 17. (c) Merchandise trade should be recorded when the change in ownership takes place. Hence,

when an Indian exporter receives payments for an earlier shipment it is debited to offset the credit given earlier.

18. (d) Any transaction which is a source of foreign currency is a credit entry.

19. (e) A current account of the balance of payments is the result of the export and import of goods, services, income, and goodwill (or unilateral transfers). A deficit in the current account must be financed by borrowing from abroad or by divestment of foreign assets, while a surplus must be loaned abroad or invested in foreign assets.

20. (e) Transactions which effect the nation’s wealth and the net creditor position are capital account transactions. IMF borrowings affect the nation’s wealth. Therefore they are capital account transactions.

21. (a) A nation’s current account balance is identically equal to its private savings-investment balance less the government budget deficit. A nation running a current account deficit is not saving enough to finance its private investment and government budget deficit.

22. (d) Official reserves include gold, reserves of convertible foriegn currencies, SDR’s and balances with IMF, which are the means of international payment. Therefore, they are recovered in the Official Reserves.

23. (d) All service transactions are recorded in the invisibles account. The service account includes investment income (interest and dividend), tourism, financial charges (banking and insurance), and transportation expenses (shipping and air travel).

24. (d) International transfers from abroad do not include transfer of goods from one country to another due to bilateral agreement.

25. (c) The BoP account includes the current, capital and the official reserve account. If there is a net deficit in the current and capital; account taken together it is referred to as BoP deficit.

26. (b) A decline in the foreign exchange reserves of a country, other thing remaining the same will cause a contraction of money supply in the country.

27. (b) The deposits of NRIs with banks is a capital account transaction. A current account of the balance of payments is the result of the export and import of goods, services, income, and goodwill (or unilateral transfers).

28. (d) A depreciation of the home currency can reduce a trade deficit in a floating-rate system. An overvalued currency acts as a tax one exports and a subsidy to imports, reducing the former and increasing the later. Permitting the currency to return to its equilibrium level will help reduce the trade deficit.

29. (d) This is an investment income recorded in the invisibles account. All service transactions are recorded in the invisibles account. The service account includes investment income (interest and dividend), tourism, financial charges (banking and insurance), and transportation expenses (shipping and air travel).

30. (e) Official reserves include gold, reserves of convertible foriegn currencies, SDR’s and balances with IMF, which are the means of international payment. The official reserves account reflects the amount of these means of international payment acquired or lost during the period for which the BOP account is constructed.

31. (c) A decrease in foreign assets is the result of a sale of asset and an inflow of foreign currency. Hence it is a credit entry.

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32. (d) Imports and exports of capital goods are shown in the current account. The balance on the current account reflects the net flow of goods, services, and unilateral transfers. It includes exports and imports of merchandise, military transactions, and service transactions.

33. (c) The threat of capital control by the government will deter the foreign investors to invest in the country. Further, it will also have a negative impact on the existing foreign investors that make them to repatriate their investment money. All these movements worsen the country’s BOP position.

34. (d) A current account of the balance of payments is the result of the export and import of goods, services, income, and goodwill (or unilateral transfers). Deposit of NRIs with Indian banks is a capital account transaction. Similarly FCNR accounts are also capital account transactions.

35. (e) The main difference between depreciation and devaluation is that devaluation is associated with official announcements and depreciation with market forces.

36. (a) The capital account records movements on account of international purchase or sale of assets. The assets include any form in which wealth may be held – money held as cash or in the form of bank deposits, shares, debentures, other debt instruments, real estate, land, antiques, etc. Hence the capital account balance decreases when the home currency is expected to weaken, other things being equal.

37. (e) The main difference between depreciation and devaluation is that devaluation is associated with official announcements and depreciation with market forces.

38. (e) Current account records all income related flows. These flows could arise on account of trade in goods and services and transfer payments among countries. A net outflow after taking all entries in current account is a current account deficit. Government expenditure and tax revenues do not fall in the current account. Forex Reserves are capital account transactions. The BOP depends on capital account surplus/deficit. Current account deficit does not mean heavy capital inflow. Therefore, answer is none of the above.

39. (a) Because double-entry bookkeeping ensures that equal debits equals credit, the sum of all transactions is zero. In the absence of official reserve transactions, a capital account surplus must offset the current account deficit and a capital account deficit must offset a current account surplus.

40. (d)

Foreign exchange reserves $35 billion Less: Current account deficit $10 billion $25 billion Net capital inflow* $15 billion Balance in reserves $40 billion

41. (e) None of the above statements are valid.

42. (e) The sale of US treasury bond will appear as a debit in the capital account as it involves an outflow of funds due to sale of an asset by a foreigner. So, the answer is none of the above.

43. (b) Current account records all transactions on account of trade in goods and services and transfer payments among countries. Trade in services consists of payments and receipts on account of interest, dividend, professional services, income on assets like patents and copyrights, tourism, transport, insurance, banking and other financial services, and other factor services involving residents of two countries. Tourism falls under invisibles. Therefore, it is recorded in the current account.

44. (c) When a foreigner purchases Indian treasury bills there is flow of foreign currency into India and demand for foreign currency decreases and the demand for rupee increases.

45. (b) When there are no capital controls in the movement for international capital flows.

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International Monetary System 46. (b) A depreciation of the home currency can reduce a trade deficit in a floating-rate system.

An overvalued currency acts as a tax on exports and a subsidy to imports, reducing the former and increasing the later. Permitting the currency to return to its equilibrium level will help to reduce the trade deficit.

47. (c) Devaluation can only boost the short-term competitiveness of the economy and not the long-term. The current trade deficit will be reduced by a fall in the value of the currency as the devaluated currency boosts the country’s exports.

48. (d) J-curve says that a decline in the value of the currency should be followed by a temporary worsening in the trade deficit before its longer term improvement.

49. (b) The failure in the Bretton Woods system is called the Triffin paradox or the Triffin dilemma after a Yale university professor, Robert Triffin who first spoke about it in 1960.

50. (b) A currency crisis tends to occur when the currency of a country whose economic fundamentals are weak appreciates.

51. (e) The US dollar become the most important currency after the collapse of Bretton Woods.

52. (d) Argentina and Hong Kong are good examples of countries that followed the currency board system of exchange management system.

53. (d) The European Union launched a common currency named Euro on January 1st, 1999.

54. (d) The tenability of fixed exchange rate system depends on the monetary discipline.

55. (c) Hong Kong’s exchange rate system closely resembles the erstwhile gold standard.

56. (c) The value of SDR is determined as a weighted average value of 5 currencies – US Dollar, Yen, Pound Sterling and Euro.

57. (d) When imports from a particular country are totally banned it is called Embargo.

58. (b) The failure in the Bretton Woods system is called the Triffin paradox or the Triffin dilemma after a Yale university professor, Robert Triffin who first spoke about it in 1960.

59. (c) The International Monetary Fund was established to ensure proper working of the international monetary system. One of the important functions of IMF was to provide reserve credit to member countries facing temporary BOP problems.

60. (b) The value of SDR is determined as a weighted average value of 5 currencies – US Dollar, Yen, Pound Sterling and Euro. Therefore, the fluctuation in SDRs is not caused by Swiss Franc.

61. (d) Under the pegged exchange rate system a country fixes the rate of its domestic currency in terms of a foreign currency, and the exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged.

62. (b) The value of SDR is determined as a weighted average value of 5 currencies – US Dollar, Yen, Pound Sterling and Euro.

63. (c) In order to reduce inefficiencies, central banks generally intervene in the currency markets to smoothen the fluctuations. Such a system is referred to as managed float or a dirty float.

64. (b) Fiat money is money which has insignificant intrinsic value, but a high face value due to the decree or fiat that it can be used for settlement of all financial obligations.

65. (e) When the demand for foreign currency rises and people start converting more and more of the domestic currency for foreign currency the reserves with the central bank get depleted. Hence, the central bank to defend its home currency decreases the money supply and increases the interest rates.

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66. (e) 11 countries adopted the Euro as its currency in 1999. They are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Greece did not join the common union.

67. (d) The Argentine Peso is pegged to the US dollar.

68. (b) Sterling was the leading currency of the world during the days of Gold standard.

69. (a) Indonesia has been worst effected by the Asian currency crisis.

70. (d) Under the currency board system, a country fixes the rate of its domestic currency in terms of a foreign, and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged.

71. (c) Under the gold standard, the long run stability of the price levels is affected by alternating periods of inflation and deflation in the short run.

72. (b) Dollar was the reserve currency under the Bretton Woods system.

73. (b) The Asian currency crisis was a result of deployment of short-term funds in property markets and long-term ventures. Since the funds were not being used to create any real activity, the probability of their being serviced kept coming down. Hence it is the result of inefficient use of funds.

74. (c) The value of SDR is determined as a weighted average value of 5 currencies – US Dollar, Yen, Pound Sterling and Euro. Therefore answer is (c).

75. (a) Devaluation is the reduction in the value of currency dictated by authorities.

The Foreign Exchange Market 76. (d )Futures contract involves an agreement between two parties to buy/sell an asset at a

predetermined price on a future date. In such contracts, the credit risk involved is minimized by the clearing house by being a counterparty to all trades.

77. (d) Rs./$ – 46.10/46.20

Rs./∈ = 55.00/55.60

$/ask = (1/Rs./$)bid x (Rs./$)ask = 1/46.10 x 55.60 = 1.2061.

78. (e) The foreign exchange brokers do not actually buy or sell any currency. They do the work of bringing buyers and sellers together.

79. (b) For arriving at the settlement date for a forward contract, first the settlement date for the corresponding spot transaction is calculated, and then the relevant number of months is added to it.

80. (d) Synthetic( A/C)ask = (A/B)ask x (B/C)ask

Rs./∈ = 44.65 x 0.9565 = Rs.42.707/∈ .

81. (d) In an Option-forward contract the customer of a bank has the option to ask for the contract to be settled anytime during a particular period called the Option period.

82. (b) Depreciation = New dollar valueof Swiss francOld dollar valueof Swiss franc

Depreciation = Forward SpotSpot

− x 100

= 0.85 0.90.9− x 100 = –5.56%.

∴There is a 5.56% depreciation the Swiss Franc.

83. (b) A Nostro account is a bank’s account with a corresponding bank located in a foreign country.

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84. (d) The spot settlement date is April 13, 2003 Tuesday. The one month forward settlement date will be May 13, 2003, which is obtained by adding a month to the spot settlement date.

85. (e) The one month forward rate for Euro is 0.9795/0.9805 and the three month forward rate is 0.974/0.9755. Hence, Euro is at a premium for one month and at a discount for three months.

86. (b) Full-fledged money lenders are authorized to both buy and sell foreign currencies. 87. (e) A currency’s settlement always takes place in the country of origin of the currency. 88. (e) As the swap points are low/high they are added to the spot rate to obtain the outright

forward rate. Hence, the outright forward rates are 43.99/44.07. 89. (c) The equation represents the no-arbitrage condition where limits are imposed by the

synthetic rates on the actual quote for a pair of currencies. 90. (d) The three months forward rates are 46.30 and 46.40. Hence, the Euro is at a discount

and the rupee is at a premium. 91. (d) When the swap points are in high/low order for exchange rate A/B then currency B is at

a discount and currency A is at a premium. The bid rate for a currency is always less than the ask rate. The bid-ask spread generally increases with increase in maturity.

92. (e) The settlement date for a spot transaction will be the second working day from the date of the spot transaction. Since 13th June, 2003 is a Friday the second working day will be 15th June, 2003.

93. (d) Since, the delivery can take place any time during the second month, the bank will base its quote on the more adverse of the one month and two month forward rates. The quote for the second month to be quoted by the bank will be 42.80.

94. (c) The spot settlement date is the second working day from the date of contract. Here, the spot settlement date will be 2nd of February since 29th is a holiday in Singapore and 31st is a Saturday. The value date is obtained by adding the number of months to the spot settlement date. Hence, the two month forward rate will be 2nd April.

95. (b) Samurai bonds are bonds issued by non- Japanese borrowers in the domestic Japanese markets.

96. (c) Spot settlement date is 4th February, 2004. Value date one month forward will be 4th March, 2004.

97. (d) The three months and one month forward rates are 1.7095/1.7105 and 1.7135/1.7145 respectively. Hence, $ is at a discount for one month and at a premium for 3 months.

98. (b) The spot settlement date will be 29th November, 1998. Hence, the value date is 28th February, 1999 which is obtained by adding the number of months to the spot settlement date. As the value date cannot be shifted to the next month it will be 28th February.

99. (e) In case of direct quote exchange margin is to be deducted from the bid rate and added to the ask rate.

100. (b) The rate to be quoted by the bank is obtained by adding the swap points to the spot rate since the swap points are in low/high order. Hence, the forward rate for delivery option second month is obtained by adding the one month swap points. Hence, bid rate will be 43.70 i.e., 43.50 + 0.20.

101. (c) The spot rate from the forward rate can be obtained by deducting the swap points from the forward rate when the swap points are in low/high order. Hence, the spot rate will be 43.65/43.85.

102. (c) SFr/£ = $/£ x 1/ ($/ SFr) Spot = 1.7380 x 1/0.6642 = 2.6167 Forward = 1.7308 x 1/0.6620 = 2.6145. 103. (d) The currency of Philippines is Peso. 104. (c) When there is heavy foreign exchange inflow then the currency will appreciate against

the foreign currency. Therefore, RBI would be worried about the appreciation of the rupee.

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105. (e) When the swap points are in low/high order the forward rate is obtained by adding the swap points to the spot rate. Hence, the forward quote is 40.5/41.5.

106. (e) Option forward contract is entered into when the time of delivery is not definite. Under this contract, the customer of the bank has the option to ask for the contract to be settled anytime during a particular period, referred to as option period.

107. (b) For both 3-months and 6-months, the $ is at a discount. 108. (d) Let the direct quote in Mexico be 100 pesos/$. The indirect quote will be 1 peso = 0.01$.

When the Mexican Peso devalues by 75% the exchange rate changes to 1 peso = 0.0025 $. Hence, 1$ = 400 pesos. There is a 300 % appreciation in the US$.

109. (d) Mid-rate is the arithmetic mean of bid and the ask rate. The difference between bid rate and the ask rate is the bid-offer spread. Hence, the bid offer rate can be obtained by deducting and adding the average of the spread (0.15) from and to the mid rate i.e., the bid-offer rate is: 55.45/55.75.

110. (c) Global Forex Markets in major currencies such as the dollar resemble perfect markets where the rate of the currency is determined by the demand and supply forces.

111. (b) Rs./£ = 80/81, Rs./$ = 45/46 Synthetic ($/£)bid = (Rs./£)bid x 1/(Rs./$)ask = 80 x 1/46 = 1.74. 112. (c) The dealer is $4 million long implies that the dealer is an overbought position. He is

getting only buy orders for dollars, without being able to sell. It means that the market is getting a competitive rate for selling the currency to the dealer, but the dealers, selling rate is too high to attract buyers. Hence, the bank will have to reduce both bid and ask rates. To return to square or near square position the dealer will have to reduce 0.15 (average of the spread) from both the bid and the ask rate.

113. (d) The spot settlement date is 25-1-2003. 114. (a) The forward rates are obtained by adding the premium to the spot buying and selling

rates and by deducting the discount from the spot buying and selling rates. 115. (c) The transaction cost involved in the money market operations is the difference between

the investment and the borrowing rate. Hence, the transaction costs are relatively less for spot transactions.

Exchange Rate Determination 116. (c) According to the relative form of purchasing power parity changes in the spot rate over

a period of time reflect the changes in the price levels over the same period in the concerned economies. It follows that a country facing a higher inflation rate would see its currency depreciating. Hence, the Euro will appreciate against the US$.

117. (b) According to the relative form of purchasing power parity principle, the percentage change in the spot rate (A/B) equals the difference in the inflation rates divided by 1 plus the inflation rate in country B.

S (A/B) = (PA – PB)/(1 + PB BB) 0.04 0.031.03− = 0.97%.

118. (c) According to the Interest rate parity principle F(A/B) = S (A/B) x (1+ rA)n/(1+ rB) ; Here, n = 1 B

n

= 39 x 1 0.091 0.04++

= 40.875 (approximately 40.88).

119. (e) F (A/B) = S (A/B) x (1 + rA)n/(1 + rB)B n

F (Rs./$) = 39 x (1 + 0.08)5/(1 + 0.03)5 = Rs.49.43/$. 120. (e) As the forward premium is less than the interest rate differential place the money in

currency with higher interest rate. Hence, Borrow in Sterling and invest in euro. 121. (e) To hedge against a possible depreciation of Dollars, an Indian exporter should Borrow $

and invest in Rupees.

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122. (c) One-way arbitrage occurs because of the presence of transaction costs. The presence of transaction costs causes the failure of covered interest arbitrage since, the one-way arbitrage depends on the intensity of transaction costs, it may or may not occur always whenever the covered interest arbitrage occurs.

123. (c) When the home currency interest rates is lower than the foreign currency interest rate, the forward margin would be at a discount. When the bank enters into a forward sale contract with the customer it arranges for delivery of the foreign currency on the due date by keeping the funds in deposit at the foreign centre concerned. When the interest rate is higher in the foreign currency the bank suffers a net gain and the gain is passed on to the customer by quoting the forward discount. Such forward discount may not be in proportion to the difference in interest rates.

124. (a) According to the International Fisher Effect the expected percentage change in the spot rate should be approximately equal to the interest differential. Hence, when currency of Country X goes from forward discount to forward premium against currency of Country Y, interest rate of currency X might have decreased.

125. (b) American imports from India will increase as America will have to pay fewer dollars for the same amount of goods when the dollar is appreciating relative to the rupee.

126. (c) The bid ask spread is the cost involved in conversion of currencies. Hence, if the bid ask spread in the forward markets is very large then the exporter will prefer foreign currency.

127. (b) The real exchange rate is given as under

Sr (A/B) = S (A/B) x IB/IB A = 44.72 x 240/350 = 30.665.

128. (a) According to the Interest Rate Parity, an investor will prefer to invest in assets denominated in foreign currency rather than in home currency when the domestic currency interest rate is less than the foreign currency interest rate plus the forward premium as it would fetch higher return. Hence, here the investor will prefer to invest in securities denominated in dollar than in C$ in the case of (a).

129. (b) The PPP theory assumes that there is free movement of goods, there are no transportation costs, no transaction costs and no tariffs. It does not assume that capital moves freely across the globe.

130. (d) The absolute form of PPP which states that the exchange rate between two countries currencies is determined by the respective price levels in the two countries, is also known as the law of one price.

131. (e) The Interest Rate Parity does not hold good because of the following reasons: Transaction costs, political risks, taxes, liquidity preference and capital control. Hence, all the above are reasons for departure from Interest Rate Parity.

132. (b) According to the Interest Rate Parity, an investor will prefer to invest in assets denominated in foreign currency rather than in home currency, when the domestic currency interest rate is less than the foreign currency interest rate plus the forward premium as it would fetch higher return. Therefore, alternative (b) satisfies the above stated condition of interest rate parity.

133. (d) F (Rs./$) = S (Rs./$) x (1 + rRs.)/(1 + r$) = 43.75 x 1.11/1.04 = 46.69.

134. (c) The absolute form of PPP states that the exchange rate between two countries currencies is determined by the respective price levels in the two countries.

135. (c) The Monetary Model assumes that PPP holds good and not the Interest Rate Parity and Fischer open condition. Therefore, it is not an assumption of the Current Accounting Monetary Model for exchange rate determination.

136. (c) According to the Interest Rate Parity theory, the cost of money (i.e., 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.

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137. (a) The real exchange rate is given by

S (A/B) = S (A/B) x IB/IB A = 42.6 x 150/230 = 27.78.

138. (c) As the inflation in India is less than that in US, the rupee would command higher number of dollars i.e. rupee appreciates. A currency having a higher rate of inflation rate would see its currency depreciating.

139. (b) As the forward premium is less than the interest rate differential, funds are placed in currency with higher interest rate. Hence, borrow in pounds and invest in US dollars.

140. (e)According to the expectations theory,

(1 + r1) (1 + r21) = (1 + r3)2

Where, r1 and r3 are interest rates for 1 year and 3 years respectively

And r21 is 2 year rate at the end of 1 year

On substituting we get (1 + r21) = (1.12)2/1.10

r21= 14%

Similarly, 1 year rate after 2 years is given by

(1 + r2) (1 + r12) = (1 + r3)2

1 + r12 = (1.12)2/1.11

r12 = 13%.

141. (a) According to the PPP theory changes in the spot rates over a period of time reflect the changes in the price levels over the same period in the concerned economies. It follows that a country facing higher inflation rate would see its currency depreciating. Hence, goods should move from low inflation to high inflation countries.

142. (b) When the interest rate is high, the currency will be in a premium i.e., forward premium is positive but if the interest rate is lowered. Therefore, forward premium also decreases. Sometimes it may turn negative i.e., when the currency is at a discount.

143. (d) When the interest rate decreases, the currency depreciates in the spot market and appreciate in the forward market.

144. (b) F3 (∈ /$) = S (∈ /$) x (1 + r∈ )/(1 + rus)

= 1.8 x (1 + 0.0125)/(1 + 0.015) = 1.8 x 0.9975 = 1.79556.

145. (a) S ($/£) = F($/£) x (1 + r$)2 / (1 + r£)2

= 1.61 x (1 + 0.03)2/(1 + 0.04)2 = 1.57918.

146. (c) According to the Interest Rate Parity theory, the cost of money (i.e., 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.

147. (b) F(Yen/$) = S (Yen/$) x (1 + rj)/(1 + rus) = 145 x (1 + 0.02)/(1 + 0.04) = 142.21.

148. (a) F(∈ /$) = rA = rB + m B

nF (A/B) S(A/B)S(A/B)

⎡ ⎤−⎢ ⎥⎣ ⎦

x (1 + rBB/m)

m = 12n

; n = 3 m = 4

∴0.03 =0.05 + 4 nF (A/B) 0.5600.560

−⎡ ⎤⎢ ⎥⎣ ⎦

x 0.0514

⎡ ⎤+⎢ ⎥⎣ ⎦

F3 (A/B) = 0.557.

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Exchange Rate Forecasting 149. (c) The outright forward rates are obtained by adding the swap points to the spot rate when

the swap points are in low/high order and by deducting the swap points from the spot rates when the swap points are in high/low order. Hence the 3 months and 6 months Rs./$ forward rate will be 43.70/4.00 and 4.15/44.45.

150. (b) According to the demand and supply approach, changes in exchange rates can be forecasted by analyzing the factors that effect the demand and supply of a currency. Since these factors are listed in the balance of payments account, this approach is also referred to as the balance of payments approach.

151. (b) Dornbusch Sticky-price theory explains the phenomenon of overshooting of exchange rates, i.e., exchange rates changing more than required by a change in an economic variable and later coming back to the new equilibrium.

152. (b) The phenomenon where current account balance continues to worsen despite a depreciation is referred to as the J-curve effect.

153. (a) The monetary approach assumes that purchasing power parity principle assumes good i.e., an increase in the price level results in the depreciation of a country’s currency.

154. (e) All the alternatives given are predictions of monetary approach.

155. (c) According to the asset approach, whatever changes are expected to occur in the value of a currency in future, gets reflected in the exchange rates immediately. Hence the current exchange rate is the reflection of the expectations of the market as a whole.

156. (d) The portfolio-balance approach states that the value of a currency is determined by two factors – the relative demand and supply of money and the relative demand and supply of bonds.

157. (e) All the above are methods of exchange rate forecasting. Therefore, the answer is none of the above.

158. (b) Dornbusch Sticky-price theory explains the phenomenon of overshooting of exchange rates, i.e., exchange rates changing more than required by a change in an economic variable and later coming back to the new equilibrium.

159. (b) The phenomenon of worsening and subsequent improvement of trade balance after currency depreciation is called the J-curve effect.

160. (e) All the functions are corporate functions that make exchange rate forecasting necessary. Therefore, answer is none of the above.

161. (e) All the alternatives given are asset market models for forecasting the exchange rates.

162. (e) International Asset pricing model is based on the premise that purchasing power parity holds good and the international capital markets are not perfectly integrated.

163. (c) The capital account monetary model is an improvement over current account monetary model as it has relaxed assumptions that there may be departures from PPP in the short run and the increase in domestic interest rates will always lead to depreciation of domestic currency.

164. (b) According to the J-curve effect when both imports and exports are price inelastic in the short run but price elastic in the long run, volume of exports and imports do not immediately respond to the change in the relative prices of exports and imports, caused by depreciation of home currency.

165. (e) The J-curve is linked to the concept of elasticity.

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Introduction to Exchange Risk 166. (d) The aim of foreign exchange risk management is to know with certainty the quantum of

future cash flows.

167. (a) Maurice D Levi describes foreign exchange risk as the variance of the domestic currency value of assets, liabilities or operating income that is attributable to unanticipated changes in exchange rates.

168. (b) Adler and Dumas define foreign exchange exposure as the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchanges in rates.

169. (c) Operating exposure is the result of economic consequences of exchange rate movements on the value of a firm and the opening of the economy.

170. (a) Maurice D Levi describes foreign exchange risk as the variance of the domestic currency value of assets, liabilities or operating income that is attributable to unanticipated changes in exchange rates.

Management of Exchange Risk 171. (a) The transaction exposure introduces variability in the firm’s profits. The price received

the Indian exporter for the goods exported by him in rupee terms will be more by 4 Rs. as the $ has appreciated by 10% from Rs.40/$ to Rs.44/$.

172. (b) Hedging through currency of invoicing involves eliminating transaction and translation exposure by invoicing all receivables and payables in the domestic currency. Hence the importer covers the forex exposure.

173. (d) Leading and Netting are internal hedging techniques whereas Swap is an external technique for hedging.

174. (a) Hedge ratio can be defined as the number of futures contracts to hold for a given positions in the underlying asset.

Hedge ratio = F utures positionUnderlying asset position

175. (c) Reducing borrowing in the currency which is facing a likely devaluation is not an appropriate hedging strategy.

176. (e) Economic exposure cannot be managed by traditional hedging techniques due to unpredictability of the changes in the cash flows.

177. (d) The dealer is getting only buying orders for without being able to sell. It means that the market is getting a competitive rate for selling the currency to the dealer but the dealer selling rate is too high to attract buyers. Hence the dealer has to reduce the and ask rates.

178. (d) If the exchange rate movements of two currencies are negatively correlated, then a firm can offset the risk arising from a long position in one currency with short position in the same currency.

179. (b) Currency of invoicing is an internal technique of hedging.

180. (e) Operating exposure is a result of economic consequences of exchange rate movements on the value of the firm. It cannot be managed by the traditional hedging techniques due to unpredictability of the changes in the cash flows. Hence it can be reduced by altering the firm’s operations.

181. (b) Translation exposure arises due to the need to translate the foreign currency values of assets and liabilities into the domestic currency.

182. (d) All the above factors influence the extent of translation exposure faced by a multinational company.

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183. (a) To hedge Swiss Francs payables that is due in six months, the US multinational can borrow Dollars, convert to Francs, lend in francs for 6 months. By doing this the firm can lock the exchange rate at which it has to buy Swiss francs.

184. (c) To reduce the uncertainty in cash flows a treasury manager normally tries to cover the forex exposure.

185. (b) In order to hedge the transaction exposure the Italian company having a short position in the currency will buy Japanese Yen with Italian Lira forward. Hence the rate at which the foreign currency transaction takes place is locked.

186. (d) Through netting the foreign exchange risk cannot be eliminated but the cost of foreign exchange transactions can be reduced.

187. (e) The Indian exporter is benefited by leading i.e., by realizing the export proceeds immediately as the US $ is depreciating and lag payments i.e., delaying the realization of export proceeds as the US $ is appreciating.

188. (e) Foreign exchange exposure is defined as the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates. Hence statements (a) and (d) are true.

189. (e) Only when the spot bid rate after one month is more than the current spot rate the speculator is going to gain from his open position.

190. (a) As the firm realized more than what it has expected there is no risk. i.e., the risk is zero. 191. (d) Alpha Implex has receivables denominated in Euro which is expected to appreciate, it

has to lag its receivables and it has payables denominated in Yen which is expected to depreciate, hence it has to lag its payments.

192. (e) Transaction exposure is the exposure that arises from foriegn currency denominated transactions which an entity is committed to complete. In other words, it arises from contractual, foreign currency, future cash flows.

193. (b) When a firm is short in Euro i.e., if it has Euro payables and Euro is expected to depreciate against Rupee it would benefit.

194. (b) When a firm has foreign currency payables which are uncertain, it can buy the currency with the same maturity. Therefore, it can buy a call option.

195. (a) Realizing the investments from the currency which is likely to appreciate will not result in any gain.

196. (b) Conversion effect of operating exposure refers to changes in the home currency value of a given foreign currency cash flow.

197. (e) Entering into forward exchange control is an external hedging technique. 198. (d) Hedging through currency of invoicing refers to invoicing all receivables and payables

in the domestic currency. Only one of the parties involved can hedge itself in this manner. 199. (e) The dealer is getting only buy orders for without being able to sell. It means that the

market is getting a competitive rate for selling the currency to the dealer but the dealer selling rate is too high to attract buyers. Hence the dealer has to reduce both bid and ask rates.

200. (d) Hedging aims to minimize or reduce risk. 201. (e) Translation exposure effects the income of the firm. By restricting its operations in the

domestic market a firm cannot insulate from foreign exchange risk. 202. (e) The Indian exporter is benefited most by leading i.e., by realizing the export proceeds

immediately as the US $ is depreciating and lag payments i.e., delaying the realization of export proceeds as the US $ is appreciating.

203. (d) In case of forward cover the cost of hedging is the difference between the forward rate and the actual spot rate prevailing on the date of maturity.

204. (a) Netting involves creating exposures in the normal course of business which offset the existing exposures.

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205. (a) Foreign currency receivables can be hedged by selling foreign currency futures. The gain or loss from the futures contract gets canceled by the loss or gain on the underlying transaction, hence the exposure gets eliminated.

206. (b) In order to hedge the transaction exposure the Italian company having a short position in the currency will buy Japanese Yen with Italian Lira forward. Hence the rate at which the foreign currency transaction takes place is locked.

International Project Appraisal 207. (b) If it is possible to recover a part of the funds (after paying withholding taxes etc.), then

that part of the funds which cannot be recovered will be treated as activated and deducted from the initial investment.

208. (d) Amount of loan = Rs.10 million Amount to be repaid at the end of 5 years = 10,00,000/(1.10)5

= 6.21 million Benefit due to loan = 10 – 6.21 = 3.79 million 209. (d) Since there will be tax shield on the borrowed funds, the firm need not pay the interest

to the extent of tax shield. In this case, 40% tax shield is available. Therefore, the firm has to pay only 6%. 10% – (10% x 40%). Thus the firm is saving 0.4 million, i.e., instead of paying 1 million, it is paying only 0.6 million.

210. (e) All the above are reasons for increasing difficulty in appraising international project using conventional NPV methods.

211. (e) Uncertainty surrounding payment from abroad or assets held abroad due to the possibility of war, revolution, asset seizure, or other similar political, social, or economic event is known as the political risk or sovereign risk or country risk.

212. (a) Adjusted present value approach first measures the present value of the basic cash flows of a project using the all equity rate of discounting. Hence the adjusted present value is based on the NPV principle.

213. (d) As the nominal foreign currency interest would have had to be paid in the absence of concessionary loan, that rate should be used as the discount rate for calculating the present value of repayments of concessional loan.

214. (a) If there is a strong probability of positive cash flows being generated and hence of the depreciation tax shield being availed, then the domestic nominal risk-free rate may be used.

215. (c) Since the borrowing capacity would be measured in nominal terms, this should be the nominal rate. If the probability of positive cash flows is strong, the domestic nominal risk-free rate may be used.

216. (a) If the currency of the subsidiary is expected to appreciate then the capital budgeting projects would look better from the company’s view.

217. (d) As the nominal foreign currency interest would have had to be paid in the absence of concessionary loan, that rate should be used as the discount rate for calculating the present value of repayments of concessional loan.

218. (a) If the future cash flow is predetermined, or contractual in nature then the nominal discount rate should be used as the cash flows would be expressed in nominal terms.

219. (d) If there is a strong probability of positive cash flows being generated, and hence of the depreciation tax shield being availed; then the risk premium may be negligible, and the domestic nominal risk-free rate may be used.

220. (a) If there is a strong probability of positive cash flows being generated, and hence of the depreciation tax shield being availed; then the risk premium may be negligible, and the domestic nominal risk-free rate may be used.

221. (c) In the APV method, the symbol “Kb” stands for discount rate for tax savings from generation of borrowing capacity. Since the borrowing capacity is measured in nominal terms, is a nominal rate. If the probability of positive cash flows is strong, the domestic nominal risk-free rate is used. Thus it is nominal borrowing rate of the country where borrowing capacity of the firm is said to be augment.

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222. (c) If there is a strong probability of positive cash flows being generated, and hence of the depreciation tax shield being availed; then the risk premium may be negligible, and the domestic nominal risk-free rate may be used.

223. (e) While taking up an overseas project, a company has to take into account all the above factors of political risk, sovereign risk, inflation risk, currency risk. The cash flow stream of the project is influenced by all the above factors.

224. (e) All the above factors i.e., the future inflation, blockage of funds, remittance provisions are relevant for evaluating international project cash flows.

225. (d) Adjusted present value approach first measures the present value of the basic cash flows of a project using the all equity rate of discounting and then tackles the problems of evaluating foreign project one by one. By breaking up the evaluation in this manner, it provides scope for analyzing an indefinite number of additional factors which may affect an international project. Hence the adjusted present value is a more flexible technique than NPV.

International Financial Markets and Instruments 226. (e) All the above are reasons for international markets to view India in a different

perspective. 227. (e) Samurai bonds are bonds issued non-Japanese borrowers in the domestic Japanese

markets. Shibosai bonds are privately placed bonds issued in the Japanese markets. 228. (a) A note issuance facility is a medium term legally binding commitment under which a

borrower can issue short-term paper, of up to one year. 229. (b) Medium term notes are defined as sequentially issued fixed interest securities which

have a maturity of over one year. 230. (a) The club loan is a private arrangement between lending banks and a borrower. When

the loan amounts are small and the parties are familiar with each other, lending banks form a club and advance a loan.

231. (b) When the real interest rates are determined by the local credit conditions it means credit market segmentation.

232. (c) Expropriation refers to the extreme form of political risk where the government takes over by paying compensation.

233. (e) All the statements are true. 234. (b) Yankee bonds are US Dollar denominated issues by foreign borrowers (usually

government or entities, supranational and highly rated corporate borrowers) in the US bond markets.

235. (c) Shibosai bonds are privately placed bonds issued in the Japanese markets. 236. (c) Bull dog bonds are Sterling denominated foreign bonds which are raised in the UK

domestic securities market. 237. (b) The facility where the borrower agrees for a minimum interest rate is referred as drop

lock.

International Equity Investments 238. (e) International diversification helps only when the stock returns is more than the foreign

exchange risk. 239. (c) International Asset Pricing Model is based on the premise that the international capital

markets are not perfectly integrated.

Short-Term Financial Management 240. (d) Striking the right balance between decentralization and centralization is the key issue in

International cash management. 241. (e) Netting is an internal hedging technique resorted by large MNC’s where intra corporate

transactions among various subsidiaries of the parent company or subsidies with parent corporate are a common feature.

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242. (d) The objective of cash management is to (i) maximize the return by proper allocation of short-term investments and (ii) minimize the cost of borrowing in different money markets.

243. (a) Leading and lagging are internal techniques of hedging.

244. (e) Futures and options are external techniques of hedging. 245. (c) The primary currency in which a subsidiary operates is called functional currency. This

is the currency in which a subsidiary reports its income; such reporting may involve translating foreign currency amounts into the functional currency.

246. (c) If the interest parity holds good, then it should not matter in which currency funds are borrowed or invested.

247. (c) A reporting currency is the currency in which the parent firm prepares its own financial statements.

248. (b) When the home currency does not have a well groomed forward market then the exporter will prefer the foreign currency.

249. (b) Functional currency is the currency of primary economic environment in which the affiliate generates and expends cash.

250. (b) Firms with substantial export business and companies too small to afford a foreign credit and collections department can turn to a factor. Factors buy a company’s receivables at a discount, thereby accelerating their conversion into cash.

International Accounting and Taxation 251. (c) According to the accounting standard II prescribed by the ICAI, a transaction in a

foreign currency should be translated at the spot rate as on the date of the transaction.

252. (b) The current/non-current method advocates the conversion of all current assets and liabilities at the closing rate and all non-current assets and liabilities at the historical rate.

253. (d) The temporal method classifies items on the basis of whether they are valued at historical basis or market price basis.

254. (c) A tax credit is given by way of reduction in the tax payable by the entity on an international transaction by the amount it has paid as withholding taxes.

255. (c) The method of translating financial statements in which items are classified based on whether they are valued at historical basis or on market price basis is known as Temporal method.

256. (d) According to the current and non current method current assets and current liabilities are translated at the current exchange rate while all other assets and liabilities are translated at historical rates.

257. (d) When the interest rate parity holds good , then it should not really matter in which currency funds are borrowed or invested as the cost of borrowing will be equal to the yield on investment. The investors would realize the same gains irrespective of the currency in which they invest.

258. (d) Current assets and current liabilities are translated at the current exchange rate. Inventory gets converted at the closing rate if it is valued in the balance sheet at realizable value.

Investment Banking – I

Part II: Problems SECTION I: INTERNATIONAL FINANCE The Foreign Exchange Market 1. The following quotes are available.

Spot (∈ /$) : 0.7940/0.8007 Three-month swap points : 25/20 Six-month swap points : 30/25

Calculate the three-month and six-month outright forward rates. 2. You are given the following information.

Spot ∈ /$ : 0.7940/0.8007 Three-month swap : 25/35 Spot $/£ : 1.8215/1.8240 Three-month swap : 35/25

Calculate the three-month ∈ /£ rate. 3. A Bank has to submit a quote to a customer for buying euros against Rupees. The customer

will have the option of taking delivery of rupees any time during the second month. Given the following spot and forward rates, what rate should it quote?

Rs./$ Spot : 45.30/45.45 One-month forward : 15/25 Two-month forward : 20/30 ∈ /$ Spot : 0.7940/0.8007 One-month forward : 15/10 Two-month forward : 20/15.

4. An Indian Bank sells SKr 1,000,000 spot to a customer at Rs.6.25. At that point of time, the following rates were being quoted.

SKr/$ : 7.2480/7.2486 Rs./$ : 45.30/45.45

How much profit do you think the bank has made cost in the transaction? 5. A customer wants to sell a bill worth $1,000,000 to a bank. The bill might mature any time

during the second month. If the bank charges a margin of 0.5% and exchange rates are as given below, determine the rate which the bank is likely to quote.

Rs./$ Spot : 45.30/45.45 One-month forward : 15/10 Two-month forward : 20/15

6. An Indian customer who has imported equipment from Germany has approached its bank for booking a forward euro contract. The delivery is expected sometime during the sixth month from now.

The following rates are being quoted.

∈ /$ Spot : 0.7940/0.8007 Three-month forward : 30/29 Six-month forward : 59/58 Rs./$ Spot : 45.30/45.45 Three-month forward : 15/25 Six-month forward : 20/30

What rate will the bank quote if it needs a margin of 0.5%?

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7. An Indian customer approaches a bank for a two-month forward contract to help it to settle a ∈ 200,000 payable maturing on 1/4/04. The bank quotes a rate of Rs.57.05/∈ . On 1/4/04, the customer requests the bank to extend the contract for one more month. If the rates prevailing on 1/4/04 are as follows, what should the bank charge for extending the contract?

Spot : Rs.45.50/$, ∈0.7940/$ One-month forward : Rs.46.00/$, ∈0.7945/$ Ignore interest rates.

8. An Indian Company obtains the following quotes:

(Rs./$) Spot : 45.30/45.45 3-month forward : 45.40/45.60 6-month forward : 45.50/45.75

The company needs $ funds for 6 months. If interest rates are as given below, determine whether the company should borrow in $ or Rupees.

3-month interest rates : Rs. – 7% $ – 4% 6-month interest rates : Rs. – 6.5% $ – 3.75%

Also, determine what should be the 3-month interest rates after 3-months to make the company indifferent between three-month borrowing and six-month borrowing in the case of

a. Rupee borrowing, and

b. Dollar borrowing.

9. A company has an exposure of $100 million payable in 3-months. A bank has offered to sell the amount required at a forward rate of Rs.46/$. Meanwhile, the company’s treasury department has prepared an exchange rate forecast whose accuracy is within 5%.

Probability 0.20 0.30 0.30 0.20 Exchange rate (Rs./$) 45.00 45.50 46.00 46.50

In your opinion, should the company accept the bank’s rate or leave the exposure uncovered?

10. In the Interbank market, the euro is quoting Rs.57.05. If the bank charges 0.125% commission for TT selling and 0.15% for TT buying, what rate should it quote?

11. You are a banker. A client has approached you for a quote to purchase ∈1,000,000. The client will be receiving the amount sometime during the third month.

You collect the following information:

Bombay: (Rs./$) Spot : 45.30/45.45 2-month forward : 45.50/45.70 3-month forward : 45.60/46.00 Singapore: (∈ /$) Spot : 0.8007/0.8015 2-month forward : 0.8017/0.8035 3-month forward : 0.8027/0.8040

What rate (Rs./∈ ) should you quote to the customer if your margin is 2.5%?

12. As a dealer in the bank, you observed the following quotes in the market:

Rs./$ 45.30/45.45

Rs./£ 82.70/82.96

Rs./Euro 57.00/57.05

Compute the cross rates for $/£ and $/Euro.

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13. Fill the blanks in the following table.

Country USD A$ GBP C$ SFr Euro US $ – 1.2895 0.6877 ? 1.2459 0.7940 Australia (A $) ? – 0.4235 1.0174 0.9662 0.6518 Britain (GBP) 1.8313 2.3615 – 2.4025 2.2816 ? Canada (C$) 0.7623 0.9829 ? – 0.9497 0.6053 Switzerland (SFr) 0.8026 ? 0.4383 1.0533 – 0.6373 Germany (E) 1.2594 1.6240 0.6877 1.6522 ? –

14. NBA Bank Ltd., transacted the following forward transactions on December 19, 2003. i. Sold $1,000,000 three-month forward to Alpha Manufacturing Co. Ltd., at Rs.45.50. ii. Purchased Euro 1,000,000 two-month forward from Beta Trading Co. Ltd., at

Rs.57.05. On February 19, 2004, both the customers approached the bank. Alpha Manufacturing Co.

wants the forward contract to be canceled while Beta Trading Co. wants the contract to be extended by one month. The following exchange rates prevailed on that day:

Rs./$ Rs./Euro

Spot 45.60/65 57.10/57.40One-month forward 15/20 25/35

Based on the above information, you are required to a. Calculate the amount to be paid to or recovered from Alpha Manufacturing

Company due to the cancelation of the forward contract. b. Calculate the amount to be paid to or recovered from Beta Trading Company due to

the extension of the forward contract. c. Indicate what the bank will do if Alpha Manufacturing Company asks for cancelation of

the contract on the day of maturity. 15. On August 18, 2003, National Bank of India entered into a three-month forward contract

for purchase of ¥10 million. The three-month forward quotation on that day was Rs./100 ¥; 42.79/42.85. The delivery date for the transaction was November 20, 2003. On August 29, 2003, the client approached the bank for a purchase of Yen under the contract on the same day. The following rates prevailed on that day.

Spot (Rs./100 ¥) 43.00/43.10 Forward rate for delivery on November 20, 2003 (Rs./100 ¥) 43.35/43.47

Calculate the amount to be collected from/paid to the customer due to the early delivery. 16. SDL, a hundred percent export oriented company based at Chennai, exports leather jackets

to various European countries. All exports are invoiced in Euro. In January 2004, SDL has sent a consignment to an import house based at Frankfurt. The receivable is likely to be realized anytime in April, 2004. SDL approaches its banker to sell these Euro earnings. The banker has the following information:

Rs./$ spot 45.30/45.45 2-m forward 25/30 3-m forward 40/50 Euro/$ spot 0.7940/0.8007 2-m forward 0.7920/0.7930 3-m forward 0.7900/0.7915

You are required to: Calculate the rupee inflow for SDL in April 2004, if the expected Euro one million is sold

to the banker through an option forward?

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17. An Indian importer has a payable of Euro 100,000 due on October 21, 2003. On July 21, 2003 he covers the payable through forward buying of Euro @ Rs.57.00 from his banker. On October 21, 2003, he requests the banker to extend the contract to November 21, 2000. On October 21, 2000 the rates are:

Spot Rs./Euro : 57.20/57.25 1-m forward : 15/20 What is the net cash outflow for the importer? 18. Jai Bharath Industries exported handicrafts to Germany under a letter of credit and

submitted all the shipping documents to its banker on November 28, 2003. The amount of the receivable is Euro300,000. The bank could negotiate the bill on December 02, 2003 and collected an exchange margin of 0.125%.

The spot exchange rates as on November 28, 2003 and December 02, 2003 are given below:

November 28, 2003 December 02, 2003 Mumbai Rs./$ 46.00/05 45.95/99 London $/£ 1.8300/05 1.8307/15 Euro/£ 1.4500/12 1.4520/30

You are required to calculate: a. The amount of gain or loss to the exporter due to delay in negotiation of bill under

the L/C. b. Actual rupee inflow to the exporter. Exchange Rate Determination 19. You are told that the spot rate is $1.8313/£. The expected inflation rates in the UK and the US for the next three years are given below.

Year UK Inflation (%) US Inflation (%) 1 2.10 1.60 2 2.15 1.65 3 2.25 1.70

Calculate the expected $/£ spot rate after three years. 20. You are given the following information.

Spot rate : ∈ 0.7940/$3-month forward rate : ∈ 0.7945/$

The inflation rate in Germany is 1.3%. Calculate the inflation rate in the USA assuming that Purchasing Power Parity holds good even in the short run.

21. An Indian Company is planning to make a capital investment of euro 500,000 in Germany. The spot rate is Rs.57/∈ . The project is expected to generate annual after tax cash flows of euro 100,000 for 5 years. At the end of this period, the salvage value of the plant and equipment will be euro 50,000. Calculate the Internal Rate of Return for the project, if inflation rates in Germany and India are as follows:

Year German Inflation (%) Indian Inflation (%)1 1.30 5.40 2 1.40 5.25 3 1.45 5.00 4 1.50 4.95 5 1.60 4.80

22. The Spot rate is Rs.45.00/$. Inflation rates in India and USA are expected to be 5.4% and 1.6% respectively. What is the expected rate of depreciation of the rupee?

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23. You are given that inflation in India is 5.4% and that in Switzerland is 0.5%. The Swiss Franc is quoting Rs.36.36 today. If the real appreciation of the SFr against the rupee is 5%, compute the exchange rates at the end of one, two and three years.

24. An Indian Company will avail of a $2 million loan. It will repay the loan with interest by making installment payments of $1 million at the end of each year for three years after receipt of the loan. The spot rate at the time of disbursement of the loan is Rs.45.00/$. The inflation rates in India and USA are 5.4% and 1.6% respectively. The expected real annual appreciation of the $ is 5%. Estimate the cost of funds.

25. An Indian Company needs long-term funds. It has a choice between a dollar loan available at 5% and a euro loan available at 2%. In both cases, the principal will be repaid in 5 equal annual installments and interest calculated on the outstanding amount. Currently, the exchange rates are ∈0.7940/$ and Rs.45.30/$. The long-term inflation rates are expected to be 1.3% in Germany, 1.6% in USA and 5.4% in India. Determine which loan is likely to be more beneficial for the Indian Company.

26. The following quotes are available.

Spot : ¥ 105.87/$ Interest rates (3 months) : $–5.0% Yen – 1.375% Interest rates (6 months) : $–5.25% Yen – 1.50%

Calculate the 3-month and 6-month forward rates. 27. A customer obtains the following quotes:

Spot Rs./$ : 45.00/45.10 6-month $ interest rates : 4.5% – 5% 6-month Re. interest rates : 6% – 7%

What are the likely limits for six-month forward quote? 28. The following quotes have been obtained:

Spot: Rs./$45.10/45.30 3-month forward: Rs./$45.50/45.70 3-month Re. interest rates: 6% – 7%

What are the conditions under which arbitrage is ruled out? 29. The following quotes are available for euro, $ and SKr (Swedish Kroner) Spot (∈ /$) : 0.7940/0.8007 Spot (SKr/$) : 7.2480/7.2485 The 3-month interest rates are as follows: – 2% 3%; SKr – 3.5%/4% ∈

Calculate the 3-month limits for SKr/∈ forward rates. 30. An Indian exporter has obtained the following quotes from his bank. Rs./£ Spot : 82.90/82.96 Three-month interest rates : £ : 3.8%– 4.00% Re. : 6% – 7% What are the expected limits for spot rates after three months? 31. In December 2003, the following rates were being quoted.

Rs./$ Spot : 45.30/45.45 Three-month forward : 0.40/0.50 Three-month interest rates : $– 4 %, Re.– 6%

Is there any scope for arbitrage?

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32. An Indian Bank obtains the following quotations:

Rs./$ Spot : 45.30/45.45 6-month Swap : 105/130

The interest rates are as follows: $ : 6-month LIBOR – 1.25% Rs. : 6-month – 7% The bank can access rupee or dollar funds. If the bank needs funds immediately for six

months where should it borrow, if it does not want to have any foreign exchange exposure? 33. In December 2003, the following rates were being quoted: SFr/$ : 1.2459/1.2465 (Spot) 25/15 (3-month forward) The three-month interest rates were: $ : 4.5/5.0 SFr : 1.75/2.00 Explain whether a trader could take advantage. 34. You have obtained the following information from your banker.

Rs./Can$ Spot : 34.50/34.53 Six-month forward : 34.75/34.90 Six-month rupee interest rate : 7%

What should be the interest rate on Can$ to eliminate arbitraging possibilities? 35. If, in the previous problem, the bank has quoted the following interest rates, and the spot

and forward exchange rates remain the same, rework the interest rate on Can$ to prevent arbitrage.

Re. interest rates: 6% – 8% for 6-months. 36. You are given the following information by your banker.

Spot (Rs./Can $) : 34.50/34.53Rupee interest rate (6-months) : 6.00/7.00Can $ Interest rates (6-months) : 2.70/3.70

Determine the limits for six-month forward rates. 37. You are given the following information by your banker.

Spot : Rs./£ 45.60/45.75 : Rs./£ 82.90/82.96 6-month forward : Rs./£ 45.70/45.90 : Rs./£ 83.00/83.15 6-month $ interest rates : 4.00/5.00

Compute the 6-month £ interest rates to prevent arbitrage. 38. You are given the following interest rates.

Re. $ 3-month 7% 4% 6-month 6.5% 3.5% 9-month 6% 3%

The 3-month forward rate is Rs.46/$. Calculate the 3-month forward rate 6-months from now.

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39. An Indian Company obtains the following quotes (Rs./$) Spot : 45.90/46.00 3-month forward : 46.00/46.15 6-month forward : 46.10/46.30

The company needs $ funds for 6-months. If interest rates are as given below, determine whether the company should borrow in $ or Rupees.

3-month interest rates : Rs.–7% $ – 4% 6-month interest rates : Rs.– 6.5% $– 3.5%

Also, determine what should be the 3-month interest rate after 3-months to make the company indifferent between three-month borrowing and six-month borrowing in the case of

a. Rupee borrowing, and b. Dollar borrowing. 40. A Swiss exporter expects to receive $1,000,000 after three months. The exporter has

collected the following information. Spot (SFr/$) : 1.2459/1.2465 Three-month forward (SFr/$) : 1.2460/1.2470 Three-month LIBOR : SFr – 1.7% $ – 4%

If the exporter decides to use the money market or forward market to cover the exposure, what will be the net position after three months in these markets?

41. A German exporter is expecting to receive $1,000,000 after six months. He has collected the following information.

Six-month interest rates : $ –5.10/5.20 ∈– 4.80/4.90 Spot (∈ /$) : 0.7940/0.8007 Six-month forward (∈ /$) : 0.7956/0.8010

Compare the two alternatives of money market and forward market for covering the exposure.

42. A UK importer will have to settle an invoice for ∈ 1,000,000 after three months. He has collected the following information.

Three-month interest rates : ∈– 4% £ – 3.5% Spot (∈ /£) : 1.4542/1.4560 Three-month forward (∈ /£) : 1.4550/1.4560

What would you recommend for covering the exposure: Forward market or money market? 43. An Indian Company is planning to invest $100 million in USA. The return on investment is

expected to be 50%. The spot rate is Rs.45/$. One year forward rate is Rs.46.00/$. The company can access rupee funds in India at 15%. An American Bank has offered to supply $100 million at a rate of Rs.44/$ and swap the same amount at Rs.44/$ after one year. The bank will charge interest of 10% on the loan. Explain whether the company should accept the bank’s offer. Assume that there is no restriction on accessing and repatriation of funds in both dollars and rupees.

44. An Indian exporter has executed an order worth ∈ 30 million. Payment will be received after 30 days on 01.05.2004. To execute the contract, the exporter had imported goods from Japan and Germany, payments for which have to be made are given.

01.04.2004 – Yen 1800 million, S$ 30 million 30.04.2004 – Yen 180 million, S$ 3 million

The exporter is also expecting to realize the following payments.

01.04.2004 – Yen 360 million, S$ 6 million 30.04.2004 – Yen 36 million, S$ 0.6 million

The exporter has to settle a major payable in $ expected to mature after 30 days.

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Explain how the exporter can generate funds in dollars after 30 days, without being exposed to exchange risk. You are given the following exchange and interest rates.

Spot : Rs.60/∈ Rs.35/SFr Yen 120/ SFr Rs.22/S$1-month Forward : Rs.61/∈ Rs.36/ SFr Yen 115/ SFr Rs.21/S$1-month : Rupees – 12% SFr – 6% Yen – 2% Euro – 7% interest S$ – 3%

45. You are given the following quotes.

NKr/SFr HK$/SFr Spot 5.43/5.52 6.12/6.31 3-month forward 4/3 8/7

Interest rates prevailing are as follows:

Norweigian Kroners 12.5 - 13% Hong Kong Dollars 13.5 - 14.0%

Banks add a spread of 0.5% to the above interest rates. Assuming you are a Norweigian importer and have payables in Hong Kong $ maturing after 90 days, what is the best strategy for hedging the exposure?

46. A Newzealand exporter expects to receive $1,000,000 in three months time. The exchange rates prevailing are as follows:

Spot (NZ$/$) : 1.55/1.57 Forward (NZ$/$) : 1.53/1.55 3 months interest rates are as follows: $ (%) : 6.10/6.30 (NZ$/$) (%) : 5.15/5.30

What strategies can the Newzealand exporter adopt to hedge the exposure? 47. An Indian importer has to settle a bill for S$ 100,000. The exporter has given the Indian company two options.

i. Pay immediately without any interest charge. ii. Pay after 3 months, with interest @6% p.a.

The importer’s bank charges 18% on overdrafts. If the exchange rates are as follows, what should the company do?

Spot (Rs./ S$) : 22.00/22.30 3-month (Rs./ S$) : 22.90/23.20

48. A German subsidiary of a US multinational needs to raise funds to meet its working capital requirements. Banks in Germany are prepared to lend at 8%. An additional service charge of 0.5% is payable. The parent company is in a position to lend to the subsidiary. Rate of interest applicable in USA is 7%. Meanwhile, the subsidiary has come to know that the rate of interest in Switzerland is very low at only 3%. If the German Government charges a withholding tax of 10% on interest in the case of funds borrowed from abroad, what is the best alternative available?

49. A Japanese multinational is working out its cash management strategy for the month of April, 2003. It has identified the following foreign exchange transactions which have to be settled with minimum exposure.

01.04.03: The company will have to make payment of 500,000∈ towards imports from Germany. It will have to remit A$ 1,000,000 to its subsidiary in Sydney, Australia. It will receive from a customer in India. The company will export goods worth SFr 20,000,000 payment for which will be received at the end of the month.

400,000∈

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30.04.03: The company will have to pay S$ 1,000,000 towards imports earlier made from a supplier in Singapore. The company will receive $ 1,000,000 from a customer who has imported its goods two months back.

You are given the following information.

Spot rates on 01.04.03 : Yen 128/∈ A$ 1.71/∈ SFr 1.5/∈ S$ 2.00/∈ $ 1.25/∈ 1-month forward rates (delivery) : Yen 125/∈ A$ 1.72/∈ SFr 1.48/∈ S$ 2.02/∈ $ 1.27/∈

The one-month interest rates prevailing on 01.04.03 are as follows:

$ – 6% Yen – 1% ∈ – 3.5% SFr – 2% S$ – 3% A$ – 6%

Explain how the company can manage its foreign exchange exposure. 50. A multinational based in Zurich, Switzerland is planning to invest NZ $ 1,000,000 in

Newzealand for a period of one year. The project is expected to yield post-tax returns of 20% in Germany. You are given the following information and asked to determine which of the two would be the better alternatives.

a. Offer from a Swiss bank to swap NZ $ for SFr at an exchange rate of NZ $ 1.2/SFr. Interest will be charged on the NZ $ loan at a rate of LIBOR + 1%. The current rate of LIBOR is 3.0%. At the end of the year, the bank will swap NZ $ for SFr at the same exchange rate.

b. Leave the exposure uncovered. The present spot rate is NZ $ 1.1915/SFr. Six-month LIBOR rates are as follows.

NZ $ – 3% SFr – 2% The LIBOR rates are expected to hold steady for the next one year. Assume that the corporate’s credit rating allows it to access funds in both NZ $ and SFr at

LIBOR + 0.5%. 51. An Indian exporter has bagged a contract to supply garments to a departmental store in UK.

The buyer has agreed to invoicing either in Sterlings or in Dollars. The Sterling price per garment will be 4. The contract will be executed one month from now. It is expected that from the time of shipment to negotiation of the LC, another month will lapse. If the following are the relevant spot rates and interest rates and the exporters’ total costs are Rs.200 per garment which currency would you choose for invoicing?

Interest rates : £ : 8% $ : 5% Rs.:15%

Spot rate : Rs.59.00/£ Rs.35.50/$

1-month forward rate : Rs.60.00/£ Rs.35.75/$

2-month forward rate : Rs.61.00/£ Rs.36.00/$

52. Assume that you are free to borrow/lend in any market and that active spot and forward markets are accessible to all parties in Rupee against any currency.

The market rates are as under:

Rs./S$ spot 24.8750 25.1250 3-m forward 25.6195 25.9805 3-m interest rates Rs. 17.50% 18.50% S$ 5.75% 6.25%

Verify whether an opportunity for covered interest arbitrage exists.

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53. Interest rates for three months in US and Canada are as follows:

Borrow Invest US$ 4.5% 4% Canada$ 1.57% 1.55%

Can$/$ spot 1.3119 1.3125 3-m forward 1.3129 1.3135

Advise the currency in which borrowing and lending for 3-months needs to be done for a US Company.

54. A Bank agreed at the request of an exporter for a 2-m forward contract based on the following rates:

Rs./$ Spot 45.30/35 1-m forward 20/28 2-m forward 35/40 The exporter requested for the cancelation of the forward contract at the end of one month

and delivered US$ 1,000,000. If the forward rates are the unbiased estimates of spot rates compute the cash flow to the exporter.

55. A US investor chose to invest in sensex for a period of one year. The relevant information is given below:

Size of investment ($) 10,00,000 Spot rate 1 year ago 45.30/50 Spot rate now 45.80/90 Sensex 1 year ago 5333 Sensex now 6220 Inflation in US 2% Inflation in India 4%

a. Compute the nominal return to the US investor. b. Compute the real depreciation/appreciation of rupee. c. What should be the exchange rate if relative purchasing power parity holds good? d. What will be the real return to an Indian investor in sensex? 56. The current market quotes are as under:

Rs./Euro Spot 49.50/65 Rs. interest rate Euro Interest Rate 1-m forward 49.20/40 1-month 9.00% 9.50% 3.50% 3.75% 2-m forward 49.00/25 2-month 9.75% 10.25% 4.00% 4.25%

Verify whether there is any scope for covered interest arbitrage. What should be the amount of money to be borrowed to make risk-free gains of Euro 25,000 if there is scope for arbitrage.

57. Consider the following information: Rs./$ one year ago : 39.50 Rs./$ Spot now : 44.50 Inflation in India in the past one year : 4% Inflation in the US for the past one year : 2% Calculate: a. The real appreciation/depreciation of the Rupee. b. The nominal appreciation/depreciation of the dollar.

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58. Consider the following market quotations: Exchange rates

Rs./Euro Spot 43.16/20 Rs./£ 1-m forward 70.40/50 Euro/£ 1-m forward 1.5565/75

Interest rates

Rs. (%) Euro (%) 1-month 11.00/11.50 3.00/3.25

a. What are the boundaries for one month forward Rs./Euro if there should not be any scope for covered interest arbitrage?

b. If the one month forward Rs./Euro rate is 43.56/66, is there any scope for triangular currency arbitrage in the forward rates?

59. Epsi Ltd. an Indian company requires Rs.10 million for six months. Epsi Ltd. has the option of borrowing either in rupees or in US dollars. Epsi Ltd. has obtained the following information from its banker:

Rs./$ exchange rate Spot 43.5700/5750 3-m swap 3900/4000 6-m swap 7000/7100Interest rates Rupee 3-months 11.00% 6-months 12.00%US dollar 3-months 6.50% 6-months 7.00%

You are required to answer the following: a. In which currency should Epsi Ltd. borrow? b. What should be the 3-month interest rate 3-months hence on the currency borrowed

as per your answer to part (a) so that Epsi Ltd. is indifferent between borrowing for 6-months and borrowing for 3-months and rolling it over for another three months?

60. An American based FII is looking to invest US$ 10 million in an emerging market. After a careful analysis of future prospects, India and Malaysia are shortlisted. For the next year, which is also the holding period for the FII, expected rates of return are 20 percent and 16 percent in Indian and Malaysian markets respectively. Withholding tax rates applicable on the returns earned are 20 percent in India and 10 percent in Malaysia. Other information available with the FII includes

Exchange rates: Rs./$ spot 43.50/43.60 M$/$ spot 3.80/3.82Expected inflation for the next year: India 4.0% Malaysia 6.0% US 2.0%

Assuming that the PPP holds good, where should the FII invest?

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61. Bharat Leathers and Piaco manufacture leather products and are based in India and Italy respectively. Both these firms export major share of their output to the USA. Invoicing currency for both the firms is US$.

Exchange rates Current spot Spot one year ago

Inflation rates during the last year

Rs./$ : 44.00 Rs./$ : 42.00 India : 5% Lit/$ : 2140.00 Lit/$ : 2050.00 Italy : 3%

USA : 1.5% a. Compute the nominal depreciations of rupee and Lira against the US$ over the last

one year. b. Compute the real depreciations of rupee and Lira against the US$ over the last one year. c. Comment on the export competitiveness of Bharat Leathers vs Piaco. 62. Sunil Bansal, a computer engineer in Stockholm decides to remit 1 million of Swedish

kroners by SWIFT to his father Ajay Bansal on June 30, 2003 to purchase a flat in Kolkata. A foreign bank in Kolkata offered a rate of Rs.5.90/SKr to Ajay Bansal. However, Ajay Bansal requested his banker (a private sector bank) to get a better rate. The branch manager contacted his dealings office at Mumbai for the rate. The dealer in Mumbai has the option to cover the transaction through Bahrain or Singapore. The spot exchange rates at Mumbai, Bahrain and Singapore markets on June 30, 2003 are given below:

Mumbai : Rs./US $ : 47.20/22 Rs./£ : 75.95/97 Bahrain : SKr/£ : 12.7532/39 Singapore : SKr/$ : 7.9652/62 You are required to determine, which market dealer should opt to cover the position.

Assume that an exchange margin of 0.005 paise is to be loaded in the rate. Calculate the gain or loss to the customer, if he relies on the rate quoted by his banker.

Show your working nearest to the rupee. 63. An importer in UK has a payable of Euro 500,000 after 3 months. He has collected the

following information from his banker. Euro/£ spot : 1.4200/1.4210

3 months forward : 1.4245/1.4256 3 months interest rates (p.a.) Euro: 2.60% – 2.80% £: 3.00% – 3.20% Which of the following would you recommend for covering the exposure through? a. Forward market b. Money market. 64. On April 01, 2003 Swastik Industries, a leading steel importer from Mumbai obtained a

forward contract from Citibank Mumbai to buy US $1million for settling their payable to the supplier in Germany on May 31, 2003. The US Dollars were quoted in the local interbank market as under:

April 01, 03 Rs./$ Spot 47.19/20 1-month forward 9/10 paise 2-months forward 19/20 paise On May 01, 2003 the supplier informs the importer that the consignment can be shipped and

delivered in June 2003. Hence the importer requested Citibank Mumbai to extend the contract to June 30, 2003. The US Dollars were quoted in the local interbank market as under:

May 01, 2003 Rs./$ Spot 47.02/03 1-month forward 7/8 paise 2-months forward 13/14 paise

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Citibank Mumbai quoted the exchange rates by loading a margin of 0.20%. The bank further agreed to offer a better rate by 4 paise while quoting the rates to the importer.

You are required to calculate the

a. Extension charges, and

b. Net cash outflow of the company as on June 30, 2003.

65. A multinational company in Germany has surplus funds of Euro 2 million for three months. The treasury manager wants to toy with the idea of investing funds in currencies other than that of the home currency. He has collected the following information on the exchange rates and interest rates:

$/Euro spot 1.1410/12

3-month forward 20/19

£/$ spot 0.6217/19

3-month forward 13/14

3-months interest rates (p.a.)

$ : 2.6%/2.8%

£ : 3.00%/3.6%

Euro : 3.2%/3.4%

You are required to determine, in which market the MNC should invest to have more returns, without exposing the investment to exchange risk.

66. The following rates were prevailing on June 30, 2003.

Spot Rs./$ 47.40/45

$/Euro 1.1410/1.1415

Rs./Euro 53.85/90

You are required to:

a. Verify whether there is any scope for three point arbitrage.

b. Calculate the arbitrage profit if you have Rs.1 million.

c. Find out the limits of Rs./Euro exchange rates to ensure no scope of arbitrage.

67. The following information is given by your banker

Spot Rs./ US $ : 47.80/82

Rs./£ : 77.45/47

Forward 6 months Rs./ US $ : 48.53/55

Rs./£ : 78.07/09

6 months $ interest rates 2.40%/2.60% p.a.

You are required to determine the 6 months £ interest rates which would prevent arbitrage.

68. Overseas Marine Products Ltd. an exporter of seafoods in Mumbai has submitted a 60 days bill for Euro 200,000 drawn under an irrevocable LC for negotiation. The company asked its banker to retain 50% of the bill amount under EEFC (Exchange Earners Foreign Currency) account.

The rates for US dollars in the interbank market are quoted as under: Rs./US $ Spot : 47.80/81 1 month forward : 10/11 paise 2 months forward : 21/22 paise 3 months forward : 32/33 paise

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Euro is quoted in Singapore market as under

US $/Euro Spot : 1.0775/80

1 month forward : 20/25

2 months forward : 40/45

3 months forward : 70/75

Note: Transit period is 20 days

Interest on post-shipment credit is 8% p.a.

Exchange margin required is 0.1%.

You are required to compute:

a. The exchange rate quoted to the company.

b. The cash inflow to the company.

c. The interest amount to be recovered by the banker from the exporter.

69. An Indian company, in its bid to improve the scale of operations, required a loan of US $300,000. The company’s banker agreed to arrange the loan with a condition that the loan is to be repaid with interest, by making equated annual installments of US $112,000 at the end of each year for a period of three years after receipt of the loan. The current exchange rate of US dollar is Rs.47.70. The inflation rate in India is 4% and that in US is 2.5%. The expected appreciation of rupee in the first year is 1% and for next two years expected depreciation of rupee is 2% and 3% respectively, on year-on-year basis.

You are required to determine the effective cost of funds in rupees to the company.

70. An American multinational corporation approached a Bank in London with a request to arrange a 3-month loan of Swedish Kroner 50 million. At that time there is no active Euromarket in Swedish Kroner for borrowing and lending. However, there is active spot and forward market for US dollar and Swedish Kroner.

The following rates are observed in the market: Interbank market SKr/ US $ Spot 8.4650/8.4655 3-month Forward 8.4670/8.4675 Merchant quote (SKr/US $) 3-month Forward 8.4695/8.4700 Interest rate US$ 3-month 3.30%/3.60% p.a. If the bank agreed to lend to the customer you are required to suggest how it will arrange

the loan without exposing to foreign exchange risk, and also the break even rate of interest for the bank.

71. M/s. Gemini Hitech plans to export software products to USA worth Rs.10 million. Sister concern of Gemini Hitech, Leo Systems, plans to import equipment from Germany worth Rs.4 million.

Export proceeds of M/s. Gemini Hitech will be realized 3 months from now. Leo Systems have to make payment 6 months from now.

The market rates are: Spot Rs./$ : 48.20/22 Rs./Euro : 48.00/02 Rs./£ : 75.25/27

Currency $ £ Euro Annualized Premium 4% 3% 2%

The invoicing can be made in any of the currencies for the exports and imports. Advice the companies about the currency of invoicing.

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72. Universal Exports and Imports is engaged in export and import of consumer durables. As on October 15, 2002, the company was to meet an export obligation in the month of January 2003. The value of export contract is US $250,000. They have also opened a letter of credit to import machinery worth US $200,000. As per the terms of the letter of credit, the import bill will be due for payment during 2nd week of January 2003. Accordingly, the company has entered into option forward contracts for both the transactions when the ongoing market rates were:

Spot Rs./$ 48.20/21 Forward Premia October 2002 11/13 Paise November 2002 34/36 Paise December 2002 61/63 Paise January 2003 84/86 Paise February 2003 105/107 Paise

On November 17, 2002, the company approached the bank to extend the forward contract booked for export to fixed delivery on February 15, 2003.

The ongoing rates on November 17, 2002 are as follows:

Spot Rs./$ 48.92/93 Forward Premia November 2002 16/17 Paise December 2002 47/48 Paise January 2003 78/80 Paise February 2003 110/112 Paise

On December 5, 2002 the company approached the bank for early delivery of the dollar which they had booked on October 15, 2002 to meet the import obligation. The ongoing exchange rates on December 5, 2002 are as follows:

Spot Rs./$ 48.85/87 Forward Premia December 2002 18/20 Paise January 2003 36/38 Paise February 2003 54/56 Paise

Note: Partial delivery of the option forward is permitted. Use proportioned premium for option deliveries, by taking 4 weeks for the month.

You are required to calculate: a. Outright forward export and import rates, as on October 15, 2002, from November

2002 to February 2003. b. Forward rates quoted to the company as on October 15, 2002 for their export and

import transactions. c. Exchange rate quoted to the company on November 17, 2002 for fixed delivery contract. d. Swap gain or loss, if any, for early delivery of dollar as on December 5, 2002. e. Total cash flows to the company if the company has to pay/receive interest @ 12% p.a.

for cash outlay/cash inflow, for the import transaction. 73. An Indian importer has a payable of £100,000. The seller has given the Indian importer the

following two options: i. Pay immediately with a cash discount of 1% on the payable.

ii. Pay after 3 months with interest at 4% p.a. The borrowing rate for the importer in Rupees is 12% p.a. The following are the exchange

rates as on December 02, 2002. Rs./£ Spot 74.76/80 3-month forward 38/40 Which of the above two options is advisable for the importer?

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74. Bharat Agro Tech Ltd. has to receive Euro 2,00,000 in August 2002. The company covered the exposure in forward market with his banker on June 01, 2002 with an option to deliver foreign currency in August 2002. The following exchange rates were prevailing on June 01, 2002:

Rs./Euro Spot 46.50/55 1 month 20/25 2 months 30/35 3 months 40/45 On July 01, 2002, the company requested its banker to extend the contract with an option to

deliver the foreign currency in September 2002. The exchange rates on July 01, 2002 are as follows:

Rs./Euro Spot 46.90/95 1 month 15/20 2 months 20/25 3 months 25/30 You are required to calculate: a. The exchange rate quoted to the customer when the bank booked the contract on

June 01, 2002. b. The extension charges and also indicate how the bank will cover in the interbank

market. c. The exchange rate at which the bank booked the contract on July 01, 2002. 75. An exporter in UK is expecting to receive Euro 1 million after 3 months. He has collected

the following information from his banker. Euro/£ Spot 1.5778/80 3 months forward 1.5770/72 3-months interest rates (p.a.) Euro 4.5% – 5% £ 6% – 6.5% Which of the following would you recommend for covering the exposure? i. Forward market ii. Money market. 76. The following rates were prevailing on August 08, 2002. Mumbai Spot Rs./£ 74.00/05 Rs./Euro 47.80/90 London Spot £/Euro 0.6338/40 You are required to: a. Verify whether there is any scope for three point arbitrage. b. Calculate the arbitrage profit if you have Rs.5,00,000. c. Find out the limits of Rs./Euro rates to ensure no scope of arbitrage. 77. Mercury Cine Film Equipments (P) Ltd. imported computer lab equipment and accessories

at a cost of JPY 50 million from M/s SONY of Japan on January 01, 2002, and the amount is payable on June 30, 2002.

The firm approaches a bank in Mumbai, which informed him that no forward quotation is available for JPY in the Indian market and the bank has to quote a rate based on the 6 month Rs./$ forward in the Mumbai market and 6 month JPY/$ forward in the Singapore market.

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The exchange rates quoted to the firm on January 01, 2002 at Mumbai and Singapore markets are given as:

Mumbai Rs./$ spot : 48.55/80 6 months forward : 50/60 Singapore JPY/$ spot : 124.50/125.00 6 months forward : 4.00/4.50

The treasurer of the firm believes that the forward market is overestimating the weakness of rupee against dollar. So instead of going to the Mumbai bank for forward selling of JPY, it is planning to buy JPY 6 month forward in Singapore market against dollar to settle the payable, and buy US $ against rupee after 6 months in the Mumbai spot market to deliver US $ against JPY in the Singapore.

If the Rs./$ spot exchange rate on June 30, 2002 in Mumbai turns out as 48.95/20. You are required to calculate the saving the firm can make from the strategy instead of

buying JPY from the Mumbai bank. 78. A company based in US has surplus funds to the tune of $5,00,000 for 3 months. The

company has obtained the following quotes/information from its bank: $/Euro Spot : 0.9079/0.9083

3 months forward : 35/33 $/£ Spot : 1.4554/1.4558

3 months forward : 54/51 3 months interest rate : $3.00% p.a. £ : 4.00% p.a. Euro : 2.50% p.a. You are required to advise the company as to the currency, in which it should invest to have

more inflow of dollars. 79. An Indian exporter has a receivable of US $ 200,000 expected to receive after 2 months. He

obtained a 2 month outright forward contract from his banker when the prevailing exchange rates are as under:

Rs./$ spot : 48.85/90 1-month forward : 35/40 2 months forward : 55/60 The exporter after one month delivered $ 2,00,000 to the bank and requested for

cancellation of the forward contract. If the forward rates are the unbiased estimates of spot rates, you are required to compute the net cash flow to the exporter.

80. An importer in UK has to settle an invoice for Euro 5,00,000 after 3 months. His banker has given the following information:

Euro/£ spot : 1.5995/1.5999 3 months forward : 30/28 3 months interest rates : Euro : 3.00% – 3.50% p.a.

£ : 3.50% – 4.00% p.a. Which of the following would you recommended for covering the exposure i. Forward market ii. Money market. 81. You are given the following information by your banker: Rs./$ Spot 48.70/75

Rs./£ Spot 70.80/85 6 months forward Rs./$ 49.85/95 Rs./£ 72.40/50 6 month $ interest rates 3.50% – 4.00% p.a.

You are required to compute the 6 months interest rates to prevent covered interest arbitrage.

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82. You are given the following information by your banker:

Exchange rates

Rs./Euro Spot 42.38/42

Rs./$ 1 month forward 48.66/86

Euro/$ 1 month forward 1.1485/95

Interest rates

Rs.(%) Euro (%)

1 month 8 – 9 p.a. 3 – 3.36 p.a.

i. You are required to determine the boundaries for 1 month forward Rs./Euro to prevent any possibility of covered interest arbitrage.

ii. If the one month forward Rs./Euro rate is 42.24/28, then verify whether there is any scope for triangular currency arbitrage in the forward rates. Also show how arbitrage profit can be made.

83. A Foreign Institutional Investor from UK proposes to invest £1 million in an emerging market. After a careful analysis of future prospects, India and Hong Kong are short listed. For the next year, which is also the holding period for the FII, expected rates of returns are 15% and 12% in Indian and Hong Kong markets respectively. Withholding tax rates applicable on the returns earned are 15% in India and 12% in Hong Kong. Other information available with the FII includes:

Current exchange rates Rs./£ 69.50/70 HK $/£ 11.15/18

Expected inflation for the next year

UK – 2% India – 4% Hongkong – 3%

You are required to find out the rate of return in India and Hong Kong in £ terms. Assume purchasing power parity holds good in both the countries.

84. An Indian importer has a payable of C$ 5,00,000 due on 31.3.2002. On 01.01.2002, the importer covers the payable through forward buying of C$ at Rs.30.34 from his banker.

On 31-3-2002, he requests the banker to extend the contract till 30-4-2002. The exchange rates as on 31-3-2002 are:

Rs./C$ Spot 30.54/63

1 month forward 30.56/68

You are required to find out the net cash outflow for the importer. Also state how the bank will cover this extension of forward contract.

85. A customer approaches Grindlays Bank with a request for a 6 month loan of Australian Dollar (AUD) 50 million. At the time there is no active euromarket in Australian dollars, so that the bank can refer to a lending rate. However, there are active spot and forward markets for Rs./AUD. The following rates are available at the market:

Spot Rs./AUD 24.95/25.00

6 month Forward 0.40/0.45

Rupee 6 month interest rate: 8.00%/8.50%.

You are required to calculate the interest rate on AUD the bank should quote to break even.

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86. The following are the quotes available at the market: Spot $ / 0.8775/0.8777 ∈ 3 months Forward 0.0015/0.0010 3 months interest rates are: $ 2.25/2.50% p.a. 3.50/3.75% p.a. ∈ You are required to: a. Verify whether there is any scope for covered interest arbitrage. b. What should be the amount borrowed to make an arbitrage profit of $1000, if there

is scope for arbitrage. 87. A Foreign Institutional Investor (FII) invested in Indian capital market on December 01,

2000. When the Mumbai stock exchange sensex was quoting at 3800. The rupee-dollar spot exchange rate at that time was Rs./$ 46.30/33. The FII sold the investment on November 30, 2001. When the Mumbai stock exchange sensex was quoting at 3250, to take back the amount in dollars. The spot exchange rate quoted on November 30, 2001 was Rs./$ 48.02/05. Inflation rate in India was 6%, and in US was 2.5% during the same period.

You are required to: a. Compute nominal rate of return to FII. b. Compute real rate of return to FII. c. Compute the real return to an Indian investor who invested Rs.100,000 in the capital

market for the same period. (You can assume return earned should be in line with the return from sensex.) 88. Laxmi Traders Ltd. exports edible oils to Middle-East and African countries. In June the

company exported an assignment worth $5 million to Jambia. The payment for the same is expected to realize during the month of September. For the company has entered into a option forward contract for delivery of $5 million over the month of September.

The market quotes on June 30 at the time of entering into the contract were as follows: June 30, Spot Rs./$ 47.05/08

Forward 1 month 23/25 paise 2 month 47/49 paise 3 month 70/72 paise

On September ‘01, the company approached the bank for extension of the contract by another two months, that is for delivery during the month of November.

The market quotes on September ‘01 were as follows: Spot Rs./$ 47.58/60 Forward 1 month 18/20 paise 2 month 37/39 paise 3 month 55/57 paise On November ‘01, the company approached the bank to cancel the forward contract. The

exchange rates as on November ‘03, were as follows: Spot Rs./$ 47.97/99 Forward 1 month 16/18 paise 2 month 33/35 paise You are required to calculate: a. The forward rate to be quoted to Laxmi Traders on June 30. b. The exchange rate to be quoted by the bank on September ‘01 for the extension of

the contract. c. The amount of cash flows due to extension of the contract. d. The exchange rate at which the forward contract to be cancelled on November ‘01. e. The amount of cash flows due to cancellation of the contract. (Ignore FEDAI margins for merchant quotes.)

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89. Techinfo Ltd. has imported speciality computer equipments worth US$ 250,000 from a company in US. The amount due for the imports is payable after 3 months. Mr. Garg, the treasury manager of Techinfo has collected the following market quotes:

Exchange rates: Spot Rs./$ 47.15/47.30 Forward 3 month 55/60 Interest rates (p.a.): Dollar (3 months) 6.00%/6.50% Rupee (3 months) 10.00%/11.00% The supplier of the equipments has offered a discount of $5000 if the payable is settled at

the current date. Mr. Garg is reviewing the following alternatives to settle the payable: i. Cover through forward market. ii. Cover through money market. iii. Avail the cash discount of $5000 by taking a bridge loan at 9% p.a. from a lending

institution. You are required to suggest Mr. Garg the best alternative to settle the payable. 90. United Pharma Ltd. (UPL) has acquired an export order to export Rs.10 million of formulations

to a European company. UPL is also planned to import bulk drugs worth Rs.5 million from a company in UK. The proceeds of the exports will be realized 3 months from now and the payment for imports will be due after 6 months from now. The invoicing for these exports and imports can be done in currencies dollar, euro or sterling at company’s choice.

The following market quotes are available: Annualized Premium Spot Rs./$ 47.10/47.20 $ 6% Rs./Euro 43.15/43.20 Euro 5% Rs./£ 68.65/68.75 £ 4%

You are required to advice the company about the invoicing currency. 91. The following market quotations are available for rupee, dollar and euro: Exchange rates: Spot Rs./Euro 42.75/42.85 Rs./$ 47.10/47.20 $/Euro 0.9051/0.9054 Interest rates (p.a.):

Rupee(%) Euro (%) 3 month 8.00/8.50 4.00/4.50

You are required to: a. Find out the boundaries for three month forward Rs./Euro exchange rate for no

scope of covered interest arbitrage? b. Verify if there is any scope for three-point arbitrage. Also, show how to make

arbitrage profit if there is scope of arbitrage. 92. Komal Finance Ltd. an Indian finance company has planned to invest rupee fund equivalent

to $50 million for one-year in USA. The return on investment over the period of investment will be 20%. The current rupee-dollar exchange rates are as follows:

Spot Rs./$ 46.90 1 year forward 49.25 A European bank is offering to supply $50 million at a rate of Rs.46.50/$ and swap the

same amount at Rs.48.75/$ after one-year. The rupee cost of funds for the company is 16%. You are required to calculate the actual return earned under forward cover or swap deal and

suggest the company whether it should go for the simple forward cover or accept the European bank’s offer. (You can consider that there is no restriction on accessing and repatriation of funds in both dollar and rupees.)

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93. The treasurer at an Indian company requires Rs.10 million for six months. He is exploring various options of financing and has collected the following information: Rs./$ Rs./£ Spot 46.90/95 65.35/40 6 months forward 70/90 paise 90/100 paise Expected spot rate after 6 months 47.50/55 66.90/95

Interest rate

Rs. $ £ 6 months 12.00% 4.00% 5.00%

You are required to advise the treasurer in which currency to borrow, if he i. Covers the exchange risk in forward market ii. Keep the open position. 94. An Indian software company had approached State Bank of India (SBI) for forward sale of

£100,000 delivery on May 31, 2001. The bank had quoted a rate of Rs.65.60/£ for the purchase of pound sterling from the customer. But on May 31st, the customer informed the bank that it was not able to deliver the pound sterling as anticipated receivable from London has not materialized and requested the bank to extend the contract for delivery July 31st.

The following are the market quotes available on May 31, 2001: Spot Rs./£ 66.60/65 1-m forward 20/25 2-m forward 41/46 3-m forward 62/68

You are required to find out the extension charges payable by the software company. 95. Proactive Ltd. imports some specialty instruments from Japan and exports the finished

product to US. The company has a payable of ¥ 500 million and a receivable of $10 million three months hence. The following exchange rates are available in the market: Rs./$ Rs./¥ Spot 46.65/85 0.4065/0.4115 3-m forward 46.90/15 0.4218/0.4268

The current interest rate scenario is as follows:

Maturity Rupee (%) Dollar (%) Yen (%) 3-m 8.0/9.0 6.00/6.50 0.4/0.5

The company is considering to cover the exposures either through the forward market or through the money market.

You are required to advise the company which alternative should be better for covering both the payables and receivables.

96. A foreign institutional investor invested in units of a mutual fund in India for a period of one year. The following information is available regarding the investment and other economic variables: Value of investment Rs.1,000 million NAV at the time of investment Rs.10.00 NAV at the end of investment horizon Rs.11.00 Dividend received per unit after 6 months Rs.1.20 Rs./$ rate at the time of investment 44.50/44.60 Rs./$ rate at the end of investment horizon 46.70/46.85 Reinvestment rate during the period 10% Inflation rate in India 8% Inflation rate in US 3%

You are required to: a. Calculate the nominal return to FII. b. Calculate the real return to FII. c. Calculate the real return to an Indian investor who invested in the same fund for the

same period.

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Management of Exchange Risk 97. An Indian corporate completes a project of value, C $1 million Canada on 31/12/01. The

contract has been executed on deferred payment terms and the necessary permission for late realization of export proceeds has been obtained from the Reserve Bank of India. The company has to bear the currency risk however till 1/1/04 when payment will be realized. When the corporate approaches its bank, it is informed that forward contracts of maturity greater than six months cannot be structured. It hence opts for six-month roll over cover.

The following are the spot rates (Rs./C$) and six-month forward rates (Rs./C$) prevailing at the end of each roll over period. Determine the cash flows and compare the result with a situation when the corporate leaves the exposure uncovered. You may assume that the cost of capital for the company is 20%.

Date Spot Rate (Rs./C$)

Six-month Forward Rate

1/1/02 35.00 35.20 1/7/02 35.15 35.30 1/1/03 35.25 35.35 1/7/03 35.35 35.50 1/1/04 35.45 35.60

98. An Indian company has availed of a C$30 million loan which it has to repay in four interest inclusive installments of C$10 million each. The company opts for six-month roll over contracts to cover its exposure. If the loan is availed of on 1/1/03 and repayments start from 1/7/03 and the exchange rates are as given below, determine the cash flows associated with roll over. Also, using a discount rate of 20%, find out whether it is better to use a roll over or simple six-month forward contracts to cover exposure to the extent of the next installment payment.

Date Spot Rate Forward Rate (Rs./C$) (Rs./C$)

1/1/03 35.50 35.60 1/7/03 35.70 35.80 1/1/04 35.90 36.00 1/7/04 36.10 36.20 1/1/05 36.30 36.40

99. An Indian exporter has an ongoing order from USA for 2000 pieces per month at a price of $100. To execute the order, the exporter has to import Yen 6000 worth of material per piece. Labor costs are Rs.350 per piece while other variable overheads add up to Rs.700 per piece. The exchange rates are currently Rs.35/$ and Yen 120/$. Assuming that the order will be executed after 3 months and payment is obtained immediately on shipment of goods, calculate the loss/gain due to transaction exposure if the exchange rates change to Rs.36/$ and Yen 110/$.

100. In the above problem, if the contracted export price is Rs.3,500, calculate losses/gains due to transaction exposure and economic exposure. Assume that the elasticity of demand for the product is –2 in USA.

101. An Indian exporter has obtained an order for supplying automotive brakes at the rate of $100 per piece. The exporter will have to import parts worth $50 per piece. In addition, variable costs of Rs.200 will be incurred per piece. Explain the impact of the following if the exchange rate which is currently Rs.36/$ moves to Rs.40/$.

a. Transaction exposure b. Economic exposure if invoicing is done in rupees, price elasticity of demand is –1.5

and the current order quantity is 1000 units.

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102. A corporate treasurer is trying to hedge the foreign currency risk associated with a loan of face value C$1,000,000. Interest is payable semi-annually on the loan at the rate of 8% p.a. The principal will be repaid after 2 years. Since forward contracts are available only for a maximum period of 6 months, the treasurer has decided to use a roll over forward cover. If the loan is availed of on 1/1/03 and interest payments begin from 1/7/03, work out the effective cost of the loan. Assume that the exchange rates on the dates of roll over of the forward contract are as follows:

Date Exchange rates (Rs./C$) Spot 6 months

1/1/2003 41.00/41.50 41.40/41.90 1/7/2003 41.45/41.95 42.00/42.50 1/1/2004 42.15/42.70 42.50/43.10 1/7/2004 42.45/43.00 43.15/43.70 1/1/2005 43.10/43.70 43.60/44.20

103. You are planning to hedge a payables exposure in dollars and have collected the following information.

Spot : (Rs./$) 42.50/42.60 3-month forward (Rs./$) 43.50/43.70 Interest rates: $ – 6%

Rs. – 15% If the exposure will mature in 3 months and there are no restrictions on trading in

forward/money market instruments, what cover would you prefer – forward cover or money market cover? Show necessary calculations.

104. You were to import an equipment for your project and you have a choice to invoice in the following currencies:

Invoice value £ 100000 S$ 290000 NKr 917000 Spot rate 67.50/90 23.25/40 7.05/15 1-m Forward rate 25/40 10/15 20/25 2-m Forward rate 50/90 – – 1-m Interest rate 6.00 4.00 4.50 2-m Interest rate 6.25 4.25 4.75

You have the option to pay at the end of 1st month or 2nd month along with interest at the applicable rates. However, the pay-out at the end of 2nd month has to be made in Euro and actual pay-out depends on how the rates are fixed with Euro. If the Rs./Euro is 47, after 2 months, compute the limits for S$/Euro and NKr/Euro rates that will make invoicing in S$ and NKr a better choice than £. Which currency do you select if you prefer to pay at the end of first month?

105. M/s. Windfall Ltd. has to import raw material in three consignments at the rate of one consignment every month in the next three months. Payments will have to be made at the end of each month. The company has the option to invoice the consignment either in US $ or Euro. The terms are as under:

US $ Euro To be paid after First Consignment 150000 157000 1 month Second Consignment 300000 312000 2 months Third Consignment 250000 262000 3 months

You, as the Finance Manager of the company, have the following forecast for the exchange rates:

After 1 month After 2 months After 3 months US $/Euro 1.0455/56 1.0418/09 1.0400/01 Rs./US$ 43.25/35 43.45/58 43.75/85

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The current forward quotes in the market are as under:

After 1 month After 2 months After 3 monthsUS $/Euro 1.0465/67 1.0426/29 1.0415/19 Rs./US$ 43.45/50 43.65/75 43.80/95

Suggest the currency in which you invoice for each of the consignment. i. If the exposure is hedged. ii. If the exposure is left uncovered. 106. International Industries Ltd. (IIL), an Indian company, has a receivable of $1,000,000,

maturing three months from now and a payable of £1,500,000, maturing in six months. The company has decided to hedge the two separately. The following information is available regarding the same:

Exchange Rates

Rs./$ Spot 43.65/70 3-m forward 44.75/85 6-m forward 44.80/95 Rs./£ Spot 70.25/50 3-m forward 70.50/00 6-m forward 71.15/80

Interest Rates (%)

Rs. $ £ 3-months 9.00/9.50 4.00/4.25 5.00/5.25 6-months 10.00/11.00 4.50/5.00 6.00/6.50

Advise the company on whether it should adopt a forward cover or a money market cover. 107. A to Z Pharma Inc., a US based company, has a receivable of C$1,000,000 maturing five

months from now. The company is considering whether the exposure should be hedged through futures or a money market cover. Six-month futures on Canadian dollars are now trading at US$ 0.7205 and the current $/C$ rate is 0.7005. The interest rate for five-month investment in US$ is 6% p.a.

a. Calculate the inflow to the company if, after five months, the futures contract trades at 0.7185 and the spot $/C$ rate is 0.7100.

b. What should be the rate of interest on Canadian dollars if the company should be indifferent between the futures and money market cover?

108. Amico, an American company imported machinery worth Euro 1 million on April 05, 2000, from a firm based in Switzerland. The payable is due in June. Amico is considering whether this exposure should be left open or hedged through forward or option market. The market rates obtained by Amico are:

$/Euro spot 0.9580/0.9590 2-months forward 20/30

July call options with a strike price of $0.9610/Euro are available at a premium of 0.005 $ per Euro.

You are required to: a. Define the cash outflows for Amico if the exposure is left open, hedged through

forward market and hedged through option market. b. Find at what expected spot rate will Amico be indifferent between

i. Open position and forward hedge ii. Open position and hedge through call option iii. Forward hedge and hedge through call option.

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109. Handex is an Indian firm exporting handicrafts to North America. All the exports are invoiced in US$. Handex is considering the use of money market or forward market to cover a receivable of $50,000, expected to be realized 3 months hence. Handex has the following information from its banker:

Exchange rates : Interest rates Spot : Rs./$ : 43.65/44.00 3-m Rs. : 9% 3-m forward : Rs./$ : 43.95/44.40 3-m $ : 6% a. Which option is better for Handex? b. Assume that Handex anticipates the spot exchange rate 3-m hence to be equal to the

current 3-m forward rate. After three months the spot exchange rate turned out to be Rs./$: 44.00/44.42. What is the foreign exchange exposure and risk of Handex?

110. An Indian Company has a payable of US $100,000 due in 3 months. The company is considering to cover the payable through the following alternatives:

i. forward contract, and ii. money market, and iii. option. The following information is available with the company: Exchange rate: Spot Rs./$ 45.50/45.55 3-m forward 40/45 3-m interest rates (%): US 4.5/5.0 India 10.0/11.0 Call option on $ with a strike price of Rs.46.00 is available at a premium of Rs.0.10/$. Put

option on $ with a strike price of Rs.46.00 is available with a premium of Rs.0.05/$. Treasury department of the company forecasted the future spot rate after 3 months to be:

Spot rate after 3-m Probability Rs.45.60/$ 0.10 Rs.46.00/$ 0.60 Rs.46.40/$ 0.30

You are required to a. Suggest the best alternative of hedging

b. Explain why it is/it is not better to have the exposure unhedged. 111. GTN Textiles exports cotton garments to the US. For the year ended 1999-2000 it has

exported 1,20,000 pieces at an average price of $12 per piece. Average cost of producing each piece is Rs.350 for GTN. The elasticity of demand for company’s product in the US market is 1.5. Prevailing rupee-dollar exchange rate during the last year was 42.00. In the current year rupee-dollar exchange rate is expected to depreciate to 44.00.

You are required to calculate a. The change in profit due to the transaction exposure. b. The change in profit due to economic exposure if the company passes on the benefit

of depreciation to the buyer. 112. Deccan Electronics Ltd. in Noida Export processing zone, exports split air conditioners to

Germany by importing all the components from Singapore. The company is exporting 2,400 units at a price of Euro 500 per unit. The cost of imported components is S$800 per unit. The fixed costs and other variable costs per unit are Rs.1,000 and Rs.1,500 respectively. The cash flows in foreign currencies are due in six months.

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The current exchange rates are as follows: Rs./Euro : 51.50/55 Rs./S$ : 27.20/25 After six months the exchange rates (at the time of receipt and payment of foreign

currency) turn out as follows: Rs./Euro : 52.00/05 Rs./S$ : 27.70/75 a. You are required to calculate the loss/gain due to the transaction exposure. b. Based on the following additional information, calculate the loss/gain due to

transaction and operating exposure if the contracted price of split air conditioner is Rs.25,000.

• The current exchange rates change to Rs./Euro : 51.75/80 Rs./S$ : 27.10/15

• Price elasticity of demand is estimated as 1.5. • Payments and receipts are to be settled/received at the end of sixth month.

113. An industrial unit in Chennai exports washing machines to Dubai at a price of $150 per unit. The company executed an order for the supply of 12000 units in December 2002. The company uses Japanese motors for the washing machines and the cost of each motor is $50. It’s other variable costs per unit are Rs.4,200. The allocable fixed costs of the company is Rs.12,00,000. The spot rate of dollar in December 2002 is Rs.48.

If rupee appreciates to Rs.47 per dollar, you are required find out by how many units should the company increase its sales, so as to maintain the current profits.

114. An Indian Company based at Mumbai needs short-term funds of Rs.50 million for a period of 3 months. The company collected the following information from its banker:

Rs./$ Rs./£ Spot 48.50/55 74.05/10 3 months forward 45/50 85/90 3 months Interest rates (p.a.)

Rs : 9% $ : 4% £ : 6% You are required to calculate the annualized effective cost of borrowing. a. If the company borrows in USD and

i. Covers the exchange rate risk through forward market. ii. Keeps the position open and spot rate after 3 months turns out to be Rs./$

48.90/95. b. If the company borrows in pounds and i. Covers the exchange rate risk through forward market.

ii. Keeps the position open and spot rate after 3 months turns out to be Rs/£ 74.75/80.

115. A UK MNC has a surplus of £1 million and a requirement of US dollars 1.44 million both for 3 months.

The spot $/£ = 1.4400/20 3 months forward = 0.0070/0.0060 It can borrow dollars at a rate of 4% p.a. and invest pounds at 3% p.a.

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You are required to determine the net cost of borrowing in dollars, by evaluating the following two alternatives:

i. Borrow dollars and invest pounds, and ii. Swap pounds in to dollars for 3 months. 116. An Indian company has taken a loan of £1,00,000 from Barclays Bank, London on 1.1.2000

with the following conditions. i. Interest is to be paid semi-annually at the rate of 6% p.a. ii. Principal amount is to be repaid at the end of 2 years, that is on 1.1.2002. The company wants to cover the foreign currency risk associated with the loan amount and

interest by obtaining forward contract. Since the forward contracts are available only for a maximum period of 6 months, the company has decided to use a roll over forward cover.

The following exchange rates materialize on the dates of the roll over of the forward contracts:

Date Exchange rates Rs./£ Spot 6 months forward

1.1.2000 67.49/54 68.00/10 1.7.2000 67.90/95 68.50/60 1.1.2001 68.40/45 68.80/90 1.7.2001 68.70/75 69.40/50 1.1.2002 69.10/15 69.80/90

You are required to show the cash flows and calculate the effective cost of the loan. 117. Pacific Leather Goods Ltd. an Indian manufacturer exports leather goods to USA. The

company is exporting 5000 units at a price of $60. The company has imported some specialty chemicals from Europe to produce the export items. The cost of chemical per unit of leather good stands at Euro 10. The fixed overhead costs per unit comes at Rs.250 and other variable overheads, including the freight cost, add up to Rs.1250 per unit. The payments for both exports and imports are due in six months.

The current exchange rates are as follows: Rs./$ 46.90 Rs./Euro 40.40 After six months (at the time of setlement of payments) the exchange rate turns out as

follows: Rs./$ 47.90 Rs./Euro 41.25 You are required to: a. Calculate the loss/gain due to transaction exposure. b. Based on the following additional information calculate the losses/gains due to

transaction and operating exposure if the contracted export price per unit is Rs.2,700: • The current exchange rate changes to Rs./$ : 47.50 Rs./Euro : 40.80 • Price elasticity of demand for the company’s product in the USA is estimated

to be 1.60. • The Payments are to be settled at the end of sixth month.

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International Project Appraisal 118. An Indian firm finds that by investing in a project in East Africa, its borrowing capacity

will go up by Rs.50 million. If the firm’s borrowing rate in India is 15% and the risk-free rate of interest is 6%, what is the net benefit owing to the increased borrowing capacity? Assume that the tax rate applicable in India is 40% and the life of the project is 5 years.

119. A US multinational is planning to invest in Newzealand. The local government has agreed to give a loan of NZ$ 100 million at a concessional rate of 5%. The competitive market rate of interest for similar loans in Newzealand is 10%. If the principal has to be repaid in 5 equal installments, what is the benefit which the US multinational will enjoy? You are given that the exchange rate at the time of investment is NZ$ 1.50/$. Life of the project is 5 years.

120. An US corporate is appraising an international project using the Adjusted Present Value method. It has calculated the APV to be negative at $70 million. The Government of India where the investment will be made has offered a concessional loan of Rs.1,400 crore. The competitive market rate of interest in India is 16% and the spot rate is Rs.35/$. At what rate should the concessional loan be negotiated so that the project is feasible? Assume that the principal repayment will be made in five equal installments starting from the second year.

121. The Nepalese government has accepted a proposal from M/s. IRCON, a reputed Indian construction company to operate a Railway project on the following conditions. (In this problem Rs. means Nepalese Rs, NR, unless otherwise specifically mentioned.) • The initial investment will be Rs.100 crore. • The project will be operated on the basis of Build/Operate/Lease/Transfer. As per

the conditions of the offer, the initial investment will be made by IRCON. IRCON will operate the Railway line and other items and in lieu of the operation, the Nepalese government will pay an annual lease rental of Rs.100 crore.

• The Nepalese government has also offered to extend a loan of Rs.50 crore without interest. The competitive market rate for similar loans in Nepal is 20% per year.

• After 5 years the project will be transferred to Nepal Railways for a lump sum amount of Rs.200 crore.

• The concessional loan provided by the Nepalese government has to be repaid in 5 equal installments starting from the end of year 1.

• As per the Income Tax Laws of Nepal, IRCON is allowed to charge a depreciation of 20% per year.

• The Nepalese government has also agreed to grant a tax holiday of three years. • The tax rate in India is 35% and in Nepal it is 40%. • The project will enable IRCON to raise its borrowing capacity by Indian Rs.100 crore. • The annual operating cost of the project is estimated at Rs.45 crore at the current

exchange rate. • Double Taxation avoidance agreement exists between Nepal and India. • No major repairs or maintenance work will be required during the tenure of the project. • All operating costs are expected to move in line with the inflation rate in Nepal.

However, the lease rental will remain at the same level of Rs.100 crore. • IRCON has been borrowing at 18% interest in India and the riskless rate of

borrowing in India can be assumed to be 10% p.a. • The long-term inflation rates in India and Nepal are 10% and 15% respectively. • The current exchange rate is Indian Rs.1 = Nepalese Rs.1.5. It is believed that PPP is

likely to hold. • The Nepal Railways has also agreed to pay a one time technical advisory fee of

Rs.100 crore to IRCON at the end of year 5. Should IRCON go ahead with the project if the discounting rate for cash flows generated from operating the railway in Nepal is assumed to be 18% p.a.?

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122. While evaluating an international project, a Singapore MNC has calculated the adjusted present value to be – S$ 15 million. The local government in the US has now offered a concessional loan of $100 million which will involve repayment of principal in five equal installments. Interest will be paid on the outstanding amount, annually. If the market rates of interest are 6% and 5% in USA and Germany respectively, at what rate should the MNC negotiate the loan? Assume that the spot rate is S$ 1.80/$.

123. A firm based in Singapore is planning to invest in India. The firm uses Adjusted Present Value method in appraising its overseas investment projects. APV estimated for the present project is negative at S$38 million. The government of India has offered a concessional loan of Rs.4,000 crore to finance the project. The market rate of interest is 16%. The spot rate is at Rs.25/S$. At what rate should the concessional loan be negotiated so as to make the project viable? Repayment of principal will be in five equal annual installments.

124. A leading textile mill based at Mumbai is planning to invest in a project in Indonesia. After the initial appraisal of the project using the Adjusted Present Value (APV) technique, the firm arrived at a negative figure of Rs.1,000 million. The Government of Indonesia evinced interest to encourage the investment, in the form of giving a concessional loan of Singapore dollars 500 millions as the project is expected to create 1000 jobs. The concessional loan has to be repaid in four equated annual instalments, starting at the end of the third-year. The market interest rate for similar type of loan is 10%. The current exchange rate is Rs.27.75/Singapore dollar.

You are required to find out the interest rate on concessional loan to make the project viable. 125. An Indian engineering company is planning to invest in a project in Turkey. After the initial

appraisal of the project using Adjusted Present Value (APV) technique, the firm arrived at a negative figure of Rs.150 crore. So the company has approached the Turkey Government for a concessional loan as the project will create 500 jobs in Turkey. The government of Turkey has also agreed to provide a loan of Euro 300 million for the project. The concessional loan has to be repaid in four equal installments starting at the end of the second year. The market interest rate for similar type of loan is 8% p.a. The current rupee-euro exchange rate is Rs.42.50/Euro.

You are required to find out the interest rate on concessional loan to make the project viable.

International Equity Investments 126. An Indian investor purchased securities on the New York Stock Exchange when the

exchange rate was Rs.35/$. One year later, his investments had fetched dollar returns of 50%. At that time, the spot rate was Rs.36/$. Calculate the investor’s returns if he brings his funds back to India at the end of one year.

127. An American investor purchased stocks on the Bombay Stock Exchange when the exchange rate was Rs.35/$. One year later, he finds that his portfolio has moved in line with the Bombay Sensex and appreciated by 25%. The spot rate prevailing at the end of one year was Rs.36/$. If the investor decides to withdraw from India, what would be his dollar returns?

128. You are given that the risk-free rate of return in India is 10%. An American investor decides to buy Indian securities with Beta = 1.50 and variance of returns = 20%. The Indian rupee has been depreciating at 5% against the dollar with a variance of 15%. If the market portfolio fetches a return of 20% in India and the correlation between the return on security and the exchange rate is 0.20, estimate the expected return and risk for the US investor.

129. Exchange rates at the beginning of 2003 and 2004 were Rs.18.53 and Rs.25.53 per S$. If the percentage return on Singapore Securities is (a) –50%, (b) –25%, (c) 50%, (d) 25%, compute the net return to the Indian investor.

130. The spot exchange rate in 2003 was Rs.45/$. The inflation rate was 5% in India and 4% in USA. What would be expected percentage return to an American Investor, if the percentage return on Indian Securities is (a) 10% (b) 30% (c) 50%.

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131. A company has surplus funds of £1,000,000. The following rates are being quoted. Spot : NZ$ 1.50/$ $1.50/£ 3-month interest rates : £ – 8% NZ$ – 4% $ – 5% 3-month forward : NZ$ 1.45/$ $1.40/£ In which currency should it invest? 132. During a year the price of British gilts (face value £ 100) raised from £ 102 to £ 106 while

paying a coupon of £ 9. At the same time, the exchange rate moved from $/£ 1.76 to $/£ 1.62. What is the total return to an investor in US who invested in the above security?

133. Mr. Robinson, an Australian investor is very much interested in investing Rs.1 million in the pharmaceutical sector in India. He decides to invest in the scrip of Morepen Labs Ltd. which is listed on BSE and the details of scrip are given below:

Beta of the security : 1.65 Variance of returns : 25(%)2

Appreciation of Australian dollar against rupees is 3% with a variance of 10(%)2. Return on BSE index is 12% annualized and return on long-dated Indian Government Securities is 6.5%. Assume that the correlation between the return on the scrip and Rs./AUS$ exchange rate is zero.

You are required to estimate the expected return and risk of Mr. Robinson, if his holding period is one year.

134. A US Institutional Investor decided to invest in a Indian security of b = 1.20 and standard deviation 15%. The return on the market portfolio is 15% and risk-free rate is 8% in India. Indian rupee in expected to depreciate by 4% in the next one-year. You are required to calculate expected return in dollar if the FII holds the investment for one year.

135. A Foreign Institutional Investor (FII) is planning to invest $10 million in an Indian security with a beta of 1.40 and standard deviation of returns 10% p.a. The holding period of investment will be one-year. The current rupee dollar exchange rate is Rs.48/$. The FII expects the rupee to depreciate against dollar by 4% over next one-year period, with a volatility of 8% p.a. The expected return from the market portfolio in India is 12% p.a., and the standard deviation of returns on the market portfolio is 9% p.a. Correlation between the return on the security and the exchange rate is 0.15. The risk-free rate of return in India is 6% p.a.

You are required to calculate the expected return and risk for the FII. 136. An American investor is considering to invest in an Indian security with a beta of 1.20 and

standard deviation of returns 8%. The holding period of investment will be one-year. The current rupee-dollar exchange rate is Rs.46/$. The expected depreciation of rupee against dollar is 6% with a standard deviation of 10%. The expected return from the market portfolio in India is 15% and the correlation between the return on security and the exchange rate is 0.10. The risk-free rate of return in India is 8%.

You are required to calculate the expected return and risk for the US investor.

Short-term Financial Management 137. An American Multinational Corporation has three subsidiaries whose cash positions for the

month of March, 2004 are given below. Swiss Subsidiary : Cash surplus of SFr 15,000,000 Singapore Subsidiary : Cash deficit of S$ 35,000,000 UK Subsidiary : Cash deficit of £ 3,000,000 What are the cash requirements if:

a. Decentralized cash management is adopted? b. Centralized cash management is adopted? (Exchange rates: SFr 1.5/$, S$ 1.75/$, $1.60/£).

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138. A Swiss multinational has subsidies in Switzerland, UK and Singapore. The following cash flows are involved among the subsidiaries and Headquarters.

From To Amount Swiss subsidiary US parent SFr 290,000Swiss subsidiary UK subsidiary SFr 29,000UK subsidiary Swiss subsidiary £ 24,390UK subsidiary US parent £ 54,878German subsidiary Swiss subsidiary S$ 504,000German subsidiary UK subsidiary S$ 134,400US parent Singapore subsidiary $ 120,000

The exchange rates are currently: £ 1 = $ 1.64 $ 1 = S$ 1.68 $ 1 = SFr 1.45 Explain how the company can use centralized cash management. 139. A Swiss MNC has three subsidiaries in the Singapore, Germany and India. The Treasurer has

tabulated the various cash flows taking place among the parent company and the subsidiaries. • German subsidiary pays S$ 1,000,000 to the Singapore subsidiary. • German subsidiary pays SFr 1,000,000 to the parent company. • Singapore subsidiary pays ∈500,000 to the German subsidiary. • Singapore subsidiary pays SFr 2,000,000 to the parent company. • Indian subsidiary receives SFr 1,000,000 from the parent company. • Indian subsidiary pays Rs.35,000,000 to the parent company. • Parent company pays ∈500,000 to the German subsidiary.

Assuming that the following exchange rates are being quoted, explain how the company can use centralized cash management to its advantage.

Exchange rates: S$ 1.50/$, SFr 1.50 /∈ , Rs.35/SFr. 140. A German subsidiary of an US based MNC has to mobilize working capital for the next

12 months. It has the following options: Loan from German bank : @6% Loan from US parent : @5% Loan from Swiss bank : @2% Banks in Germany charge an additional 0.5% towards loan servicing. Loans from outside

Germany attract withholding tax of 10% on interest paid. If the interest rates given above are market determined, examine which loan is the most attractive.

141. A multinational company based in Germany has its subsidiaries in UK, Singapore, Hongkong and Japan. The cash position of these subsidiaries for the month of February 2003 is as follows:

UK. Cash surplus of £1 million Singapore Cash deficit of S$1 million Honkkong Cash deficit of HK$2 million Japan Cash surplus of JPY 50 million The current exchange rates are given below: Euro/£ 1.5025 S$/Euro 1.8910 Euro/HK$ 0.1190 JPY/Euro 130 You are required to determine the cash requirement if the MNC adopts: i. Centralized cash management, and ii. Decentralized cash management.

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142. A multinational white goods company based in US has its subsidiaries in UK, France, Japan and Australia. The following are the cash flows occurred during December 2001 among the subsidiaries and the parent company:

From To Amount UK subsidiary France subsidiary £500,000 France subsidiary Australia subsidiary Euro 600,000 Japan subsidiary France subsidiary Yen 50 million Australia subsidiary US Parent AUD 750,000 Australia subsidiary Japan subsidiary AUD 400,000 Japan subsidiary UK subsidiary Yen 10 million Japan subsidiary US Parent Yen 80 million UK subsidiary US Parent £ 650,000 France subsidiary US Parent Euro 500,000

The current exchange rates are given below: $/Euro 0.8815 Yen/$ 123.42 $/£ 1.4226 AUD/$ 1.9153 If the centralized cash management is followed by the company, then you are required to

arrive at the net cash flows of the subsidiaries and US Parent in US $ terms. 143. A multinational company has surplus fund of £400,000 in UK for 90 days. The company is

planning to invest the fund for 90 days. The company is considering to invest the fund in 90-day deposit in banks or invest in CDs for 90 days. The interest rate offered by a British bank on 90-day deposit is 5.5%. The interest rate on CD is 9%, and the minimum size of investment is £ 500,000 and in multiples of £ 500,000. The overdraft charges applicable to the company is 14%.

You are required to: a. Find out the break-even size of investment in CD and suggest the bank whether to

invest in CD or not. b. Compare the gain/loss if the company have decided to invest in a CD against the

investment in bank deposits.

Part II: Solutions SECTION I: INTERNATIONAL FINANCE The Foreign Exchange Market 1. In this case, swap points are given in descending order. Hence, we have to subtract the swap

points from the spot rates to arrive at the outright forward rates. This will ensure that the spread widens (by subtracting the larger number from the bid rate and the smaller number from the offer rate) as the time horizon increases.

Three-month forward bid rate = 0.7940 – 0.0025 = 0.7915

Three-month forward offer rate = 0.8007 – 0.0020 = 0.7987

Six-month forward bid rate = 0.7940 – 0.0030 = 0.7910

Six-month forward offer rate = 0.8007 – 0.0025 =0.7982 2. The first rule we apply is that when the swap points are in ascending order we add to the

spot rate and when they are in descending order, we subtract from the spot rate in order to arrive at the forward rate. This is to increase the spread.

∈ /$ Three-month forward: Bid : 0.7940 + 0.0025 = 0.7965 Offer : 0.8007 + 0.0035 = 0.8042 $/£ Three-month forward: Bid : 1.8215 – 0.0035 = 1.8180 Offer : 1.8240 – 0.0025 = 1.8215 To calculate the ∈ /£ forward bid and offer rates, we start with basic principle, that we have

to sell low and buy high as the spread will always work against us. In order to arrive at the three-month ∈ /£ rate, we have to use the ∈ /$ and ∈ /£ rates arrived

at above. (∈ /£)bid = (∈ /$)bid x ($/£)bid = 0.7965 x 1.8180 = 1.4481 (∈ /£)ask = (∈ /$)ask x ($/£)ask = 0.8042 x 1.8215 = 1.4648 Thus, the forward quote will be ∈ /£ : 1.4481/1.4648. 3. The bank has to buy euros from its customer. It will have to cover its exposure by selling

euros. Its quote will hence be based on the rate at which it can sell euros to obtain Rupees. In this case, the outright Rs./$ forward rates have to be obtained by adding swap points to

the spot rates. In the case of ∈ /$, the swap points have to be subtracted from the spot rates to obtain the outright forward bid rates.

Rs./$ : One-month forward : Bid : 45.30 + 0.15 = 45.45

Offer : 45.45 + 0.25 = 45.70

Rs./$ : Two-month forward : Bid : 45.30 + 0.20 = 45.50

Offer : 45.45 + 0.30 = 45.75

∈ /$ : One-month forward : Bid : 0.7940 – 0.0015 = 0.7925

One-month forward : Offer : 0.8007 – 0.0010 = 0.7997

∈ /$ : Two-month forward : Bid : 0.7940 – 0.0020 = 0.7920

Two-month forward : Offer : 0.8007 – 0.0015 = 0.7992 Since, the delivery can be made any time during the second-month, the bank will base its

quotation on the more adverse of the rates prevailing at the beginning or end of the second-month.

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Rs./∈ forward rates can be obtained as follows: One-month forward:

(Rs./∈ )bid = (Rs./$)bid x ($/∈ )bid = (Rs./$)bid x 1/(∈ /$)ask = 145.450.7997

× = 56.83

(Rs./∈ )ask = (Rs./$)ask x ($/∈ )ask = (Rs./$)ask x 1/(∈ /$)bid = 145.700.7925

× = 57.66.

Two-month forward:

(Rs./∈ )bid = (Rs./$)bid x 1/(∈ /$)ask = 145.500.7992

× = 56.93

(Rs./∈ )ask = (Rs./$)ask x 1/(∈ /$)bid = 145.750.7920

× = 57.76

One-month forward = 56.83/57.66 Two-month forward = 56.93/57.76 This is a case of option forward. Since, the bank has to buy euros, and the currency (euro) is

at premium, the bank will add on the minimum possible premium to the spot rate. Therefore, it will base its rate on more adverse of the rates prevailing at the beginning or end of the second-month.

Hence, the bank will quote a rate of Rs.56.83/∈ . To this it will add its margin (say 1%). Thus, it will quote (56.83) (1 – 0.01) = Rs. 56.26/∈ .

4. Since, the bank has to deliver SKr to the customer, it would have to cover itself by buying SKr in the spot market.

The bank will first sell Rupees to obtain $. It will have to sell Rs.45.45 to get $1 (and not 45.30) as the spread will work against it.

When it sells $1, it will get SKr 7.2480 (and not 7.2486 for the same reason mentioned above).

Thus, the bank has to sell Rs.45.45 to obtain SKr 7.2480. Hence, the exchange rate at which the bank does the cover transaction is 45.45/7.2480 = Rs.6.27/SKr

So, loss for the bank = (6.27 – 6.25) (1,000,000) = Rs.20,000. 5. We first determine the outright forward rates. In this case, since the swap points are in

descending order, we have to subtract from the spot rates to obtain the outright forward rates. One-month forward : 45.15/45.35 Two-month forward : 45.10/45.30 Since, the delivery can take place any time during the second-month, the bank will base its

quote on the more adverse of the one-month and two-month forward rates, as the bank has to buy $, and the currency is at discount. When the customer sells $ to obtain Rupees, the most adverse rate the bank will quote for him is Rs.45.10/$.

Subtracting a margin of 0.5%, the rate quoted by the bank will be (45.10)(1 – 0.005) = Rs. /$. 6. We first calculate the outright forward rates. In the case of Rs./$, since the swap points are

in ascending order, we work out the outright forward rates by adding the swap points. In the case of ∈ /$ rates, since the swap points are in descending order, we subtract the swap points. The outright forward rates are given below:

3-m forward : (∈ /$)bid = 0.7940 – 0.0030 = 0.7910 (∈ /$)ask = 0.8007 – 0.0029 = 0.7978 (Rs./$)bid = 45.30 + 0.15 = 45.45 (Rs./$)ask = 45.45 + 0.25 = 45.70

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6-m forward : (∈ /$)bid = 0.7940 – 0.0059 = 0.7881

(∈ /$)ask = 0.8007 – 0.0058 = 0.7949

(Rs./$)bid = 45.30 + 0.20 = 45.50

(Rs./$)ask = 45.45 + 0.30 = 45.75

As the bank has to sell ∈ to the customer it will cover itself by buying ∈ . The bank will first sell rupees to obtain $ and then sell $ to obtain ∈ .

The rates which the bank will use as the basis for quoting will be the more adverse of the rates prevailing at the beginning and end of the sixth month.

Consider the Rs./$ rates. In this case, as the bank is selling Rupees to obtain $, the more adverse rates are those at the end of the sixth month. So, the rate applicable is Rs.45.75 = $1.

When it sells $ to obtain euros, the most adverse rate is ∈0.7881/$ again at the end of the sixth month.

So, the bank has to sell Rs.46.75 to obtain ∈0.7881. The exchange rate applicable will be 46.75/0.7881 = Rs.59.32/∈ . Adding a margin of 0.5%, the bank will quote a rate of (59.32) (1 + 0.005) = Rs.59.62/∈ .

7. The bank has to sell ∈200,000 to the customer. So, it would have covered itself by buying ∈200,000 forward. On 1/4/04, the bank will take delivery and sell ∈200,000 in the spot market at a rate of 45.5/0.7940 = Rs.57.30/∈ .

It will then buy ∈ forward at 46.00/0.7945 = Rs.57.89/∈

So, the cash flow on account of this transaction, ignoring interest. = (200,000) (57.30 – 57.05) = Rs.50,000

The bank will hence pay Rs.50,000 to the customer on extension.

8. Suppose the company borrows 100$ for six months.

Repayment after six months = 100 (1 + 0.0375/2) = $101.875.

To repay this loan, the company has to buy forward (101.875) (45.75) = Rs.4,660.78

Suppose the company borrows Rupees and converts into dollars.

In this case, the company has to sell forward to get rupees needed to generate $100

= (100) (45.50) = Rs.4,550

Repayment of loan after 6 months = (4,550) 0.06512

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.4,697.875

So, it is cheaper to borrow in $ rather than in rupees.

Suppose the company borrows Rs.100 for 3-months and rolls over the loan at the rate of interest prevailing after 3 months, for another 3-months. To make the company indifferent between three-month and six-month borrowing, we equate the repayment involved in the two cases.

100(1 + 0.07/4) (1 + i/4) = 100 (1 + 0.065/2)

or i = 5.89%

Suppose the company borrows $100 for 3 months and rolls over the loan at the rate of interest prevailing after 3 months at the then prevailing rate of interest for another 3 months. To make the company indifferent between three-month and six-month borrowing, we equate the repayments involved in the two cases.

100(1 + 0.0375/2) = 100 (1 + 0.04/4) (1 + i/4)

or i = 3.47%.

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9. Expected spot rate after three months = (0.2)(45.00) + (0.3)(45.50) + (0.3)(46.00)+ (0.2)(46.50) = Rs.45.75/$ So, the spot rate can range from (45.75) (1– 0.05) to (45.75) (1 + 0.05) or 43.46 to 48.04. Thus, the value of the Rupee outflow to settle the payable can range from (100m x 43.46 =)

Rs.4,346 million to (100m x 48.04 =) Rs.4,804 million. Variance of exchange rates = 0.2(45.00 – 45.75)2 + 0.3(45.50 – 45.75)2 + 0.3(46.00 – 45.75)2 + 0.2(46.50 – 45.75)2 = 0.1125 + 0.01875 + 0.01875 + 0.1125 = 0.2625. Standard deviation = Rs.0.512/$ This exposes the firm to foreign exchange risk. On the other hand, by opting for the

forward contract, the rupee outflow is a certain Rs.(46) (100) = Rs.4,550 million. This is also marginally more than the Rs.4,575 million arrived at by using the expected spot rates. Hence, it is very much preferable to use a forward contract.

10. TT selling rate = 57.05 (1 + 0.00125) = Rs.57.12/∈

TT buying rate = 57.05 (1 – 0.00150) = Rs.56.96/∈ .

11. Bank has to purchase ∈1,000,000 (Rs./∈ ) spot = 56.52/56.76 (Rs./∈ ) 2-m forward = 56.63/57.00 (Rs./∈ ) 3-m forward = 56.72/57.31

The bank is purchasing euro and the currency is at premium. Therefore, the bank will add minimum possible premium to the spot rate. Thus, the bank will quote the more adverse rate of ∈ applicable to the beginning of the option period.

The bank will quote Rs.56.63/∈ . The bank would deduct the margin and give its quote as 56.63 (1– 0.0025) = Rs.56.49/∈ .

12. Cross rates for $/£:

($/£)bid = ($/Rs.)bid x (Rs./£)bid = ask

1(Rs./$)

x (Rs./£)bid = 1 82.70 1.819645.45

× =

($/£)ask = ($/Rs.)ask x (Rs./£)ask = bid

1(Rs./$)

x (Rs./£)ask = 82.96 1.831345.30

= .

Cross rates for $/Euro:

($/Euro)bid = ($/Rs.)bid x (Rs./Euro )bid = ask

1(Rs./$)

x (Rs./Euro)bid = 57.00 1.254145.45

=

($/Euro)ask = ($/Rs.)ask x (Rs./Euro)ask = bid

1(Rs./$)

x (Rs./Euro)ask = 57.05 1.259445.30

= .

13. a. $/C$ = 0.7623 ⇒ C$/$ = 1/0.7623 = 1.3119.

b. A$ 1.2895US$

= (given)

US$ 1 0.7755.A$ 1.2895

⇒ = =

c. £/∈ = 0.6877 (given)

⇒ ∈ /£ = 10.6877

= 1.4541.

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d. C$/£ = 2.4025

⇒ £/C$ = 12.4025

= 0.4162.

e. SFr/A$ = 0.9662

⇒ A$/SFr = 10.9662

= 1.0350.

f. ∈ /SFr = 0.6373

⇒ SFr/∈ = 10.6373

= 1.5691.

14. a. The early cancelation of contracts to sell is made at the bank’s forward buying rate on the day of cancelation. The difference between the two is paid (collected) to (from) the customer.

Rs. Rate of the original contract = 45.50 Rate for cancelation = Rs.44.60 + Rs.0.15 = 45.75 Difference between the two = 0.25 Amount to be paid by the customer = Rs.0.25 x 1,000,000 = Rs.2,50,000.

b. To meet the forward purchase from Beta Trading Company the bank assumes that it entered into a forward contract at Rs.57.05 to sell Euro 1,000,000. The cancelation of this contract has to be met through a purchase of Euro from the spot market at Rs.57.40. The difference, Rs.0.35 per Euro, will be collected from the customer.

The amount to be collected = Rs.0.35 x 1,000,000 = Rs.3,50,000.

c. If the cancelation is requested for on the last day of the contract, the bank will still receive dollars from the other contract it booked to cover itself, sells the dollars spot and collects (or pays) the difference from (to) the customer.

15. NBI entered into an agreement to purchase ¥10 million in 3-month forward at 42.79. The bank covers the transaction with a contract to sell the ¥ in the interbank market 3-month forward.

On early delivery date the bank buys ¥ from the customer at the agreed upon forward rate of 42.79, and sells the same in the spot market at 43.00. Due to early delivery, there is additional cash flow to the bank on 29/8/2003 to the extent of difference between the spot sell and forward purchase contract rate i.e. Rs.(43.00 – 42.79) = Rs.0.21. Since, this additional cash flow is with bank for 84 days, i.e., till the original contract date, NBI will pay interest on this amount at its deposit rate (Fedai Rule) (10%).

Interest amount to be paid to the customer = 0.21100

x 10,000,000 x84 x 0.10365

= Rs.483.29

(Assuming deposit rate to be 10%)

The bank will do a swap by selling the ¥ in the spot market on the day of early delivery and buying forward. In this process the bank would square off the forward contract it had entered to cover itself for the original contract. That is, it sells spot at 43.00 and buys forward at 43.47. The difference between these two i.e. Rs.0.47, the bank will recover from the customer. The swap loss can be recovered by NBI at the time of early delivery or on the day of original contract due date.

Therefore, the net amount to be collected from the customer is Rs.(47,000 – 483.29) i.e. Rs.46,516.71.

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16. (Rs./∈ ) Spot = 45.30 45.45/0.8007 0.7940

= 56.58/57.24.

(Rs./∈ ) 1-m forward = 45.55 45.75/0.7930 0.7920

= 57.44/57.77.

(Rs./∈ ) 2-m forward = 45.70 45.95/0.7915 0.7900

= 57.74/58.16.

The bank is buying euro and euro is at premium. Therefore, the bank quotes the adverse of all the rates. Here, it will quote Rs.57.44/∈ . Therefore, rupees realized by SDL will be 57.44x1 million = Rs.57.44 million.

17. The bank must have sold Euro 100,000 for delivering to the customer on October 21, 2003. When the customer requests for extension, the bank has to sell Euros at the spot rate and book a fresh forward contract. The customer enjoys the loss/benefit on selling Euros in the spot market.

On October 21, 2003: Gain on selling Euros in the spot market is Rs.(57.20 – 57.00) 100,000 = Rs.20,000 On November 21, 2003: Cash outflow on account of Euro bought @57.45 in the forward market = Rs.57,45,000 Net cash outflow = Rs.57,25,000

18. i. The customer has to sell Euro to the bank. Hence, the relevant rate is Rs./Euro bid rate. To calculate the gain or loss in the transaction, we have to compare the notional rupee inflow on November 28, 2003 with the actual rupee inflow on December 02, 2003.

Notional rupee inflow on November 28, 2002.

Rs./Euro bid rate = (Rs./$)bid x ($/£ )bid x (£/Euro)bid

= (Rs./$)bid x ($/£)bid x ask

1(Euro / £)

= 146.00 1.83001.4512

× × = 58.00

Effective rate offered by the bank = 58.00 x (1 – 0.00125) = 57.927 Say Rs.57.93

Actual rupee/Euro bid rate on December 02, 2002

Rs./Euro bid rate = 145.95 1.83071.4530

× × = 57.89

Effective rate offered by the bank = 57.89 x (1 – 0.00125) Rs.57.82

Loss to the customer = 3,00,000 (57.93–57.89) = Rs.12,000.

ii. Actual rupee inflow to the exporter = 3,00,000 x 57.89 = Rs.17.367 million.

Exchange Rate Determination 19. Today, £1 and $ 1.8313 can both buy the same basket of goods if we apply PPP. The same basket of goods will have the following price after three years. In UK, (1) (1.0210) (1.0215) (1.0225) = £ 1.0664 In US, (1.8313) (1.016) (1.0165) (1.017) =$1.9235 Applying PPP, £ 1.0664 = $1.9235

1 £ = 1.9235 $1.80371.0664

=

Hence, the expected spot rate after three years is $1.8037/£.

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20. Applying PPP, we can state that ∈0.7940 and $1 can buy the same basket of goods today. Let inflation rate in USA be i. After three months, the price of the basket will be as follows: In Germany, (0.7940) (0.013/4) = ∈0.7966 In USA, (1) (1 + i/4) = $(1 + i/4) The expected spot rate after three months is then (0.7966)/(1 + i/4). But, the expected spot rate is nothing but the forward rate. So, we can write 0.7945 = (0.7966) / (1+ i/4) or i = 0.01057 = 1.057%. Hence, the inflation rate in USA is expected to be 1.057%.

21. At time, t = 0, outflows = (500,000) (57) = Rs.2,85,00,000. The expected spot rates at the end of each year can be calculated as given below. We can also make a reasonable assumption that the conversion into rupees and repatriation occurs at the end of each year.

Year Expected Spot Rate (Rs./∈ )

1 (57.00)(1.0540)/(1.013) = 59.31

2 (59.31)(1.0525)/(1.014) = 61.56

3 (61.56)(1.0500)/(1.0145) = 63.71

4 (63.71)(1.0495)/(1.015) = 65.88

5 (65.88)(1.048)/(1.016) = 67.95

The Indian Company is interested in cash flows in rupee terms. Hence, we have to calculate the after tax cash flows in rupee terms applying the spot rates calculated for each year.

Year Rupee Cash Flows (millions)

0 –28.50

1 + (59.31) (.10) = + 5.931

2 + (61.56) (.10) = + 6.156

3 + (63.71) (.10) = + 6.371

4 + (65.88) (.10) = + 6.588

5 + (67.95) (.15) = + 10.193

To calculate IRR we have to equate the present value of all cash flows taken together to 0.

Thus, we get 2 3

5.931 6.156 6.37128.5 + (1+r) (1+r) (1+r)

− + + 4 5

6.588 10.193(1+r) (1+r)

+ + = 0

By trial and error, we find that r is around 7.32%.

22. We use the principle of Purchasing Power Parity.

One year from now, the expected spot rate is (45)(1.054)/(1.016) = Rs.48.68/$

Spot rate today = Rs.45.00/$ = $0.0222/Re.

Expected spot rate after one year = Rs.48.68/$ = $ 0.0205/Re.

Depreciation of the Re. = 0.0222 0.02050.0222

− x 100 = 7.66%

Appreciation of the dollar = 48.68 4646− = 5.83%.

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23.

Year

Exchange rate based on PPP

Adjustment required for real appreciation

Exchange rate

(1) (2) (3) (4)

1 (36.36)(1.054)(1.005) (2) x (1.05) 38.13

2 (36.36)(1.054)2/(1.005)2 (2) x (1.05)2 44.09

3 (36.36)(1.054)3/(1.005)3 (2) x (1.05)3 48.55

24. We first calculate the expected exchange rates at the end of year 1, 2, 3. At the end of year 1, Exchange rate = (45) (1.054)/(1.016)x(1.05) = 49.02

At the end of year 2, Exchange rate = (45) (1.054)2 /(1.016)2 x (1.05)2 = 53.39

At the end of year 3, Exchange rate = (45) (1.054)3/(1.016)3x (1.05)3 = 58.15

The cash inflows and outflows in terms of rupees can now be tabulated below.

Year Cash flow (Rs. million)

0 + (2) (45) = + 90.00

1 – (1) (49.02) = – 49.02

2 – (1) (53.39) = – 53.39

3 – (1) (58.15) = – 58.15

To calculate cost of funds, we have to determine IRR. Let us say IRR = r

Then, 90 = 49.021+ r

+ 253.39(1+r)

+ 358.15(1+r)

⇒ r = 34.6%

So, the cost of funds is approximately 34.6%.

25. Spot rates : ∈0.7940/$; Rs.45.30/$

The cross rate is 45.30/0.7940 = Rs.57.05

We assume that Purchasing Power Parity holds good. Hence, expected spot rates at the end of each year, for 5 years, can be calculated using the given trend inflation rates. Let us assume that the company needs $1,000,000. Then, it has to choose between borrowing $1,000,000 and ∈0.7940 million. On each repayment date, we have to work out the total repayment consisting of interest and principal and apply the expected spot rate to determine the rupee outflow. We can then calculate the effective rate of interest by equating the present value of the cash outflows with the cash inflow.

$ loan

Time Interest ($) Principal ($) Total ($) Exchange Rate (Rs./$)

Rupee Outflow (Rs.)

0 – –1,000,000 – 45.30 –45,300,000 1 50,000 200,000 250,000 46.99 +11,747,500 2 40,000 200,000 240,000 48.57 +11,656,800 3 30,000 200,000 230,000 50.38 +11,587,400 4 20,000 200,000 220,000 52.27 +11,499,400 5 10,000 200,000 210,000 54.22 +11,386,200

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119

To arrive at the effective rate of interest r, we equate

45,300,000= 2

11,747,500 11,656,800(1 r) (1 r)

+ ++ + 3 4 5

11,587, 400 11,499,400 11,386, 200+(1 r) (1 r) (1 r)

++ + +

⇒ r = 8.83%. ∈ loan

Time Interest (∈ ) Principal (∈ ) Total (∈ ) Exchange Rate (Rs./∈ )

Rupee Outflow (Rs.)

0 – –794000* – 57.05 – 45297700 1 15880 158800 174680 59.36 10369005 2 12704 158800 171504 61.76 10592087 3 9528 158800 168328 64.26 10816757 4 6352 158800 165152 66.86 11042063 5 3176 158800 161976 69.56 11267051

*Note: The figures are rounded off to nearest decimal. To arrive at the effective rate of interest, we equate the following:

2

10369005 1059208745297700 = (1+r) (1+r)

+ + 3 4 5

10816757 11042063 11267051(1+r) (1+r) (1+r)

+ +

⇒ r = 8.45% It is better to avail ∈ loan as the effective cost of funds is less. 26. In this case, since transaction costs are nil, the problem is fairly straight forward. We

assume, of course, that interest parity holds good. $1 will fetch returns of $ (1) (1 + 0.05/4) = $1.0125 after 3 months. $1 is equivalent to Yen 105.87 based on the spot rate given. Yen 105.87 will fetch returns of Yen (105.87) (1 + 1.01375/4) = Yen 106.23 after 3 months. Hence, applying interest parity, we get: 6-month forward rate = 106.23/1.0125 = Yen 104.92/$ If we invest $1 for 6 months, we would get returns of $ (1) (1 + 1.0525/2) = $1.02625 $1 is equivalent to Yen 105.87 Yen 105.87 will give a return of Yen (105.87) (1 + 0.015/2) = Yen 109.38 after 6 months. Applying interest parity condition, we get:

6-month forward rate = 109.381.02625

= Yen 106.58/$.

27. The points to be noted here are that the more adverse rate will be applicable when we try to sell or buy a currency. Also, when investing, we will get a lower rate of interest and while borrowing we will have to pay a higher rate of interest.

Assume the customer borrows $100 for 6 months. At the end of six months, he has to repay the principal with interest. Borrowing is possible

only at the higher rate of 5%. So, interest payable = $100 (0.05/2) = $2.5 Total repayment after 6 months = $100 + 2.5 = $102.5 If he converts the dollars into rupees, he would obtain Rs.(100) (45) = Rs.4,500. Since the loan has to be repaid only after 6 months, he can invest Rs.4,500 in the money

markets. When he invests, he will only get the lower interest rate, i.e. 6%. Interest earned = Rs.4,500 (0.06/2) = Rs.135 Total returns after 6 months = Rs.4,500 + Rs.135 = Rs.4,635

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Since, the repayment has to be made in dollars, the customer has to convert the rupees into dollars.

∴Rs.4,635 will get us $ a

4,635F

If there is to be no arbitrage, repayment should be greater than or equal to the investment proceeds.

∴ $102.5 ≥ a

4,635F

Fa ≥ 4,635102.5

= 45.22

Now, assume that the customer borrows Rs.100 for 6 months. After 6 months, he will have to repay 100 (1 + 0.07/2) = Rs.103.5 as the interest rate

applicable for borrowing is 7%. The customer can convert Rs. into dollars and invest for 6 months as he has to repay the

loan only after 6 months. The interest earned on the $ will be 4.5%. After 6-m the $ investment will be =$(100/45.1) (1 + 0.045/2) = $ 2.27 Rupee Repayment = Rs.103.5 To avoid arbitrage Rs.103.5 ≥ 2.27 Fb

Fb ≥ 103.52.27

= 45.59

∴Limits for forward quotes are Fb ≤ Rs.45.59 Fa ≤ Rs.45.22 The effect of the bank’s commission is widespread. 28. The points to be noted here are that the more adverse rate will be applicable when we try to

sell or buy a currency. Also, when investing, we will get a lower rate of interest and while borrowing we will have to pay a higher rate of interest.

Assume a trader borrows Rs.100 for 3 months. After 3 months, he will have to repay 100 (1 + 0.07/4) = Rs.101.75 since, the higher rate of interest has to be paid while borrowing.

Since, the trader can utilize the borrowed funds for 3 months, he can convert into dollars, invest and then sell the proceeds forward.

On converting Rs.100, the trader will receive (100)/(45.30) = $2.208. He can invest the dollars so obtained at an interest rate of say, i. In that case, he can hope to

get $(2.208) (1 + i/4) after 3 months. When he converts into rupees, he will obtain (45.50) (2.208) (1 + i/4) = 100.46 (1 + i/4).

Arbitrage is ruled out when repayment exceeds the investment returns. This means, Rs.101.75 > (100.46) (1 + i/4) or i < 5.14%. Now assume that the trader borrows $100. Let the interest rate applicable be i. In this case,

he has to repay $(100) (1 + i/4) after 3 months. If he converts the dollars borrowed into rupees, invests for 3 months and sells forward the

rupee earnings for dollars, he would get (100) (45.10) (1 + 0.06/4)/(45.70) = $100.17 To prevent arbitrage, repayment must exceed borrowing and returns. This means that

(100) (1 + i/4) > 100.17 or i > 0.67%. Thus, the necessary condition for preventing possibilities of arbitrage is that the $

investment rate should be less than 5.14% and borrowing rate should be more than 0.67%. 29. (SKr/∈ ) Spot :

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121

(SKr/∈ )bid = (SKr/$)bid x 1/(∈ /$)ask = 17.24800.8007

× = 9.0521

(SKr/∈ )ask = (SKr/$)ask x 1/(∈ /$)bid = 17.24850.7940

× = 9.1291

∴ Spot (SKr/∈ ) = 9.0521/9.1291.

Now, suppose you borrow 100∈ for 3 months. Therefore, the amount to be repaid after

3-months = 0.03100 1 100.754

⎛ ⎞+ =∈⎜ ⎟⎝ ⎠

If 100∈ is converted into SKr at the spot rate and invested, then amount received

= 0.035100 9.0521 14

⎛ ⎞× × +⎜ ⎟⎝ ⎠

= SKr 913.13.

When converted at the forward rate no. of euros received = a

913.13F

∈ .

To avoid arbitrage, amount repaid > amount received

i.e. a

913.13100.75F

>

Fa > 9.0633.

Suppose you borrow SKr100 for 3 months.

∴ Amount to be repaid after 3-months = 0.04100 14

⎛ ⎞+⎜ ⎟⎝ ⎠

= SKr 101.00.

If SKr 100 is converted into ∈at the spot rate and invested then amount received

= 1 0.02100 1 11.008759.1291 4

⎛ ⎞× × + =∈⎜ ⎟⎝ ⎠

Amount of SKr received when converted at the forward rate = 11.00875 x Fb

To avoid arbitrage,

101.00 > 11.00875 x Fb

Fb > 9.1745.

30. Suppose the exporter borrows Rs.100 for three months. If the exporter converts Rupees into Sterlings, he would obtain 100/82.96 = £1.2054 Since repayment of loan has to be made only after three months, the exporter can invest

sterlings at a rate of 3.8%. In that case, the investment would yield (1.2054) (1 + 0.038/4) = £1.2169 after three months.

The loan repayment after three months would be (100) (1 + 0.07/4) = Rs.101.75 If interest parity holds good, £1.2169 = Rs.101.75 To leave no scope for arbitrage, £ 1.2169 Fb ≥ Rs.101.75 Fb ≤ Rs.83.61 Suppose the exporter borrows £100. If he converts into rupees, he can obtain (100) (82.90) = Rs.8,290. This amount can be

invested for three months to fetch (8,290) (1 + 0.06/4) = Rs.8,414.35 after three months. Loan repayment = (100) (1 + 0.04/4) = £101.

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To leave no scope for arbitrage.

£ 101 ≥ a

Rs.8,414.35F

Fa >Rs.8,414.35 Rs.83.31

101=

Therefore, the limits for the forward quotes are Fb ≤ Rs.83.61/£ Fa ≥ Rs.83.31/£. 31. Rs./$ Spot : 45.30/45.45 3-m forward : 45.70/45.95 Suppose we borrow Rs.100 for three months. We have to repay (100) (1 + 0.06/4) = Rs.101.5 after three months. If we convert into dollars, we could obtain $100/45.45 = $2.2002 This can be invested for three months to yield (2.2002) (1 + 0.04/4) = $2.2222 When sold in the forward market, $2.2222 will yield Rs.(2.2222 x 45.70) = Rs.101.55. Since Rs. inflow is more than the repayment, there is scope for arbitrage. Suppose we borrow $100 for three months. We would have to repay (100) (1 + 0.04/4) = $101.00 after three months. By selling $100, we can obtain (100) (45.30) = Rs.4,530. This can be invested at 6% to get (4,530) (1 + 0.06/4) = Rs.4,597.95 after three months. When sold in the forward market, Rs.4,597.95 will yield $ 4,597.95/45.95 = $100.06. Since $ inflow is less than the $ outflow, there is no scope for arbitrage. 32. Suppose the bank requires Rs.100.

If the bank borrows in Rupees, repayment after 6 months is Rs.100 0.0712

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.103.50.

If borrowed in $, repayment after 6 months is Rs. 100 0.0125x 1+ x 46.7545.30 2⎡ ⎤⎛ ⎞

⎜ ⎟⎢ ⎥⎝ ⎠⎣ ⎦ = Rs.103.84

It is cheaper to borrow in Rupees. 33. From the figures, we can see that the interest differential appears to be far more than the

forward premium on SFr. This suggests SFr borrowing.

Suppose the trader borrows SFr 1000 for three months.

Repayment after three months = (1000) (1 + 0.0200/4) = SFr 1005

If he converts SFr 1000 into $, he would obtain 1000/1.2465 = $802.246

This can be invested at 4.5% for three months to fetch (802.246) (1 + 0.045/4) = $811.271

The forward rates, obtained by subtracting swap points from the spot rates are: 1.2134/1.245

So, SFr obtained by selling forward $680.87 = (811.271) (1.2134) = SFr 984.40

As the SFr inflow is less than the SFr outflow, there is no scope for arbitrage. Therefore, the trade cannot take any advantage.

Suppose the trader borrows $100 for 3-months.

Amount to be repaid after 3 months = 0.05100 14

⎛ ⎞+⎜ ⎟⎝ ⎠

= $101.25.

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123

If $ are converted into SFr and invested, then SFr received

= 0.0175100 1.2459 1 SFr 125.1354

⎛ ⎞× × + =⎜ ⎟⎝ ⎠

.

When converted at the forward rate, dollars received = 125.135 $100.511.245

=

Since, the amount received is less than the amount repaid, there is no scope for arbitrage. Hence, trader cannot take advantage.

34. Suppose we borrow Rs.100.

By converting, we can obtain Can$ 100/34.53.

Investing this amount for six months will fetch us Can$ (100/34.53) (1 + i/2) where, i is the investment rate of interest on the Can$.

Since, we have to repay the rupee loan, we have to sell this amount forward at Rs.34.75

The loan repayment will be (100) (1 + 0.07/2) = 103.50

To prevent arbitrage, repayment should exceed the inflow.

So, (100/34.53) (1 + i/2) (34.75) ≤ 103.5

i ≤ 5.69%

Suppose we borrow Can$100. By converting, we can obtain Rs.(100) (34.50). Investing this amount for six months, we can get (100.00) (34.50) (1 + 0.07/2). If we convert this amount back to Can$, we would obtain Can$(100) (34.50) (1 + 0.07/2)/(34.90).

Meanwhile, we have to pay Can$ (100) (1 + i/2) to settle the loan liability where, i is the borrowing rate of interest.

To prevent arbitrage, repayment must exceed the investment returns.

or (100) (1 + i/2) ≥ (100) (34.50) (1 + 0.07/2)/34.90

or i ≥ 0.0463

or i ≥ 4.63%

Thus, we find that when i is between 4.63% and 5.69%, arbitrage is not possible.

35. Suppose we borrow Rs.100. Converting this amount into Can$ and investing for 6 months will fetch us Rs.(100/34.53)

(1 + i/2) (34.75) Loan repayment = 100 (1 + 0.08/2) To prevent arbitraging, repayment must exceed the returns obtained from the investment.

or (100) (1 + 0.08/2) ≥ (100/34.53) (1 + i/2) (34.75)

or 0.0668 ≥ i

or i ≤ 6.68%

Suppose we borrow Can$ 100.

Converting into rupees and investing for 6-months will fetch us Can$ (100) (1+0.06/2)/34.90

Loan repayment = Can$ 100 (1 + i/2)

To prevent arbitrage,

100 (1 + i/2) ≥ (100) (34.50) (1 + 0.06/2)/(34.90) i 3.64%≤

Thus, we find that when i is between 3.64% and 6.68%, riskless arbitraging profits are ruled out.

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36. Let F be the Forward rate (Rs./Can$). Suppose we borrow Rs.100 for 6 months. Conversion into Can$ and investment for 6 months yields. Rs.(100/34.53) (1 + 0.027/2) (Fb) Loan repayment = 100 (1 + 0.16/2) To prevent arbitrage, 100 (1 + 0.07/2) ≥ (100/34.53) (1 + 0.027/2) (Fb) or 35.26 ≥ Fb or Fb ≤ Rs.36.25/Can$. Assume we borrow Can$100 for 6 months. Conversion into Rs. and investment for 6

months will yield Can$ (100) (34.50) (1 + 0.06/2)/Fa Loan repayment = (100) (1 + 0.037/2) To prevent arbitrage, (100) (1 + 0.037/2) ≥ (100) (34.50) (1 + 0.06/2)/Fa or Fa ≥ 34.89 So, to prevent arbitrage, forward rates should be Fb ≤ Rs.36.25/C$ Fa ≥ Rs.34.89/C$. 37. We first work out the $/£ cross rates,

($/£)bid = (Rs./£)bid x 1/(Rs./$)ask = 182.90 x 45.75

= 1.8120

($/£)ask = (Rs./ £)ask x 1/(Rs./$)bid = 82.96 x 1/45.60 = 1.8193 ∴ Spot ($/£) = 1.8120/1.8193 ($/£) 6-m forward = 1.8083/1.8195. Suppose we borrow $100. To prevent arbitrage, the following condition must be satisfied 100 (1 + 0.05/2) ≥ [(100)/(1.8193)] (1+i/2) (1.8083) or 0.1394 ≥ i or i ≤ 6.25% Suppose we borrow £ 100. To prevent arbitrage, the following condition must be satisfied.

100 (1 + i/2) ≥ (100 1.8120)1.8195× x 0.041

2⎛ ⎞+⎜ ⎟⎝ ⎠

i ≥ 3.2% Thus, we find that the interest rate on £ should be between 3.2% and 6.25% to prevent

arbitrage. 38. Let S be the Spot rate.

Applying interest parity, (S) (1 0.07 / 4)(1 0.04 / 4)

++

= 46

S = Rs.45.66 Let F be the six-month forward rate now. Applying interest parity, F = (45.66) (1 + 0.065/2)/(1 + 0.035/2) = 46.33

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125

We use expectations theory to determine 3-month interest rates 6-months from now. Let i denote this interest rate.

Rupee interest rate is given by the equation

(1 + 0.065/2) (1 + i/4) = (1 + 0.06x 3/4)

i = 4.84%

$ interest rate is given by the equation

(1 + 0.035/2) (1 + i/4) = (1 + 0.03 x 3/4)

i = 1.97%

Applying interest parity, 3-month forward rate 6-months from now is given by (46.33) [(1 + 0.0484/4)/(1 + 0.0197/4)] = Rs.46.67/$.

39. Suppose the company borrows $100 for six months.

Repayment after six months = 100 (1 + 0.035/2) = $101.75

To repay this loan, the company has to sell forward (101.75) (46.30) = Rs.4,711.025

Suppose the company borrows rupees and converts into dollars.

In this case, rupees needed to generate $100 = (100) (46.00) = Rs.4,600

Repayment of loan after 6-months = (4,600) (1 + 0.065/2) = Rs.4,749.5

So, it is cheaper to borrow in $ rather than in rupees.

Suppose the company borrows Rs.100 for 3-months and rolls over the loan at the rate of interest prevailing after 3 months, for another 3-months. To make the company indifferent between three-month and six-month borrowing, we equate the repayment involved in the two cases.

100(1 + 0.07/4) (1 + i/4) = 100 (1 + 0.065/2)

or i = 5.90%

Suppose the company borrows $100 for 3-months and rolls over the loan at the rate of interest prevailing after 3-months at the then prevailing rate of interest for another 3-months. To make the company indifferent between three-month and six-month borrowing, we equate the repayments involved in the two cases.

100 (1 + 0.035/2) = 100 (1 + 0.04/4) (1 + i/4) or i = 2.97%.

40. Money Market Cover: The exporter has a receivables exposure. Hence, the exposure can be covered in the money

market by borrowing in $. The receivables can be used to pay-off the loan with interest while the dollars borrowed today can be converted into Swiss Francs and invested.

Amount which can be borrowed today = [1,000,000]/[1+ 0.04/4] = $990,100

This amount can be converted today into SFr (990,100) (1.2495) = SFr 12,33,566

If this is invested for three months the exporter can get

= (12,33,566) (1 + 0.017 x 3/12) = SFr 12,38,809.

Forward Cover: Instead of using money market cover, if the exporter had used the forward market, the

exporter would have received (1,000,000) (1.2460) = SFr 12,46,000 after three months.

In this case, the forward discount on SFr is more than the interest differential. Hence, using the forward market is more profitable.

41. Forward Cover: The exporter can sell $1,000,000 forward.

∈obtained = (1,000,000) (0.7956) = ∈7,95,600.

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Money Market Cover: The exporter can borrow today: $ (1,000,000)/(1 + 0.052/2) = $974,659 This can be converted into ∈ (974,659) (0.7940) = ∈773,879 If this amount is invested we will receive (773,879) (1 + 0.048/2) = ∈792,452 after

six months. So, the forward market cover generates more revenues in this case. 42. Forward Cover: If the importer uses the forward market, outflow after three months will be £(1,000,000)/1.4550 = £687,285. Money Market Cover: If the importer uses the money market he will have to invest today ∈ (1,000,000) / (1 + 0.04/4) = ∈990,100. This necessitates a borrowing in sterlings to the extent of (990,100)/(1.4542) = £680,855. After three months, the loan repayment inclusive of interest will be (680855) (1 + 0.035/4) = £686,812. In this case, the money market alternative is clearly better as it minimizes the outflow. 43. The company needs $100 million, for which it will have to pay Rs.(45) (100) = Rs.4,500 million in the spot market. Returns at the end of one year = (100) (1.50) = $150 million If it sells the receivables forward, Rupee inflow after one year = (150) (46) = Rs.6,900 million Rupee borrowing = Rs.4,500 million Repayment after one year = (1 + 0.15) = Rs.5,175 million So, profits = 6,900 – 5,175 = Rs.1,725 million. If the company accepts the offer from the bank, it will have to borrow

Rs.(44) (100) = Rs.4,400 million and pay to the bank. Interest on Rs.4,400 million = (0.15) (4,400) = Rs.660 million Interest payable to bank = (0.10) (100) = $10 million Return from investment = (0.50) (100) = $50 million So, net $ returns = $40 million If sold forward, this will yield (40) (46) = Rs.1,840 million So, profits = 1,840 – 660 = Rs.1,180 million. (Note that in this case, the company will swap $100 million for Rs.4,400 million and repay

the loan earlier availed.) 44. We first determine the net receivables/payables position on 1/4 and 30/4. 01.04.2004: Net Yen payables = 1800 – 360 = Yen 1440 million Net S$ payables = 30 – 6 = S$ 24 million 30.04.2004: Net Yen payables = 180 – 36 = Yen 144 million Net S$ payables = 3 – 0.6 = S$ 2.4 million Net Euro receivables = ∈30 million Alternative I a. Borrow Euros. b. Sell Euros to obtain Yen and S$. c. Invest Yen and S$ for one month.

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127

d. Sell Sterlings receivable forward for $. e. Use part of Sterlings receivable to repay borrowings. We need Yen 144 million after one month.

This is equivalent to 144/(1 + 0.02/12) = 143.76 million today.

So, total Yen requirement today = 1440 + 143.76 = Yen 1583.76 million.

We need DM 2.4 million after one month.

This is equivalent to 2.4/(1 + 0.03/12) = 2.39 million today.

So, total DM requirement today = 24 + 2.39 = DM26.39 million

£1 = Rs.60 = $ 60/35; $1 = Yen 120

⇒ £1 = Yen (120) (60)/35 = Yen 205.71

£1 = Rs.60; DM1 = Rs.22

⇒ £1 = DM60/22 = DM2.73

Thus, Yen 1583.76 million = 1583.76/205.71 = £7.70 million

and DM 26.39 million = 26.39/2.73 = £9.67 million

So, the exporter can borrow 7.70 + 9.67 = £17.37 million, convert into Yen 1583.76 million and DM 26.39 million. It can pay Yen 1440 million and DM 24 million to settle dues on 1/4/96. The balance amounts of Yen 143.76 million and DM 2.39 million can be invested for 30 days and used to settle the liabilities of Yen 144 million and DM 2.4 million on 30/4/96.

Since the exporter has borrowed £17.37 million, he would have to repay (17.37) (1 + 0.07/12) = £17.47 million after one month.

The exporter can sell 30 – 17.47 = £12.53 million forward for $ as he is in need of $ on 30/4/96.

Forward rate = 61/36 = $1.69/£

So, $ obtained on 30/4/96 = (12.53) (1.69) = $21.18 million.

Alternative II To pay Yen 1440 million on 1/4/96, we need 1440/205.71 = £7 million. To pay DM 24

million on 1/4/96, we need 24/2.73 = £8.79 million.

On the whole, we need £15.79 million (i.e. £7 + 8.79 million).

Hence, the exporter can borrow £15.79 million.

Repayment after one month = (15.79)(1 + 0.07/12) = £15.88 million

On 30.4.96 Yens needed = 144 million

DM needed = 2.4 million

We can cover this exposure using forward market.

Forward rates: £1 = Yen 61/36(115) = Yen 194.86

£1 = DM 61/21 = DM 2.90

On 30/4/96, Sterlings needed = (144/194.86) + (2.4/2.9) = 0.74 + 0.83 = £1.57 million

So, total value of Sterlings needed to repay borrowings and to settle payables on 30/4/96 = 15.88 + 1.57 = £17.45 million.

So, the exporter can sell forward 30 – 17.45 = £12.55 million.

Total $ obtained after 1 month will be 12.55 x 1.69 = $21.21 million.

Other alternatives are also possible by combining elements of Alternative I and Alternative II.

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45. Alternative I We cover using the forward market. If we sell NKr 5.52, we would obtain SFr in the spot market. If we sell SFr1, we would obtain HK$ 6.12 in the spot market. So, the spot rate is 6.12/5.52 = HK$ 1.1087/NKr or NKr 0.9020/HK$ Three-month forward rates (by subtracting swap points from the spot rate) are NKr/SFr : 5.39/5.49 HK$/SFr : 6.04/6.24 If we sell NKr 5.49, we get SFr1. If we sell SFr1, we get HK$ 6.04. So, the forward rate is 6.04/5.49 = HK$ 1.1002/NKr or NKr 0.9089HK$ Outflow of NKr for purchase of HK$1 after three months = NKr 0.9089 Alternative II Borrow NKr at 13.00 + 0.50 = 13.50% Convert into HK$ spot and invest to obtain 13% (i.e. 13.5% – 0.5%) interest. To obtain HK$ 1 after three months we have to invest 1/(1 + 0.13/4) = HK$ 0.9685 today. To buy HK$ 0.9685 we have to sell NKr 0.9685/1.1087 = NKr 0.8736 today. Repayment of NKr loan after 90 days = (0.8736) (1 + 0.135/4) = NKr 0.9030

Hence, covering through the money market is preferable.

46. Various alternatives are possible. Some of them are considered below. i. The exporter can cover the exposure using the forward market. He can sell the

receivable at a rate of 1.53 NZ$/$. So, NZ$ received after 3 months = (1,000,000) (1.53) = NZ$ 1,530,000 ii. The exporter can borrow $, convert into NZ$, invest NZ$ and repay the $ loan with

his receivables. Value of receivable maturing after three months = $1,000,000 Borrowing rate of interest for 3 months = (0.0630) (3/12) = 0.01575

So, the exporter can borrow 1,000,000(1 0.01575)+

= $984,494

He can sell $984,494 in the spot market to receive (984,494) (1.55) = NZ$1,525,966. If the exporter invests for three months, he can obtain

NZ$ 1,525,966 (1 + 0.0515 x 312

) = NZ$ 1,545,613.

iii. The exporter can try to lead the dollar receivables by offering a discount of 6.30/4 = 1.575%.

So, dollars obtained today = (1,000,000) (1 – 0.01575) = $984,250 This can be sold in the spot market to earn (984,250) (1.55) = NZ$ 1,525,588 By investing, the exporter would obtain (1,525,588) (1 + 0.0515 x 3/12) after 3 months = NZ$ 1,545,230 So, the second option of covering by use of the money market seems to be the best

strategy. 47. Alternative I Settle the payable immediately Amount to be paid = S$ 100,000 = Rs.(100,000) (22.30) = Rs.2,230,000

Interest payable for 3 months = 0.184

(2,230,000) = Rs.1,00,350

So, total payment at the end of 3 months = Rs.23,30,350.

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129

Alternative II Settle the payable after three months. Amount to be paid = S$ 100,000 Interest for three months = (0.06/4) (100,000) = S$ 1500 Total repayment = S$ 101,500 at the end of three months. To obtain S$ 101,500, the company will have to sell forward Rs.(101,500) (23.20) = Rs.23,54,800. Since rupee outflow is lesser in the first case, it is advisable to settle the payable

immediately. The reason for this is that the 3-month forward premium on the S$ exceeds the interest differential.

48. Alternative I The company borrows in Germany. Borrowing rate = 8% Service charges = 0.5% Cost of funds = 8.5% In this case, there is no foreign exchange risk and hence no need for any cover transaction.

Also, no withholding tax is applicable. Alternative II The company borrows from the US parent. Cost of funds in USA = 7%. Suppose the company borrows $100 from USA. Interest payable = (100) (0.07) = $7 Tax payable = (7) (0.10) = 0.7 So, effective rate of interest received by US parent = (7 – 0.7)/100 = 6.3% This means that the parent will have to charge a higher interest rate to compensate for the

loss in interest income due to taxes. Let i be the interest rate charged. Then 100i – (0.10) (100i) = 7 ⇒ 100 (0.9i) = 7

⇒ i = 7(100) (0.9)

= 7.78%

Since forward rates are not given, we can assume that interest differentials reflect the forward premia.

So, premium on dollar = 1.08/1.07 – 1 = 0.93% Hence, total cost of funds = 0.93 + 7.78 = 8.71% Alternative III The company borrows from Switzerland. Nominal interest rate payable = 3% Effective interest rate because of withholding tax = 3/(1 – 0.1) = 3.33% Forward premium on Swiss Franc = 1.08/1.03 – 1 = 4.85% So, net cost of funds = 3.33 + 4.85 = 8.18% Hence, the third alternative is the best. Students need to appreciate that when withholding tax on interest remitted abroad is

applicable, low interest rate currencies offer a tremendous advantage. In this case, because of the low interest rate, the additional tax liability in the case of SFr was only 0.33% as against 0.78% in the case of $. Further, this tax liability was lesser than the service charge of 0.5% payable in Germany. As a result, even though interest parity was assumed to exist, the regulatory and transaction costs decided which was the most cost effective currency for borrowing.

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49. Several alternatives are available. Some of them are considered below. As a first step, we net the receivables and payables wherever possible. On 01.04.03, the

company receives ∈400,000 and pays ∈500,000. So, its net payable is ∈100,000. There is no other opportunity to net.

We next work out the Yen requirements to meet its liabilities on 01.04.03.

To pay ∈100,000 it needs (100,000) (128) = Yen 12,800,000

To remit A$1,000,000 it needs (1,000,000) 1281.71

= Yen 74,854,000

Total Yen requirements on 01.04.03 = Yen 87,654,000

The company will have to borrow this amount or use its surplus to settle this liability. In any case, it is reasonable to assume that the cost of funds will be 1%.

So, repayment of loan on 30/4 = (87,654,000) (1 + 0.01/12) = Yen 87,730,000 On 30.04.03, the company will need the following amounts to settle its liabilities. It can use

the forward market. To pay S$ 1,000,000, it will sell forward (1,000,000) (125/2.02) = Yen 61,880,000. To repay the Yen loan taken earlier it will need Yen 87,730,000. On the other hand, it will realize the following from its receivable by selling in the

forward market.

SFr 20,000,000 = Yen (125/1.48) (20,000,000) = 1689,1,90,000

$1,000,000 = Yen (125/1.27) (1,000,000) = Yen 98,430,000

Net Yen receivable on 30.04.03 = 1689,190,000 + 98,430,000 – 61,880,000 – 87,730,000

= Yen 1638,010,000

As an alternative, the company can use the money market to cover all the payables. S$ 1,000,000 on 30/4 is equivalent to S$ 1,000,000/ (1 + 0.03/12) = S$ 997,506 on 1/4

To obtain S$ 997,506, it has to sell on the spot market.

Yen (997,506) (128/2.00) = Yen 63,840,384.

So total borrowing on 1/4 = 87,654,000 + 63,840,384

= 151,500,000

Repayment on 30/4 = (151,500,000) (1 + 0.01/12)

= 151,627,000.

So, yens available on 30/4 = 1689,190,000 + 98,430,000 – 151,627,000

= 1636,000,000. The first alternative is hence marginally better. Essentially what we have tried to do in the problem is to convert all receivables and payables

denominated in non-yen currencies into yens so that all exposures have been fully covered. 50. Alternative I The company has to borrow SFr (1,000,000)/1.2 = SFr 833,333 to convert into NZ$

1,000,000 Inflows after one year = NZ$ (1,000,000) (1.20) = NZ$ 1,200,000 Interest on NZ$ loan = NZ$ (1,000,000) (0.04) = NZ$ 40,000 Interest on SFr loan = SFr (833,333) (0.025) = SFr 20,833 After paying off interest and principal, Net NZ$ inflow = 1,200,000 – 1,000,000 – 40,000 = NZ$ 160,000.

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131

This can be swapped at NZ$ 1.2/SFr to get 160,000/1.2 = SFr 133,333 Net returns = 133,333 – 20,833 = SFr 112,500

Return on investment = 112,500/833,333 x 100 = 13.50%

Alternative II The company has to borrow (1,000,000)/1.1915 = SFr 839,278 to convert into

NZ$ 1,000,000 in the spot market.

Inflows after one year = NZ$ 1,200,000

We work out the one-year forward rate by applying interest parity principle based on the six-month forward rate and interest rates given in problem.

One-year forward rate = (1.1915) [(1 + 0.03)/(1 + 0.02)] = NZ$ 1.2032/SFr Repayment of SFr loan = (839,278) (1.025) = SFr 860,260 Returns from Newzealand = SFr (1,200,000/1.2032) = SFr 997,340 Net profit = SFr (997,340 – 860,260) = SFr 137,080 Return on investment = (137,080/839,278) (100) = 16.33%

So, the second alternative is clearly better. 51. Alternative I Invoice in £ Since the receivables will mature in 2 months, they can be sold forward at Rs.61.00 per £.

If we ignore bank charges, Realization = (61) x (4) = Rs.244/garment Cost = Rs.200/garment Net Profit = Rs.44/garment

We have another option, i.e. use the money market cover. We would get £4 per garment two months from now.

So, we can borrow £4/[1 + (0.08/6)] today being the present value of the receivables.

If we sell in the spot market, we get 4/(1 + [0.08/6]) (59.00) = Rs.232.89

We can invest this for two months to get (232.89) (1 + (0.15/6)) = Rs.238.71 after three months.

We can use the receivables in £ which will mature after 2 months to pay-off the loan availed of earlier.

So, Profit = 238.71 – 200 = Rs.38.71 per garment.

Clearly, the forward cover is more attractive.

Alternative II Invoice in $

The invoice price will be obviously

$(4) (59)/35.50 per garment = $6.65 per garment

If we use forward market the receivable can be sold at Rs.36.00/$.

So, realization = (36) x (6.65) = Rs.239.30

Cost = Rs.200/garment Net Profit = Rs.39.30/garment

We have another option, i.e. use the money market cover.

We can borrow $6.65/(1 + [0.05/6]) = $6.60

If we sell in the spot market, we get (6.60) (35.50) = Rs.234.30

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We can invest this for two months to get (234.30) (1 + (0.15/6)) = Rs.240.16 So, Profit = 240.16 – 200 = Rs.40.16 per garment Comparing all the alternatives we find that it makes sense to invoice in £ and cover the

exposure using a forward contract. 52.

Spot rate (Rs./S$) 24.8750 25.1250

3 months forward 25.6195 25.9805

3 months Rupee interest rate (%) 17.5000 18.5000

3 months S$ interest rate (%) 5.7500 6.2500

Option I Borrow Rs.25.1250 at 18.5%. Convert Rs.25.1250 into S$ at the spot rate.

Invest S$ @5.75% for 3 months. After three months, we get 1 + 14

x 0.0575 = S$ 1.014375

Amount required to repay the Rupee borrowing: 25.1250 (1 + x 0.185) = 26.287 Convert S$ invested in forward market to get Rs.25.6195 x 1.014375 = 25.9877 The amount received from buying S$ spot, investing in 3 months S$ deposit and selling S$

forward is less than the amount required to repay the Rupee borrowing. Therefore, there is no possibility of arbitrage.

Option II Borrow S$ at 6.25% for 3 months. Sell the S$ in the spot market at Rs.24.8750.

Amount to be paid on S$ borrowing after three months = [1 + 14

x (0.0625)] = S$ 1.015625

Invest Rs.24.875 at 17.5% for three months to get 24.875 [1 + 0.25(0.175)] = Rs.25.9633

Buy S$ forward to get = 25,963325,9805

= S$0.9993

As the S$ that can be purchased with the Rupee inflows are lower than the S$ liability, there is no scope for arbitrage.

53. Investment in US$ will yield for every dollar invested, (1 + 0.25 x 0.04) = $1.01

Investment made in Can$ will yield 1.31191.3135

x [1 + 0.25 (0.0155)] = $1.002652

That is, buy Can$ 1.3114 for each US$, invest the Can$ at 1.55% and sell the proceeds forward for US$.

Since, the return from investment made in Canada is less than that made in US, it is advisable to invest in US$.

If borrowing is made in US$, one has to repay for each dollar. (1 + 0.25 x 0.045) = $1.01125 Borrowing in Canadian dollar implies that for each US$ required, 1.3125 Can$ need to be

borrowed. Liability in Can$ = 1.3125 (1 + 0.25 x 0.105) = Can$ 1.3470 If converted to $, at forward rate it becomes 1.3470/1.3129 = $1.0260

As the outflow in $ is lower, if borrowing is made in Can$, the firm should borrow in Can$.

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54. Rs./$ Spot: 45.30/35 1-m forward: 20/28 2-m forward: 35/40 Forward contract for two months booked at Rs.45.65 spot rate on the day of cancelation is

the same as the one-month forward rate on the day of booking the contract. That is, 45.50/45.63.

The bank sells to the customer one-month forward and buys one-month forward to cover itself. The one-month forward rate on the day of cancelation is 45.65/45.75

Bank recovers from the customer (45.75 – 45.65) x 1,000,000 = Rs.1,00,000. Cash flow to the customer = 45.50 x 1,000,000 – 1,00,000 = Rs.45,400,000.

55. a. Nominal return to the investor

= $2,000,000 x 45.30 x 6,2205,333x 45.90 x 2,000,000

– 1 = 15.11%

b. Real rate of exchange = 45.80 x1.021.04

= 44.92.

Real appreciation of Rs. = 45.30 44.9245.30− = 0.84%

c. Exchange rate if relative purchasing power parity holds good = 45.30 x1.041.02

= 46.19

d. Real return to Indian investor in sensex = 62205333

x 11.04

– 1 = 12.15%.

56. 1 month: Borrow Rs. and invest in Euro: Borrow Rs.49.65 Buy one Euro

Invest one Euro to get 0.035112

⎛ ⎞+⎜ ⎟⎝ ⎠

= 1.0029 Euro

Sell 1.0029 Euro forward to get (Rs.1.0029 x 49.20) = Rs.49.34

Amount repayable = Rs.49.65 0.095112

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.50.04

As the amount received is lower than the amount repayable, no arbitrage is possible. Borrow Euro and invest in Rs.: Borrow one Euro Sell the Euro to get Rs.49.50

Invest Rs.49.50 to get Rs.49.50 0.09112

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.49.87

Sell Rs.49.87 forward to get 49.8749.40

⎛ ⎞⎜ ⎟⎝ ⎠

= 1.0095 Euro.

Repay 0.0375112

⎛ ⎞+⎜ ⎟⎝ ⎠

Euro = 1.0031 Euro.

As the Euro received is more than the Euro required to repay the loan, there is an opportunity for arbitrage.

Profit for every Euro borrowed : 1.0095 – 1.0031 = 0.0064 Euro

Number of Euro to be borrowed for a profit of Euro 25,000 = 25,0000.0064

= Euro 3,906,250

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2 months:

Borrow Rs. and invest in Euro Borrow Rs.49.65 Buy one Euro

Invest the Euro to get 0.0416

⎛ ⎞+⎜ ⎟⎝ ⎠

Euro = 1.0067 Euro.

Sell 1.0067 Euro forward to get Rs.(1.0067 x 49.00) = Rs.49.33

Repay Rs.49.65 x 0.102516

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.50.50

As the amount received is less than the amount to be repaid, there is no arbitrage opportunity.

Borrow Euro and Invest in Rupees Borrow one Euro

Sell spot for Rs.49.50

Invest Rs.49.50 to get Rs.49.50 0.097516

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.50.30

Repay 0.042516

⎛ ⎞+⎜ ⎟⎝ ⎠

Euro = 1.0071 Euro

Sell Rs.50.30 forward to get 50.3049.25

⎛ ⎞⎜ ⎟⎝ ⎠

Euro = 1.0213 Euro

As the amount received in Euro is higher than the Euro payable, there is possibility of arbitrage profit.

The profit = (1.0213 – 1.0071) Euro = 0.0142 Euro

Number of Euros to be borrowed for making profit of Euro 25,000 = 25,0000.0142

= Euro 1,760,563

57. a. Rs./$ spot rate now = 44.50

Real exchange rate now = 44.50 x 1.021.04

= 43.64

Real depreciation of the rupee =

1 143.64 39.50

139.50

− = 9.49%

b. Nominal appreciation of the dollar = 44.50 39.5039.50− = 0.1266 or 12.66%.

58. a. i. (Rs./Euro)bid rate: Borrow Rs.43.20 for one month and buy one Euro.

Repay Rs.43.20 (1 + 0.11512

) = Rs.43.61

Invest one Euro for one month to get Euro(1 + 0.0312

) = Euro1.0025

1.0025 x (Rs./Euro)bid ≤ 43.61

(Rs./Euro)bid ≤ 43.50

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135

ii. (Rs./Euro)ask rate: Borrow 1 Euro for one month and sell it to get Rs.43.16

Repay Euro(1 + 0.032512

) = Euro1.0027

Invest Rs.43.16 for one month to get Rs.43.16(1 + 0.11/12) = Rs.43.56 1.0027 x (Rs./Euro)ask ≥ 43.56 (Rs./Euro)ask ≥ 43.44 b. The synthetic quotes to prevent three-point arbitrage: (Rs./Euro)bid = (Rs./£)bid x (£/Euro)bid = (Rs./£)bid x 1/(Euro/£)ask = 70.40 x 1/1.5575 = 45.20 (Rs./Euro)ask = (Rs./£)ask x (£/Euro)ask = (Rs./£)ask x 1/(Euro/£)bid = 70.50 x 1/1.5565 = 45.29 ∴ Synthetic rate: Rs./Euro 45.20/45.29 Since Actual (Rs./Euro)ask < Synthetic (Rs./Euro)bid, there is scope for triangular

currency arbitrage. 59. a. Spot Rs./$ = 43.5700/43.5750 6-m forward = 44.2700/44.2850 Funds required for Epsi Ltd. is Rs.10 million

If Epsi Ltd. borrow Rs. repayment after 6-months is Rs.10 0.1212

⎛ ⎞+⎜ ⎟⎝ ⎠

m = Rs.10.6m

If Epsi Ltd. borrow in US$

US$ to be borrowed = Rs.10m43.57

= US$ 229515.72

Repayment of US$ borrowing after 6-months = US$ 229515.72 0.0712

⎡ ⎤+⎢ ⎥⎣ ⎦

= US$ 237548.77 This liability can be covered through forward buying of $. ∴Rupee outlay for the $ borrowing is 237548.77 x 44.2850 = Rs.10,519,847.28 Therefore, Epsi Ltd. should go for $ borrowing since the rupee outlay is less than the

outlay for rupee borrowing. b. If Epsi Ltd. is to be indifferent between borrowing 6-m and borrowing 3-m and

rolling it for another 3-m, the cost of borrowing should be count in both the cases. That is

0.065 F 0.071 1 14 4 2

⎡ ⎤ ⎡ ⎤ ⎡ ⎤+ + = +⎢ ⎥ ⎢ ⎥ ⎢ ⎥⎣ ⎦ ⎣ ⎦ ⎣ ⎦

1.01625 F14

⎡ ⎤+⎢ ⎥⎣ ⎦ = 1.035

F14

+ = 1.0351.01625

F4

= (1.01845 – 1)

F = 7.38% (where F is the 3-m interest on $ months hence) ∴ If the 3-months interest on $ is 7.38% p.a. 3-months hence, Epsi Ltd. will be

indifferent between the two options.

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60. Investment in India

Size of portfolio US$ 10 million

Investment in India = (10 x 43.50) = Rs.435 million

Return earned = (0.20 x 435) = Rs.87 million

Post-tax return = 87 x (1 – 0.20) = Rs.69.6 million

Total amount to be repratriated = 435 + 69.6 = Rs.504.6 million

If PPP holds good, exchange rate after one year is

(Rs./$)bid = 43.50 x 1.041.02

= 44.35

(Rs./$)ask = 43.60 x 1.041.02

= 44.45

∴Rs./$ spot after one year = 44.35/44.45

∴FII can repatriate Rs.504.6 million by buying USD.

∴USD = 504.644.45

= $11,352,081

∴Rate of return in $ term is 13.52%.

When invested in Malaysia

$ 10-m = M$ 38.00

Return earned = (0.16 x 38) = M$ 6.08 m

Post-tax return = 6.08 x 0.90

= M$ 5.472

M$ to be repatriated = 38 + 5.472 = M$ 43.472

Expected (M$/$)bid after one year = 3.80 x 1.061.02

= 3.95

(M$/$)ask = 3.82 x 1.061.02

= 3.97

Repatriated $ = 43.4723.97

= $10.95 million

Rate of return earned is 9.5%.

As the expected return earned in India is higher, so FII should invest in India.

61. a. Rupee

Current spot Rs./$ = 44.00; $/Rs. = 144.00

Spot one year ago : 42.00; $/Rs. = 142.00

Depreciation of rupee is 1 1 1/44 42 42⎡ ⎤−⎢ ⎥⎣ ⎦

= – 0.0455

Nominal depreciation is 4.55%.

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137

Italian Lira Current spot Lit/$ = 2140; $/Lit = 1/2140 Spot one year ago = 2050; $/Lit = 1/2050

Depreciation = 1 1 1/2140 2050 2050⎡ ⎤−⎢ ⎥⎣ ⎦

= – 0.0421

Nominal depreciation is 4.21%. b. Rupee

Real exchange rate = 44 x 1.0151.05

= Rs.42.53/$

Real depreciation of rupee = 1 1 1/42.53 42 42⎡ ⎤−⎢ ⎥⎣ ⎦

= – 1.25%

Lira

Real exchange rate = 2140 x 1.0151.05

= Lit 2108.83/$

Real depreciation of Lira = 1 1 1/2108.83 2050 2050⎡ ⎤−⎢ ⎥⎣ ⎦

= –2.79%

c. Piaco has become more competitive since real depreciation of Italian Lira is more than the Indian Rupee against the US$.

62. The customer gets Rs.59.00 laks if he relies on the rate of Rs.5.90/SKr quoted by the foreign bank. Since he approached his banker (a private sector bank), the rate quoted by him is to-* be compared with the rate quoted by the foreign bank.

The dealer of the private sector bank can cover his position either in Bahrain or Singapore market.

i. If the dealer covers the transaction through Singapore market: Sell 1 million Swedish Kroner at the rate of 7.9662 and acquire dollars and sell the

dollars in Mumbai at the buying rate of Rs.47.20/$. The exchange margin of 0.005 paise is to be deducted.

(Rs./ SKr)bid = (Rs./$)bid x ($/SKr)bid = (Rs./$)bid x ask

1(Skr/$)

= 47.20 x 17.9662

= 5.925 Less exchange = 0.005 margin 5.92 per SKr ii. If the dealer covers the transaction, through Bahrain market: Sell 1 million Swedish Kroner at the rate of 12.7539 and acquire pounds and sell the

pounds in Mumbai at the buying rate of 75.95. The exchange margin of 0.005 paise is to be deducted.

(Rs./ SKr)bid = (Rs./£) bid x (£/SKr) bid = (Rs./£) bid x ask

1(Skr / £)

= 75.95 x 112.7539

= 5.955 Less: Exchange = 0.005 margin 5.95 per SKr

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138

The dealer must cover the transaction through Bahrain market as the rate per SKr is Rs.5.955.

The customer gains 5 paise per SKr if he chooses to rely on the rate given by his banker. The gain is 0.05 x 10,00,000 = Rs.50,000.

63. Forward cover: If the importer uses the forward market, outflow of pounds after 3 months will be at the forward rate of 1.4245/£

Outflow of pounds = 5000001.4245

= £ 351000

Money market cover: If the importer uses money market cover, he will have to invest today.

Euro 5000000.0261

4⎛ ⎞+⎜ ⎟⎝ ⎠

= Euro 496770.99 = Say 496771

This necessitates a borrowing of pounds 4967711.4200

= £ 349838.73

After 3 months, the loan repayment with interest at 3.20%

= 349838.73 x 0.03214

⎛ ⎞+⎜ ⎟⎝ ⎠

= £ 352637.44

Forward cover is better as it minimizes the outflow.

64. a. Swastik Industries obtained a forward contract from Citibank Mumbai at the rate as mentioned below.

Interbank spot selling rate per dollar 47.20

Add: Premium for two months 0.20

47.40

Add: Exchange margin of 0.2% 0.09

47.49

Less: Amount of 4 paise as Citibank agreed to give a better rate 0.04

47.45/$

When the customer requests for the extension of the contract earlier to the due date the bank will cancel the original contract at the relevant forward rate and rebook at the current rate.

Computation of forward buying rate

Interbank spot buying rate 47.02

Add: Premium 0.07

47.09

Less: Exchange margin of 0.20% 0.09

47.00

Sold to the company at 47.45 Purchased from the company at 47.00 Extension charges payable by the company per dollar 0.45

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139

b. Forward contract is rebooked on May 01, 03 at the rate as mentioned below:

Interbank spot selling rate per dollar 47.03 Add: Premium for two months 0.14 47.17 Add: Exchange margin of 0.2% 0.09 47.26 Less: Amount of 4 paise as Citibank agreed to give a better rate 0.04 Rs.47.22

Net cash outflow of the company

$1 million x 47.22 Rs.47.22 mio Extension charges 1,000,000 x 0.45 Rs.0.45 mio Net cash outflow Rs.47.67 mio

65. Alternative I - Investing in Euro (home currency) Returns after 3 months = 2000000 = 2016000

Returns for 3 months = 2016000 – 2000000 = Euro 16000

Alternative II investing in dollars

$/ Euro spot 1.1410/12

MNC buys dollars at 1.1410/ Euro

Inflow of dollars for Euro 2 mio = 2000000 x 1.1410 = $2282000

Invest dollars at 2.6% for 3 months.

Returns in dollars = 2282000 0.02614

⎛ ⎞+⎜ ⎟⎝ ⎠

= $2296833

MNC will sell $, to buy Euro at forward rate of $1.1393/Euro = 22968331.1393

= Euro 2016003.69 = say Euro 2016004

Returns for three months = 2016004 – 2000000 = Euro 16004

Alternative III invest in pounds.

£/Euro spot bid rate = (£/$)bid x ($ /Euro)bid = 0.6217 x 1.1410 = £0.7094/Euro

£/Euro ask rate = 0.6219 x 1.1412 = £ 0.7097 /Euro

£/Euro 3 months forward bid rate = 0.6230 x 1.1390 = £ 0.7096/Euro

£/Euro 3 months forward ask rate = 0.6233 x 1.1393 = £ 0.7101/Euro

MNC buys pounds at 0.7094/Euro

Inflow of pounds for Euro 2 mio = 2000000 x 0.7094 = £ 1418800

Invest pounds at 3% for 3 months 1418800 x 0.0314

⎛ ⎞+⎜ ⎟⎝ ⎠

= £1429441

After 3 months MNC will sell pounds to buy Euro at forward rate of £ 0.7101/Euro

Inflow of Euro = 14294410.7101

= Euro 2013013.66 = Say Euro 2013014

Return for 3 months = 2013014 – 2000000 = 13014

If MNC invests in dollars the inflow is more by just Euro 4 only.

Hence it is advisable to invest in home currency of Euro, to avoid transaction costs.

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140

66. a. To ensure no arbitrage opportunity, the following conditions must be satisfied.

i. (Rs./$)bid x ($/Euro)bid x (Euro/Rs)bid ≤ 1

or (Rs./$)bid x ($/Euro)bid x ask

1(Rs./Euro)

≤ 1

or 47.40 x 1.1410 x 153.90

= 1.0034 ≥ 1

ii. (Rs./$)ask x ($/Euro)ask x (Euro/Rs)ask ≥ 1

or (Rs./$)ask x ($/Euro)ask x ask

1(Rs./Euro)

≥ 1

or 47.45 x 1.1415 x 153.85

= 1.0058 ≥ 1

There is scope for arbitrage in (i) as 1.0034 > 1.

b. If we have Rs.1 million we can buy Euro, sell Euro for dollars and sell dollars to buy rupees.

Euro inflow = 100000053.90

= Euro 18552.88

$ inflow = 18552.88 x 1.1410 = $21168.84

Rupee inflow = 21168.84 x 47.40 = Rs.1003403

Arbitrage profit = 1003403 – 1000000 = Rs.3,403

c. (Rs./Euro)bid ≤ (Rs./$)ask x ($/Euro)ask

≤ 47.45 x 1.1415

≤ 54.16

(Rs./Euro)ask ≥ (Rs./$)bid x ($/Euro)bid

≥ 47.40 x 1.1410

≥ 54.08.

67. We have to calculate $/£ cross rates

($/£)bid rate = ($/Rs.)bid x (Rs./£)bid = 147.82

x 77.45 = 1.6196

($/£)ask rate = 147.80

x 77.47 = 1.6207

Spot rate $/£ : 1.6196/1.6207 Similarly, the 6 months forward quote for $/£

$/£bid = 148.55

x 78.07 = 1.6080

$/£ask = 148.53

x 78.09 = 1.6091

6 months forward rate $/£: 1.6080/91 Suppose we borrow $100

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141

To prevent arbitrage the following condition must be satisfied

bidi1+0.026 100100 x 1+ (1.6080)2 1.6207 2

⎛ ⎞⎛ ⎞ ⎡ ⎤≥⎜ ⎟ ⎜ ⎟⎢ ⎥⎝ ⎠ ⎣ ⎦ ⎝ ⎠ or 0.042 ≥ i or ≤ ibid ≤ 4.2% Suppose we borrow £ 100 To prevent arbitrage, the following condition must be satisfied

100 x aski 100 x 1.6196 0.0241+ x 1+2 1.6091 2

⎛ ⎞ ⎛ ⎞≥ ⎜ ⎟⎜ ⎟ ⎝ ⎠⎝ ⎠

or, iask ≥ 3.72%.

68. a. Bank has to quote (Rs./Euro)bid rate. Transit period and usance period involve 80 days. In Rs./$ quote, dollar is at premium. Therefore the transit period and usance period will be rounded off to the lower month and 2 months forward bid rate is to be taken.

Rs./$ spot bid rate = Rs.47.80

Add: Premium for 2 months = Rs. 0.21

Rs.48.01

Less: Exchange margin at 0.1% = 0.048

Bid rate for dollar 47.9620 In $/Euro quote. Euro is at premium. The transit and usance period will be rounded

off to lower month.

$/Euro spot bid rate 1.0775

Add: Premium for 2 month 0.0040

1.0815 Rs./Euro bid rate = (Rs./$)bid x ($/Euro)bid = 47.9620 x 1.0815 = Rs.51.87/Euro b. Cash inflow to the exporter

Amount of the Export bill = Euro 200000

Less: 50% to be kept in EEFC a/c = Euro 100000

Euro 100000 Amount paid to the exporter at the rate of Rs.51.87 per Euro = 51.87 x 100000 = 5187000

c. Interest amount recovered = 5187000 x 8 x 8036500

= Rs.90,950

69. We have to calculate the expected exchange rates at the end of years 1, 2 and 3 considering the appreciation of rupee against dollar in the first year and depreciation in the second and third year.

At the end of year 1, exchange rate = 47.70(1 0.01)+

= 47.701.01

= Rs.47.23

At the end of year 2, exchange rate = 47.23(1 0.02)−

= Rs.48.19

At the end of year 3, exchange rate = 47.23(1 0.03)−

= Rs.49.68

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The cash flows in terms of rupees for the loan and repayment are:

Year Cash flow Rupees

0 +300000 x 47.70 + 1,43,10,000

1 –112000 x 47.23 –52,89,760

2 –112000 x 48.19 –53,97,280

3 –112000 x 49.68 –55,64,160 To calculate the cost of funds, we have to determine IRR. Let us say IRR = r

1,43,10,000 = 2 3

5289760 5397280 5564160+ +(1+r) (1+r) (1+r)

The cost of funds is approximately 6.58%. 70. The bank can arrange a loan by doing the following:

i. Borrow dollars ii. Do a dollar – SKr swap. That is, sell dollars against SKr and buy dollars 3 month

forward and

iii. Loan SKr to the MNC.

Bank borrows 508,4650

⎛ ⎞⎜ ⎟⎝ ⎠

= $5.90667million to buy SKr 50 million to loan to MNC.

At maturity it has to buyback the same amount of dollars at a rate of 8.4675. In addition to this, it has to pay interest on dollar loan, which it must recover from the customer at outright forward merchant rate of 8.4700. The amount of interest in $

is 50 0.036x8, 4650 4

⎛ ⎞⎜ ⎟⎝ ⎠

x = $0.05316

At 3-month forward rate interest amount = SKr 0.05316 x 8.47 = SKr 0.45027

The amount of SKr, the bank must recover from the MNC

= 508, 4650

[8,4675] + 0.45027= 50.01477 + 0.45027 = SKr 50.46504

Hence the break even rate of interest = 50, 4650450

⎡ ⎤⎢ ⎥⎣ ⎦

= 3.72%.

71 M/s. Gemini Hitech exports to USA and its sister concern M/s. Leo systems imports from Germany and the invoicing can be done any of the three currencies: $, Euro, £.

Also given, exports take place after 3 months and imports can be paid for after 6 months.

Spot rates:

Rs./$ : 48.20/22

Rs./Euro : 48.00/02

Rs./£ : 75.25/27

Annualized Premium:

$ : 4%

£ : 3%

Euro : 2%

Now, let us calculate the three month and six month forward rates for all the currencies.

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143

Three months forward rates (for exports):

Rs./ $ – 48.20 0.0414

⎛ ⎞+⎜ ⎟⎝ ⎠

= 48.68

Rs./Euro – 48.00 0.0214

⎛ ⎞+⎜ ⎟⎝ ⎠

= 48.24

Rs./£ – 75.25 0.0314

⎛ ⎞+⎜ ⎟⎝ ⎠

= 75.81

Six months forward rates (for imports):

Rs./$ – 48.22 0.0412

⎛ ⎞+⎜ ⎟⎝ ⎠

= 49.18

Rs./Euro – 48.02 0.0212

⎛ ⎞+⎜ ⎟⎝ ⎠

= 48.50

Rs./£ – 75.27 0.0312

⎛ ⎞+⎜ ⎟⎝ ⎠

= 76.40

Now, let us calculate the proceeds of exports and imports for all the currencies.

Imports takes place after six months

if invoiced in $, then proceeds = 40,00,00048,22

= 82953.12 x 49.18 = 40,79,635

If invoiced in Euro, then proceeds = 40,00,00048.02

= 83,298.63 x 48.50 = 40,39,984

If invoice in £, then proceeds = 40,00,00075.27

= 53,142.02 x 76.40 = 40,60,050

In imports, since cash outflow is lowest in Euro, M/s. Leo Systems is advised to invoice in this currency.

Exports takes place after three months

If invoiced in $, then proceeds = 1,00,00048.20

= 2,07,468.88 x 48.24 = 1,00,50,000

If invoiced in Euro, then proceeds = 1,00,00048

= 2,08,333.33 x 48.24 = 1,00,50,000

If invoice in £, then proceeds = 1,00,00075.25

= 1,32,890.37 x 75.81 = 1,00,74,419

In exports, as the cash inflow is higher in $,

M/s. Gemini Hitech is advised to invoice in $.

72. i. Outright forward export rates:

Rs.

October 48.31

November 48.54

December 48.81

January 2003 49.04

February 2003 49.25

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144

Outright forward import rates: Rs. October 48.34 November 48.57 December 48.84 January 2003 49.07 February 2003 49.28

ii. Exchange rate for export transaction: = 48.20 + 0.61 = 48.81 Exchange rate for import transaction: = 48.21 + 0.745 = 48.955

iii. Exchange rate quoted to the company on November 17, 2002 fixed delivery February 15, 2003 = 48.92 + 0.94 = 49.86

iv. Swap difference It is a buy sell swap

Bank buys from market Rs.48.85 Bank sells to market (48.85 + 0.27) Rs.49.12 Swap difference Rs. 0.27

The premium up to January 15, 2003 would be (premium up to December 2002 : 0.18 and for 15 days up to January 15, 2003 : Rs.0.09) Rs.0.27

This premium will be passed on to the customer.

v. Effective cost of the import transaction:

Rs. Total cash outflow for the Import transaction per dollar 48.955 Less: Swap gain 0.270 Effective cost 48.685

Interest on outlay of funds

Rs The notional buy rate 48.850 Contracted rate 48.955 Inflow of funds per dollar 0.1050

Bank at its discretion may pay interest on Rs.21,000 (2,00,000 x 0.1050) from December 05, 2002 to January 15, 2003 at 12%.

= 21,000 x 12 x 4136,500

= Rs.283.

73. Payable £ 1,00,000

Option 1: Pay now, by availing a cash discount of 1%

Amount payable is £ 99,000

Borrow at 12% for 3 months

Amount to be borrowed = 99,000 x 74.80 = 74,05,200

Rupee outflow after 3 months = 74,05,200 0.1214

⎛ ⎞+⎜ ⎟⎝ ⎠

= 76,27,356

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145

Option 2: Pay after 3 months

Payment in foreign currency = 1,00,000 x 0.0414

⎛ ⎞+⎜ ⎟⎝ ⎠

= £ 1,01,000

Obtain forward cover for £ 1,01,000 at the rate of Rs.75.20/£ Rupee outflow = 75,95,200. Option 2 is beneficial to the Indian importer as the rupee outflow is lower, by Rs.32,156. 74. a. The exchange rate quoted by the bank on 01.06.2002

Spot buying rate 46.50Add: Premium for 2 months only Since the exporter may deliver the Foreign currency on the first day of the option period

0.30

46.80

b. When a bank entered into a forward purchase contract with the customer, it would have covered its position by entering into a forward sale contract with the market for the same amount and for a matching period. If the customer requests for extension of the contract, earlier to the due date, it would be cancelled at the relevant forward rate. Bank has entered into a forward sale contract, to neutralize this, now bank will enter into a forward purchase contract with the market. And again rebook a forward contract for the customer.

Spot selling rate 46.95

Add: premium for 2 months 0.25

47.20

Bank buys Euro under original contract at 46.80

It sells under the cancellation at

Difference per Euro payable by company 47.20

Rs.0.40

Exchange difference for Euro 2,00,000 payable by company is 2,00,000 x 0.40 = Rs.80,000.

c. The exchange rate at which the bank booked the contract on 01.07.2002

Spot buying rate 46.90Add: Premium for 2 months 0.20 47.10

75. Forward market

If the exporter uses the forward market, inflow after 3 months will be =10,00,001,5772

= £ 634035.

Money market: If the exporter borrows Euros, converts in to pounds and invests for 3 months, the inflow

will be:

Amount of Euros to be borrowed 10,00,0000.051

4

=⎛ ⎞+⎜ ⎟⎝ ⎠

= Euro 987654.32.

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146

The loan will be closed with receivable of Euro 10,00,000. Convert Euro in to pounds at the spot rate.

= 987654.321.5780

= £ 625889.94.

Invest this amount for 3 months and the amount with interest after 3 months

= 625889.94 0.0614

⎛ ⎞+⎜ ⎟⎝ ⎠

= 635278.29

Money market cover is better as it maximizes the inflow.

76. i. To ensure no arbitrage opportunity, the following conditions should be satisfied.

a. (Rs./£)bid x (£/Euro)bid x (Euro/Rs.)bid ≤ 1

(Rs./£)bid (£/Euro)bid x ask

1 1(Rs./Euro)

≤

∴74.00 x 0.6338 x 147.90

= 0.9791

0.9791 < 1

∴No scope for arbitrage.

b. (Rs./£)ask x (£/Euro)ask x (Euro/Rs.)ask ≥ 1

or (Rs./£)ask (£/Euro)ask x ask

1(Rs./Euro)

≥ 1

∴ 74.05 x 0.6340 x 147.80

= 0.9822.

Since 0.9822 ≤ 1, there is a scope for arbitrage.

ii. If we have Rs.5,00,000, we can buy pounds in Mumbai, sell pounds for Euro in London and sell Euro to buy rupees in Mumbai.

£ inflow = 5,00,00074.05

= £ 6752.19

Sell £ in London to get Euro

Euro inflow = 6752.190.6340

= Euro 10,650.14

Sell Euro in Mumbai to get rupees

10650.14 x 47.80 = Rs.5,09,076.69

Say Rs.5,09,077.

Arbitrage profit = 5,09,077 – 5,00,000 = 9077.

iii. (Rs./Euro)bid ≤ (Rs./£)ask x (£/Euro)ask

≤ 74.05 x 0.6340

≤ 46.95

(Rs./Euro)ask ≥ Rs./£)bid x (£/Euro)bid

≥ 74.00 x 0.6338

≥ 46.90.

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147

77. Here, we have to compare the cash outflows on account of the payable between (i) notional cash outflow involved in the Rupee/Japanese yen forward cross rate, and (ii) actual cash outflow involved in rupees against purchase of dollars in spot market for sale/delivery against the Japanese yen forward purchase contract in order to calculate the amount of savings to the company on account of the above strategy.

INR/JPY 6 months forward cross rate i : 0.3788/0.3844 i. If the company buys JPY forward against rupees from the Mumbai bank, it has to

pay. = 50,000,000 x 0.3844 = Rs.1,92,20,000. ii. Amount of US dollars to be delivered on due date to purchase. JPY 50 million forward = 5,00,00,000/128.50 = $ 3,89,105.06. Rupee amount paid to purchase US dollars on the due date in the spot market in

Mumbai. = 3,89,105.06 x 49.20 = Rs.19,143,969. iii. The company could save = 19,220,000 – 19,143,969 = Rs.76,031. 78. Alternative I Invest in US dollars

Return after 3 months = 5,00,00 x 0.034

= $3,750.

Alternative II Invest in Euro after converting dollars into Euro at spot market Return after 3 months

= Euro 5,00,000 0.02510.9083 4

x ⎛ ⎞+⎜ ⎟⎝ ⎠

= Euro 553919.41.

The company has to sell Euro and buy $ at 3-months forward rate of 0.9044 = 553919.41 x 0.9044 $ 500,964.71 ∴Return after 3 months = $964.71 Alternative III Invest in pounds after converting dollars in to pounds at spot market Return after 3 months

= £ 5,00,000 0.04x 11, 4558 4

⎛ ⎞+⎜ ⎟⎝ ⎠

= £ 346,888.31

The company has to sell pounds and buy $ at 3 months forward rate of 1.4500 = 346,888.31x 1.4500 = $ 502,988.05 Return in $ = $2988.05 Considering all the three alternatives, it is better to invest in dollars at 3%. 79. Forward contract for 2 months:

Base rate 48.85 Add: Premiumfor 2 months 0.550 49.40

Spot rate on the date of cancellation = 49.20/30 which is one month forward rate on the day of booking the contract (since forward rates are the unbiased estimates of spot rates).

The bank sells to the customer one month forward to cover it self. The one month forward rate on the day of cancellation is Rs.49.40/50.

Bank recovers from the exporter (49.50 – 49.40) x 2,00,000 = Rs.20,000. Cash flow to the exporter =2,00,000 x 49.20 = Rs.98,40,000. Net cash flow to the exporter = 98,40,000 – 20,000 = Rs.98,20,000.

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148

80. Forward cover

If the importer uses the forward market, outflow in £ after 3 months will be: = 5,00,0001.5965

= £3,13,185.09 Money Market Cover If the importer uses the money market cover, he will borrow sterling convert into Euro at

spot and invest. He will have to invest today

Euro 5,00,0000.03104

⎛ ⎞+⎜ ⎟⎝ ⎠

= Euro 496277.92

This necessitates a borrowing in sterlings to the extent of 496277.921.5995

= £310270.66.

After 3 months the loan repayment inclusive of interest will be

310270.66 x 0.0414

⎛ ⎞+⎜ ⎟⎝ ⎠

= £3,13,373.37.

In this case the forward cover is better as it minimizes the outflow. 81. We have to work out the $/£ cross rates $/£bid rate = ($/Rs.)bid x (Rs./£)bid

= ask

1(Rs./$)

(Rs./£)bid

= 148.75

= 1.4523 $/£ask rate = ($/Rs.)ask x (Rs./£)ask

= bid

1(Rs./$)

x (Rs./£)ask

= 148.70

= 1.4548 ∴ $/£ cross rate = 1.4523/1.4548 Similarly we can work out the 6 months forward rate

72.40 72.5049.95 49.85

⎛ ⎞ ⎛ ⎞⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠

= 1.4494/1.4544.

Suppose we borrow $100 To prevent arbitrage the following condition must be satisfied

100 0.04 i1 [(100 /(1.4548)] 12 2

⎛ ⎞ ⎛ ⎞+ ≥ +⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠

(1.4494)

102 ≥ 99.6288 2 i2+⎛ ⎞

⎜ ⎟⎝ ⎠

In other words ibid ≥ 4.76%.

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149

Suppose we borrow £ 100 To prevent arbitrage the following condition must be satisfied

i 100 x 1.4523 0.035100 1 x 12 1.4544 2

⎛ ⎞ ⎛ ⎞+ ≥ +⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠

i100 1 101.60302

⎛ ⎞+ ≥⎜ ⎟⎝ ⎠

iask ≥ 3.21%. 82. i. (Rs./Euro)bid rate

Borrow Rs.42.42 for 1 month at 9% p.a. and buy 1 Euro

Repay with interest at 9% = 42.42 0.09112

⎛ ⎞+⎜ ⎟⎝ ⎠

= 42.74

Invest 1 Euro for 1 month to get = 0.03112

⎛ ⎞+⎜ ⎟⎝ ⎠

= 1.0025

To prevent covered interest arbitrage,

1.0025 x (Rs./Euro)bid ≤ 42.74

(Rs./Euro)bid ≤ 42.63.

(Rs./Euro)ask rate Borrow 1 Euro for 1 month at 3.36%p.a and sell it to get Rs.42.38

Repayment in Euro = 1 0.336112

⎛ ⎞+⎜ ⎟⎝ ⎠

= 1.0028

Invest Rs.42.38 at 8% = 42.38 0.08112

⎛ ⎞+⎜ ⎟⎝ ⎠

= 42.66.

To prevent covered interest arbitrage,

1.002 x (Rs./Euro)ask ≥ 42.66

(Rs./Euro)ask ≥ 42.54.

ii. The synthetic quotes to prevent 3 point arbitrage: (Rs./Euro)bid = (Rs./$)bid x ($/Euro)bid

= (Rs./$)bid x ask

1(Euro/$)

= 48.66 x 11.1495

= 42.33.

(Rs./Euro)ask = (Rs./$)ask x ($/Euro)ask

= (Rs./$)ask x bid

1(Euro/$)

= 48.86 x 1(1.1485)

= 42.54.

Synthetic rate: Rs./Euro = 42.33/54. Since the actual (Rs./Euro)ask which is 42.28 is less than synthetic (Rs./Euro)bid rate

of 42.33, there is scope for triangular currency arbitrage. Buy 1 Euro for Rs.42.28

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Convert Euro to $ to get 11.1495

= $0.8699

Sell $ to get 0.869 x 48.66 = Rs.42.33 Thus by investing Rs.42.28

We are making a gain of Rs.0.05.

83. Investment in India Size of the investment : £ 1 million

Investment in Rs. : 1 x 69.50 = Rs.69.50 million.

Return earned = 0.15 x 69.50 = Rs.10.425 million

Post-tax return = Rs.10.425 x (1– 0.15) = Rs.8.86125 million

Total amount to be repatriated = Rs.(69.50 + 8.86125) million = Rs.78.36125 million

If PPP holds good, exchange rate after 1 year is

(Rs./£)bid = 69.50 x 1.041.02

= 70.86

(Rs./£)ask = 69.70 x 1.041.02

= 71.07

Rs./£ after 1 year = 70.86/71.07

∴FII can repatriate Rs.78.36125 million by buying pounds at Rs.71.07 per pound

= 78.3612571.07

= £ 1.1026 million

∴ Return in £ = 1.10261.00

= 10.26%.

Investment in Hong Kong Investment in HK $ = 1 x 11.15 = HK $ 11.15 million

Return earned = 0.12 x 11.15 = HK $1.338 million

Post-tax return = 1.338 x 0.88 = HK $1.1774

HK$ to be repatriated = 11.15 + 1.1774 = HK$12.3274

Expected (HK$/£)bid after 1 year = 11.15 x 1.031.02

= 11.26.

(HK $/£)ask = 11.18 x 1.031.02

= 11.29.

FII can repatriate in pounds at the rate of HK$11.29/£ = 12.327411.29

= £1.09189

Return in £ = 1.09189 11

− = 9.19%.

As the expected return earned in India is higher, the FII should invest in India.

84. The bank must have bought C$ 5,00,000 in interbank market for delivering to the importer on 31.3.2002. When the importer requests for extension, the bank has to take the delivery of C$ from interbank market and sell the same at the spot rate and book a fresh forward contract at 30.68 for which bank will again cover it in the interbank market. The customer enjoys gain/incurs loss in the spot market.

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On 31.3.2002 Gain on selling C$ in the spot market = (30.54 – 30.34) x 5,00,000 = Rs.1,00,000

On 30.4.2002 Cash outflow on account of C$ bought at 30.68 in the forward market = 30.68 x 5,00,000

= 153,40,000 Less: Gain 1,00,000 Net cash outflow Rs.1,52,40,000

85. The bank can cater to customer’s loan requirement by doing the following: i. Borrow rupees for 6 months. ii. Do a rupee – AUD 6 months swap i.e., buy AUD spot against rupee and sell AUD 6

months forward. iii. Lend the AUD amount to the customer. As the bank has to buy AUD, so it has to pay Rs.25.00 for each AUD and a swap

margin of Rs.0.40/AUD, i.e., on the forward leg it will get Rs.25.35 per AUD. ∴ Amount to be borrowed in rupees = AUD 50 million x Rs.25/AUD = Rs.1,250 million

Amount of rupee to be repaid after 6 months = 1,250 0.08512

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.1,303.125 million. After 6 months banks should recover from the customer AUD amount equivalent to

Rs.1,303.125 million to be converted at exchange rate of Rs.25.35/AUD. ∴ Amount of AUD to be recovered from customer to break even

= 1303.12525.35

= AUD 51.4053 million

Hence, the break even rate of interest should be = 51.4053 50.0050.00

− x 2 = 5.62%.

86. a. Spot $/Î:0.8775/0.8777 3 months forward:0.8760/0.8767 Suppose we borrow $100 for 3 months. Convert it into Euro and invest for 3 months

and after 3 months convert Euro into $ at forward rate and repay the dollar loan.

$ loan to be repaid = 100 0.025014

⎛ ⎞+⎜ ⎟⎝ ⎠

= $ 100.625.

Euros received at spot = 100 x 10.8777

= Euro 113.93.

Euros received after 3 months = 113.93 0.03514

⎛ ⎞+⎜ ⎟⎝ ⎠

= 114.93.

Convert Euro into $ at 3 months forward bid rate to get = 114.93 x 0.8760 = $ 100.6787. Since the returns on investment in Euro are more to cover the repayment of

dollar loan with interest, there is scope for covered interest arbitrage. Now, if we borrow Euro 100 for 3 months, convert into $ at spot rate and invest

for 3 months and after 3 months convert $ into Euro at forward buying rate to repay the Euro loan with interest.

Euro loan to be repaid = 100 0.03714

⎛ ⎞+⎜ ⎟⎝ ⎠

= Euro 100.9375.

Dollars received at spot = 100 x 0.8775 = $87.75

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$ received after 3 months = 87.75 0.022514

⎛ ⎞+⎜ ⎟⎝ ⎠

= $88.24.

Convert $ into Euro at 3 months forward ask rate to get

= 88.24 x 10.8767

= Euro 100.65.

Since, the Euro loan to be repaid is more than the Euro proceeds from $ investment, there is no scope for covered interest arbitrage.

b. We have seen $ (100.6787 – 100.6250) = $ 0.0537 arbitrage profit can be earned by borrowing $100. So to make a profit of $1000, amount to be borrowed in $

= 1000.0537

x 1000 = $1,862,197.40.

87. a. Value of investment in rupee = 50 x 46.30 = Rs.2,315 million

Return from sensex = 3, 250 3,8003,800− = –14.47%

Value of investment in rupee on November 30, 2001 = 2,315 x (1 – 0.1447) = Rs.1,980.02 million

Value in $ on November 30, 2001 = 1,980.0248.05

= $ 41.2075 million

Nominal return to FII = 41.2075 5050

− = –17.59%.

b. Real return to FII = 1+ Nominal return1+ Inflation rate in US⎛ ⎞⎜ ⎟⎝ ⎠

– 1 = 1 0.17591 0.025−+

– 1 = –19.60%.

c. Initial investment = Rs.1,00,000 Return from investment = –14.47%

Real return to Indian investor = 1+Nominal return1+Inflation rate in India⎛ ⎞⎜ ⎟⎝ ⎠

– 1

= 1 0.14471 0.06−+

– 1 = –19.31%.

88. Laxmi traders obtained a forward cover for its receivable of US $5 million on June 30, for delivery in September.

a.

The forward rate to be quoted is Rs.47.05(+) 2 months premium 0.47Since the dollar is at premium 47.52

b. The exchange rate to be quoted on September ‘01 for delivery during November is Rs.47.95.

c. On September ‘01, the company approached for extension by another 3 months. The request of the company is considered by canceling at one month forward selling rate, that is Rs.47.80.

The amount of cash flow due to extension of the contract is as follows:

Bank buys dollars under original contract at Rs.47.52Bank sells under cancellation at Rs.47.80Difference payable by party is Rs.0.28

Amount of cash flow due to extension of the contract is 50,00,000 x 0.28 = Rs.14.00 lakh.

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d. The company approached for cancellation on November ‘01, which means early cancellation by one month. The contract would be cancelled at one month forward selling rate prevailing on the date of cancellation.

i.e., 47.99Add: Premium 0.18 48.17

e. The amount of cash flow due to cancellation of forward contract is as follows:

Rs.Bank buys under original contract at 47.95Bank sells on cancellation at 48.17Amount payable by customer is per $ 0.22

Total cash flow due to cancellation is 5,00,0000 x 0.22 = Rs.11.00 lakh. 89. Spot Rs./$ 47.15/47.30 3-m forward 47.70/47.90

Forward market cover: Rupee outflow after 3-month = 2,50,000 x 47.90 = Rs.119.75 lakh. Money market cover: As the company has to pay dollar 3 months hence, so it will borrow in rupees, convert into

dollar at spot and invest in dollar.

Dollar amount to be invested today = $250,0000.061

4+

= $ 246,305.42

∴Rupee amount to be borrowed today = $246,305.42 x 47.30 = Rs.116.50 lakh. ∴ Rupee outflow after 3 months = 116.50 = Rs.119.70 lakh. Availing cash discount Amount to be paid if cash discount is availed = $245,000 Rupee equivalent of $ 245,000 at the spot rate = 245,000 x 47.30 = Rs.115.89 lakh

∴Rupee outflow after 3 months = 115.89 0.0914

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.118.50 lakh

So it is better to avail cash discount as the outflow is minimum in this case. 90. As the bank has a receivable after 3 months, so it will convert the export proceeds into

rupee 3 months hence and exchange rate applicable will be 3 month forward bid rate. So we will find out 3 month forward bid rates for all currencies.

3 month forward bid rates:

Rs./$ 47.10 0.0614

⎛ ⎞+⎜ ⎟⎝ ⎠

= 47.81

Rs./Euro 43.15 0.0514

⎛ ⎞+⎜ ⎟⎝ ⎠

= 43.70

Rs./£ 68.65 0.0414

⎛ ⎞+⎜ ⎟⎝ ⎠

= 69.34

If invoiced in $, rupee proceeds = 1047.10

x 47.81 = Rs.10.1507 million

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If invoiced in euro, rupee proceeds = 1043.15

x 43.70 = Rs.10.1275 million

If invoiced in sterling, rupee proceeds = 1068.65

x 43.70 = Rs.10.1005 million

For payable the company has to pay in foreign currency i.e., it will buy foreign currency by giving rupee after 6 months. Hence we will calculate 6 month forward ask rates.

6 month forward ask rates:

Rs./$ 47.20 0.0614

⎛ ⎞+⎜ ⎟⎝ ⎠

= 48.62

Rs./Euro 43.20 0.0512

⎛ ⎞+⎜ ⎟⎝ ⎠

= 44.28

Rs./£ 68.75 0.0414

⎛ ⎞+⎜ ⎟⎝ ⎠

= 70.13

If invoiced in $, rupee outflow = 547.20

= Rs.5.1504 million

If invoiced in euro, rupee outflow = 543.20

= Rs.5.125 million

If invoiced in sterling, rupee outflow = 568.75

= Rs.5.1004 million

So, for exports it is best to invoice in dollar as inflow is highest in that case and for imports best invoicing currency is sterling as outflow is minimum for that.

91. a. Borrow rupee for three months, convert into euro at spot rate and invest. Rupee amount to be borrowed = Rs.42.85 By converting to euro we will get 1 Euro

Invest euro for 3-month to get = 1 0.0414

⎛ ⎞+⎜ ⎟⎝ ⎠

= Euro 1.01

Amount of rupee to be repaid = 42.85 0.08514

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.43.76.

If there is no scope for covered interest arbitrage, this rupee amount to be repaid should be less than rupee proceeds from the euro investment.

Therefore, 1.01 x (Rs./Euro)bid ≤ 43.76 (Rs./Euro)bid ≤ 43.33. Borrow euro for three month, convert into rupee spot and invest. Borrow 1 Euro for 3 month and convert to get Rs.42.75.

Amount of Euro to be repaid = 1 0.04514

⎛ ⎞+⎜ ⎟⎝ ⎠

= Euro 1.0113

Invest rupee for 3 month to get = 42.75 0.0814

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.43.61

If there is no scope for arbitrage, this rupee investment after converting into euro at 3 month forward rate should be less than euro amount to be repaid.

Therefore, 1.0113 x (Rs./Euro)ask ≥ 43.61 or, (Rs/Euro)ask ≥ 43.12

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b. Buy euro for rupees, convert euro into dollar and again convert dollar into rupee to check any arbitrage opportunity.

Buy 1 Euro for Rs.42.85 Convert Euro into dollar to get $ 0.9051 Convert dollar back into rupee to get = 0.9051 x 47.10 = Rs.42.63 Therefore, there is no scope for arbitrage. Now, buy 1 dollar for Rs.47.20

Convert dollar into euro to get Euro 10.9054

= Euro 1.1045

Convert euro back into rupee to get = 1.1045 x 42.75 = Rs.47.22 So, there is a scope for three-point arbitrage. We can earn arbitrage profit by buying dollar for rupee, converting dollar into euro and then

converting euro back into rupees.

92. Rupee outflow at spot for acquiring $50 million = 50 x 46.90 = Rs.2,345 million

Rupee cost of funds = 2,345 x 0.16 = Rs.375.20 million

Returns from the investment = $50 million x 0.20 = $10 million

Total dollar inflow = 50 + 10 = $60 million

Rupee inflow if covered through forward = 60 x 49.25 = Rs.2,955 million

∴ Net gain = 2,955 – 2,345 – 375.20 = Rs.234.80 million

∴ Return = 234.802345

= 10.01%

If the company accepts European bank’s offer:

Initial rupee outflow = 50 x 46.50 = Rs.2,325 million

Rupee cost of funds = 2,325 x 0.16 = Rs.372 million

Out of total investment matured $50 million is to be paid to bank and bank will pay Rs.48.75/$ and the $10 million can be sold through forward cover at 49.25.

Rupee inflow from swap deal = 50 x 48.75 = Rs.2437.5 million

Rupee inflow from forward cover = 10 x 49.25 = Rs.492.50 million

Total rupee inflow after one year = 2437.5 + 492.5 = Rs.2,930 million

∴ Net gain = 2,930 – 2,325 – 372 = Rs.233 million

Return = 2332,325

= 10.02%

As the return is almost equal, so the company can accept European bank’s offer as it entails lower cash outflow.

93. The treasures requires Rs.10 million Borrow in Dollars:

Amount of dollar required to be borrowed = 1046.90

= $0.21322 million

Amount to be repaid after 6 months = 0.21322 0.0412

⎛ ⎞+⎜ ⎟⎝ ⎠

= $0.2175 million

If covered through forward market rupee outflow = 0.2175 x 47.85 = Rs.10.4073 million

∴ Effective cost of borrowing = 1.4073 1010

− x 2 = 8.15%

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If kept open position rupee outflow = 0.2175 x 47.55 = Rs.10.3421 million

∴ Effective cost of borrowing 10.4073 1010

− x 2 = 6.84%.

Borrow in Sterling:

Amount of sterling required to be borrowed = 1065.35

= £ 0.15302 million

Amount to be repaid after 6 months = 0.15302 0.0414

⎛ ⎞+⎜ ⎟⎝ ⎠

= £ 0.1568 million

If covered through forward market rupee outflow = 0.1568 x 66.40 = Rs.10.4145 million

∴ Effective cost of borrowing = 10.4145 1010

− x 2 == 8.29%

If kept open position rupee outflow = 0.1568 x 66.95 = Rs.10.4978 million

∴ Effective cost of borrowing = 10.4978 1010

− x 2 = 9.95%

So it is better to borrow in dollar and keep open position. 94. The forward purchase contract will be first cancelled at the spot rate.

Sterling bought from the customer under original contract at 65.60 Sterling sold to customer under cancellation contract at 66.65 Exchange difference per sterling payable by customer 1.05 Exchange difference for £ 100,000 is Rs.1,05,000 Charges for cancellation: Exchange difference Rs.1,05,00 (+) Flat charge Rs.100 Rs.1,05,100

The bank will book a fresh forward purchase of sterling on 31st July. Spot buying rate for sterling 66.60 (+) Two month premium 0.41 Rs.67.01

On extension of the forward contract, Rs.1,05,100 will be recovered as cancellation charges from the customer and fresh contract will be booked at Rs.67.01.

95. Payable of ¥500 million after 3 months: Covering through forward market Rupee outflow = ¥500 million x Rs.0.4268/¥ = Rs.213.40 million Covering through money market: Borrow rupee, convert into yen spot and invest for 3 months.

Yen to be invested = 5000.0041

4+

= ¥ 499.500 million

Rupee amount to be borrowed = ¥499.500 million x Rs.0.4115/¥ =Rs.205.5443 million Rupee amount repayable = Rs.205.5443 million = Rs.210.1690 million So, we see outflow through money market is lower than the forward market cover. So

money market cover is preferable.

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Receivable of $10 million after 3 months: Covering through forward market:

Rupee inflow = $10 million x Rs.46.90/$ = Rs.469 million

Covering through money market:

Borrow $, convert into rupee spot and invest for 3 months.

$ amount to be borrowed = 100.0651

4⎛ ⎞+⎜ ⎟⎝ ⎠

= $9.84 million

Rupee inflow at spot = $9.84 million x Rs.46.65/$ = Rs.459.036 million

Rupee inflow after 3 months = 459.036 0.0814

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.468.217 million

So, forward cover is preferable.

96. a. Value of investment in dollar = 100044.50

= $22.472 million

Value of income from the unit by the end of one-year

10001000

x 1.20 0.1012

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.126 million

Total inflow at the end of year = 10001000

x 11.00 + 126 = Rs.1,226 million

Value of total inflow in dollar at the end of year = 122646.85

= $26.169 million

Nominal return = 26.169 22.47222.472− = 16.45%.

b. Real return = 1+ Nominal return1+ Inflation rate in US⎛ ⎞⎜ ⎟⎝ ⎠

– 1 = 1 0.16451 0.03++

–1 = 13.06%.

c. Let the invested amount be Rs.1,000 Value of income received from the investment by the end of the year

= Rs.1000Rs.10.00

x 1.20 0.1012

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.126

Total inflow at the end of the year = Rs.1,000 + 126 = 1126

Nominal return = 1,126 1,0001,000− = 12.6%

Real return = 1 0.1261 0.08++

= 4.26%.

Management of Exchange Risk 97. We first work out the cash flows in the event of the company opting for roll over cover. On 1/1/02 The company will sell $1 million forward at Rs.35.20 On 1/7/02 The company will buy $1 million at the spot rate of 35.15. It will deliver $1 million

at 35.20

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So, net inflow = (35.20 – 35.15) (1,000,000) = Rs.50,000 The company will roll over the forward cover by selling $1 million six-month forward

at 35.30. On 1/1/03 The company will buy $1 million spot at Rs.35.25. It will deliver $1 million at Rs.35.30. So, net inflow = (35.30 – 35.25) (1,000,000) = Rs.50,000 It will sell $1 million forward at 35.35. On 1/7/03 The company will buy $1 million spot at 35.35. It will deliver $1 million at 35.35 So, net inflows/outflows = 0 The company will sell $1 million forward at 35.50. On 1/1/04 The company will deliver $1 million received from its middle east customer for 35.50 and

receive Rs.35.50 million. Thus, the cash flows associated with the roll over are

On 1/7/02 : Rs.50,000

On 1/1/03 : Rs.50,000

On 1/7/03 : Nil

On 1/1/04 : Rs.35,500,000 So, the future value of cash flows, using a half-yearly discount rate of 10%

(We are given that the cost of capital for the company is 20%.)

= (50,000) (1 + 0.10)3 + (50,000) (1 + 0.10)2 + 35,500,000 = Rs.35,627,050

If the exposure had been left uncovered, inflows on 1/1/05 would have been

Rs.(1,000,000) (35.45) = Rs.35,450,000.

So, the benefit obtained by using a roll over cover = Rs.177,050

98. The cash flows associated with roll over cover are as given below.

Date Cash Flows (Rs. million)

1/1/03 (30) (35.50) = + 1065

1/7/03 (–40) (35.60) + (30) (35.70) = – 353

1/1/04 (–30) (35.80) + (20) (35.90) = – 356

1/7/04 (–20) (36.00) + (10) (36.10) = – 359

1/7/05 – (10) (36.20) = – 362 The above cash flows are obtained as follows.

On 1/1/03, the loan of $30 million is equivalent to a rupee inflow at the prevailing spot rate of Rs.35.50/$.

As on 1/7/03, the company has a total exposure of $40 million. So, it will buy $ 40 million forward. On 1/7/03, it will take delivery of $40 million at the contracted forward rate of Rs.35.60. It will use $10 million from this sum to pay the first installment. Since the balance amount is not needed immediately, the company will sell $30 million at the prevailing spot rate of Rs.35.70/$.

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As on 1/7/03, the company’s exposure is $30 million. So, it will buy forward $30 million. On 1/1/04, the company will take delivery of $30 million at the contracted forward rate of Rs.35.80/$. It will use $10 million to pay the second installment. Since the balance $20 million is not needed immediately, the company will sell in the spot market at Rs.35.90/$.

As on 1/1/04, the company has an exposure of $20 million which it will cover by buying forward at Rs.36.00. It will take delivery of this amount on 1/7/04 and use $10 million to pay the third installment. The balance $10 million is sold forward at Rs.36.20/$.

On 1/1/05, the company will take delivery of $10 million and use the same to pay the final installment.

The present value of cash flows = 1065 – (353)/(1.10) – 356/(1.10)2 – 359/(1.10)3 – 362/(1.10)4 = –Rs.67.09 million. If the company uses simple forward contracts, it will buy $10 million forward every six

months. The cash flows associated with this strategy are tabulated below.

Date Cash Flows 1/1/03 + (30) (35.50) = + 1065 1/7/03 – (10) (35.60) = – 356 1/1/04 – (10) (35.80) = – 358 1/7/04 – (10) (36.00) = – 360 1/7/05 – (10) (36.20) = – 362

Present value of cash flows = 1065 – (356)/(1.10) – 358/(1.10)2 – 360/(1.10)3 – 362/(1.10)4 = –Rs.72.23 million.

99. At the existing level of exchange rates, we can calculate profits as follows. Revenues = (2000)(100)(35) = Rs.7000,000 Costs

Material : (2000)(6000)(35/120) = Rs.35,00,000Labor : (2000)(350) = Rs.700,000Overhead : (2000)(700) = Rs.35,00,000 Rs.56,00,000

Hence, profits = 7,000,000 – 5,600,000 = Rs.14,00,000. After the exchange rates change, Revenues = (2000)(100)(36) = Rs.7,200,000 Costs

Material : (2000)(6000)(36/110) = Rs.3,927,272

Labor : (2000)(350) = Rs. 700,000

Overhead : (2000)(700) = Rs.1,400,000

Rs.6,027,272 Profits = 72,00,000 – 60,27,272 = Rs.11,72,728 So loss due to transaction exposure = 1,400,000 – 1,172,728 = Rs.2,27,272

100. Transaction Exposure Existing level of profits = Rs.14,00,000 After the exchange rates change, we have the following revenues and costs. Revenues : (2000)(3500) = Rs.70,00,000

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Costs

Material : (2000)(6000)(36/110) = Rs.39,27,272Labor : (2000)(350) = Rs. 7,00,000Overhead : (2000)(700) = Rs.14,00,000 Rs.60,27,272

So profits = 70,00,000 – 60,27,272 = Rs.9,72,728 So decline in profits owing to transaction exposure = 14,00,000 – 9,72,728 = Rs.4,27,272 Economic Exposure Current $ price = 3500/35 = $100/piece After the change in exchange rates, $ price = 3,500/36 = $97.22/piece Hence, reduction in price = (100 – 97.22) = 2.78% So, increase in demand = (2)(2.78) = 5.56% Hence, size of order changes to (2000) (1 + 0.0556) = 2111 (In this case, we have assumed that the exporter has sufficient unutilized capacity to meet

the additional demand.) Revenues : (2111) (3500) = Rs.7,388,500 Costs

Rs.Material : (2111)(6000)(36/110) = 41,45,236 Labor : (2111)(350) = 7,38,850 Overhead : (2111)(700) = 14,77,700 63,61,786

Profits = 73,88,500 – 63,61,786 = Rs.10,26,714. Existing level of profits = Rs.14,00,000 So, decline in profits = Rs.3,73,286. 101. Currently, revenues generated per piece = (100)(36) = Rs.3,600 Costs incurred

Imports : (50)(36) = Rs.1,800Variable costs = Rs.200 Rs.2,000

So, contribution is 1600 per piece. a. The impact of transaction exposure will be as follows.

Revenues generated per piece = (100)(40) = Rs.4,000Imports per piece = (50)(40) = Rs.2,000Variable costs = Rs. 200 Rs.2,200

So, contribution per piece = 4,000 – 2,200 = 1,800 Thus, contribution increases by Rs.200 per piece on account of transaction exposure. b. When invoicing is done in rupees, the price per unit will be Rs.3,600. As worked out earlier, the contribution at the current spot rate will be Rs.1,600 per

piece. When the rupee depreciates, the dollar price per unit will change to $90. Earlier, the

dollar price was 100. Thus, there is a 10% drop in price. Since elasticity of demand is –1.5, this will lead to a 15% increase in order quantity.

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Revenues per piece = Rs.3,600Imports per piece = (50)(40) = 2,000Variable costs = 200 2,200So, contribution = 1,400

Since the order quantity will increase by 15%, the net contribution generated will be (1.15)(1,400) (1,000) = Rs.1,610,000.

Presently, the contribution is Rs.(1,600)(1,000) = Rs.1,600,000. So, additional contribution generated on account of economic exposure = Rs.1,610,000 – 1,600,000 = Rs.10,000. We have of course assumed here that the exporter has sufficient idle capacity to

execute the additional order quantity. 102. Inflows today : Rs.(1,000,000) (41.00) = Rs.4,10,00,000 Installment payments I – $40,000 II – $40,000 III – $40,000 IV – $40,000 Principal repayment – $1,000,000 Total exposure = $1,160,000

Date Cash flows (Rs.)

1.1.03 +41,000,000 1.7.03 –(1,160,000) (41.90) + (1,120,000) (41.45) = –Rs.2,180,000 1.1.04 –(1,120,000) (42.50) + (1,080,000) (42.15) = –Rs.2,078,000 1.7.04 –(1,080,000) (43.10) + (1,040,000) (42.45) = –Rs.2,400,000 1.1.05 –(1,040,000) (43.70) = –Rs.45,448,000

IRR is the value of ‘r’ in the following equation:

41,000,000 = 2

2,180,000 2,078,000+1+ r/2 (1+ r/2)

+ 3 4

2,400,000 (45,448,000)(1 r / 2) (1 r / 2)

++ +

r = 13% 103. Suppose we need $1000 after 3 months Forward cover ⇒ Outflow = (1000) (43.70) = Rs.43,700 Money market cover

⇒ Investment today = 10001 06 / 4+

= $985.22

⇒ Rupees needed today = (42.60) (985.22) = Rs.41,970 ⇒ Rupee outflow after 3 months = (41,970) (1 + 0.15/4) = Rs.43,544 Money market is better as it results in lesser rupee outflow at the end of 3 months when the

exposure will mature. 104.

Amount Payable Currency After 1-m After 2-m Outflow in Rs. after 1-m

£ 100,500 101,042 1,00,500 x 68.30 = 6,864,150 S$ 290,967 292,054 2,90,967 x 23.55 = 6,852,273 NKr 920,439 924,260 9,20,439 x 7.40 = 6,811,249

NKr is the best currency for making payment at the end of the first month.

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Outflow in Rs. if payment is made in £ after two months: 1,01,042 x (67.90 + 0.90) = Rs.6,951,690.

Value of the outflow in Euro 6,951,69047

= = 147,908

Break even S$/Euro rate = 2,92,0541, 47,908

= 1.9746

Break even NKr/Euro rate = 9, 24,2601,47,908

= 6.2489

Hence, payment in S$ and NKr will be better choice if the S$/Euro and NKr/Euro rates are less than the break even rates.

105. The Rs./Euro rates can be calculated as follows: Forward rates:

(Rs./Euro)bid : (Rs./$)bid x ($/Euro)bid

1 month : 43.45 x 1.0465

2 months : 43.65 x 1.0426

3 months : 43.80 x 1.0415

(Rs./Euro)ask : (Rs./$)ask x ($/Euro)ask

1 month : 43.35 x 1.0467 = 45.53

2 months : 43.75 x 1.0429 = 45.63

3 months : 43.95 x 1.0419 = 45.79 Expected rates:

(Rs./Euro)ask : (Rs./$)ask x ($/Euro)ask

1 month : 43.35 x 1.0456 = 45.33

2 months : 43.58 x 1.0409 = 45.36

3 months : 43.85 x 1.0401 = 45.61

Consignment Invoicing in Hedged/Not hedged

Rate Outflow in FC Outflow in Rs.

First $ Hedged Rs.43.50/$ $ 150,000 6,525,000 Euro Hedged Rs.45.53/Euro Euro 157,000 7,148,210 Second $ Hedged Rs.43.75/$ $ 300,000 13,125,000 Euro Hedged Rs.45.63/Euro Euro 312,000 14,236,560 Third $ Hedged Rs.43.95/$ $ 250,000 10,987,500 Euro Hedged Rs.45.79/Euro Euro 250,000 11,996,980 First $ Unhedged Rs.43.35/$ $ 150,000 6,502,500 Euro Unhedged Rs.45.33/Euro Euro 157,000 7,116,810 Second $ Unhedged Rs.43.58/$ $ 300,000 13,074,000 Euro Unhedged Rs.45.36/Euro Euro 312,000 14,152,320 Third $ Unhedged Rs.43.85/$ $ 250,000 10,962,500 Euro Unhedged Rs.45.61/Euro Euro 262,000 11,949,820

All three consignments have to be invoiced in $ and left uncovered.

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106. Receivables: Forward cover: $1,000,000 x Rs.44.75/$ = Rs.447.50 lakh Money market cover:

Borrow 1,000,0001 0.0425 x 0.25+

= $989487

Convert at spot rate to 989487 x 43.65 = Rs.431.91 lakh Invest the rupees for three months to get: 431.91 (1 + 0.09 x 0.25) = Rs.441.63 lakh Forward cover is better. Payables: Forward cover: 1,500,000 x Rs.71.80/£ = Rs.1077.00 lakh Money market cover:

Invest £1,500,0001+0.06 x 0.5

= £ 1,456,311

Borrow = £1,456,311 x Rs.70.50/£ = Rs.1026.70 lakh Repay: 1026.70 x (1 + 0.11 x 0.05) = Rs.1083.17 lakh Forward cover is better. 107. a. The company is long on Canadian $, so it would take a short position in futures on

Canadian $. That is, it sells futures for C$ 1,000,000. As the price of the futures contract has reduced after the short position, the company gains to the extent of:

$1,000,000 (0.7205 – 0.7185) = $2,000. Selling the C$ at 0.7100 in the spot market, the company receives $710,000. Total inflow = $712,000. b. The inflow from hedging through the futures is $712,000. If the company should be

indifferent between futures and money market cover, the inflow from the money market hedge should be $712,000.

The money market hedge can be designed as follows:

Borrow C$ C$

1,000,000(1 r )+

today

Sell them at the spot rate to get $ C$

0.7005 x 1,000,000(1+ r )

and invest for 5 months.

The interest rate on the C$ can be calculated as follows:

C$

0.7005 x 1,000,000 x 1.0251+r

= 712,000

C$C$

0.7005 x 1,000,000 x1.0251 + r =1+r

=1.0084

rC$ = 0.84% for 5 months. Hence, annualized rate = 0.84 x 125

= 2.02%.

108. a. Cash outflow for Amico: If the position is left open, $ (1 x St) million, when St is the spot $/Euro rate at the time of repayment. It hedged through forward buying of Euro 2-m forward rate is 0.9600/0.9620 ∴Cash outflow = $(1 million x 0.9620) = $ 0.9620 million = $ 962,000

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If call options are bought, Premium payable for Euro 1 million = $(1 million x 0.005) = $5000 Strike price is 0.9610/Euro If St < 0.9610, option will not be exercised and the cash outflow will be

$[1 million x St + 5,000] If St > 0.9610, option will be exercised and the cash outflow will be

$[(1 x 0.9610 ) m + 5,000] = $ 966,000

b. Amico will be indifferent between two strategies if the cash outflow is equivalent in both the positions.

i. To be indifferent between open position and forward hedge,

ii. $ (1 x St) m = $ 0.9620m

St = $ 0.9620/Euro To be indifferent between open position and call option, iii. $(1 x St ) m = $ 966,000 ∴St = $ 0.9660/Euro To be indifferent between forward hedge and call option $ 0.9620 m = $[(1 x St ) m + 5000]

∴ St = 957,0001m

= $ 0.9570/Euro

That is if the Euro depreciates below $0.9570, call option is better.

109. a. i. Forward market cover: Handex can sell US$ 50,000 @Rs.43.95/$ in the forward market and realize a

cash inflow of Rs.21,97,500 three months hence. ii. Money market cover:

Handex can borrow US$ 50,0000.061

4⎛ ⎞+⎜ ⎟⎝ ⎠

which can be repaid when the receivable

is realized.

US$ borrowed is 50,0001.015

= 49261.08

Sell these $ in the spot market and invest the Re. proceeds for 3 months.

Rs. realized after 3 months is [43.65 x 49261.08] 0.0914

⎡ ⎤+⎢ ⎥⎣ ⎦ = Rs.21,98,626

Handex should go for money market cover since the cash inflow is more.

b. Since the foreign currency value of asset is fixed, exposure is equal to the value. Therefore, exchange exposure of Handex is $50,000.

Exchange rate anticipated is Rs./$ : 43.95/44.00

Actual is Rs./$ : 44.00/44.42

Handex should sell the receivable at the bid rate.

Hence unanticipated change in the exchange rate is (44.00 – 43.95) = 0.05

Unanticipated change in the value is Rs.(0.05 x 50,000) = Rs.2,500

Foreign exchange risk is Rs.2,500.

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110. a. Exchange rate Rs./$ Spot 45.50/45.55

3-m forward 45.90/46.00

3-m interest rates (%)

US 4.5/5.0

India 10.0/11.0

i. Forward Hedge

After 3-m, Rs. outflow for the firm is Rs.(100,000 x 46.0) = Rs.46,00,000.

ii. Money Market Hedge

The firm should borrow Rs. convert into $ at the spot rate, invest $ proceeds for 3-m and settle the payable at the maturity out of $ investment.

$ to be invested to get $ 100000 3-m hence is 1000000.0451

4⎛ ⎞+⎜ ⎟⎝ ⎠

= $ 98887.52

To get $ 98887.52, required Rs. is (98887.52 x 45.55)

The firm need to borrow Rs.45,04,326.54 to get required $.

Rupee repayment after 3-m is

Rs.45,04,326.54 x 0.1114

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.46,28,195.52.

iii. Option Hedge

Since the firm has a $ liability, it should go long on call $ options. That is buy $ call option with a strike price of Rs.46.00 at a premium of Rs.0.10/$.

∴ Total premium paid is Rs.(1,00,000 x 0.10) = Rs.10,000

Possible spot rate after 3-m (Rs./$)

Exercise option? Total rupee outflow

Probability

45.60 No 4570000 0.10

46.00 No 4610000 0.60

46.40 Yes 4610000 0.30

∴ Expected rupee outflow after 3-months is (4570000 x 0.10) + 46,10,000 x (0.60 + 0.30) = Rs.46,06,000 The firm can also go short on the put option, that is sell $ put option with

strike price of Rs.46.00 at a premium of Rs.0.05/$. ∴Total premium received is Rs.(1,00,000 x 0.05) = Rs.5,000

Possible spot rate after 3-m (Rs./$)

Exercise option?

Total Rupee outflow

Probability

45.60 Yes 4595000 0.10 46.00 No 4595000 0.60 46.40 No 4635000 0.30

Expected rupee outflow after 3-m is (45,95,000 x 0.10 + 45,95,000 x 0.60 + 46,35,000 x 0.30) = Rs.46,07,000

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166

iv. No Hedge

Possible spot rate after 3-m (Rs./$) Rupee outflow Probability 45.60 4560000 0.10 46.00 4600000 0.60 46.40 4640000 0.30

Expected rupee outflow after 3-m is (45,60,000 x 0.10) + (46,00,000 x 0.60) + (46,40,000 x 0.30) = Rs.46,08,000 ∴Forward hedge is suggested to cover the payable since the rupee outflow is

less than the outflow under money market hedge and less than the expected outflow under option covers.

Forward cover is also better than keeping the exposure uncovered. b. It is always better to hedge the exposure because foreign exchange market is full of

uncertainty. The rupee may remain stable for fairly long period against dollar and other major currencies. But it is impossible to predict that it will remain stable in the future also. Since international economics is full of uncertainty and currently we can observe the level of volatility in the foreign exchange market. So in future foreign exchange rates can move adversely, thus leading to huge amount of loss. By hedging the exposure we can be certain about the amount of inflow or outflow in the future.

111. a. Current profit at exchange rate of Rs.42/$ = Rs.1,20,000 x (12 x 42 – 350) = Rs.1,84,80,000 Profit if rupee depreciates to Rs.44/$ = Rs.1,20,000 x (12 x 44 – 350) = Rs.2,13,60,000 Increase in profit due to depreciation of rupee (transaction exposure) = Rs. (2,13,60,000 – 1,84,80,000) = Rs.28,80,000. b. Selling price of each garment in rupee term = Rs. 12 x 42 = Rs.504

Price in dollar terms after depreciation of rupee = Rs.504Rs.44/$

= $11.45

∴Decrease in price of each piece = 4.58% ∴Change in quantity demanded = –1.5 x (–4.58)% = 6.87% ∴Number of pieces to be sold = 1,20,000 x (1 + 0.0687) = 1,28,244 Profit = Rs.1,28,244 x (504 – 350) = Rs.1,97,49,600 ∴ Increase in profit due to economic exposure = Rs. (1,97,49,600 – 1,84,80,000) = Rs.12,69,600. 112. Profit at the current exchange rates = 2400 [500 x 51.50 – (800 x 27.25 + 1000 + 1500)] = 2400 [25750 – 24300] = Rs.34.80 lakh Profit after the change in exchange rates = 2400 [500 x 52 – (800 x 27.75 x 1000 + 1500)] = 2400 [26000 – 24700] = Rs.31.20 lakh. ∴ Loss due to transaction exposure = 34.80 – 31.20 = Rs.3.60 lakh. Profit based on new exchange rate = 2400 [25000 – (800 x 27.15 + 1000 + 1500)] = 2400 [25000 – 24220] = Rs.18.72 lakh. Profit after change of exchange rates at the end of six months. = 2400 [25000 – (800 x 27.75 + 1000 + 1500)] = 2400 [25000 – 24700] = Rs.7.20 lakh. ∴ Decline in profit due to transaction exposure = 18.72 – 7.20 = Rs.11.52 lakh

Current price of each unit in Euro = 25,00051.50

= Euro 485.44

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167

After the change in exchange price per unit in Euro = 485.44 483.09485.44− = Euro 483.09

∴ % reduction in price = 485.44 483.09485.44− = 0.48%

Increase in demand due to reduction in price = 0.48 x 1.50 = 0.72% ∴ Size of the increased order = 2400 (1 + 0.0072) = 2417.28 say 2417 units Profit = 2417 [25000 – (800 x 27.75 + 1000 + 1500)] = 2417 [25000 – 24700] = Rs.7.251 lakh ∴ Decrease in profit due to operating exposure = 18.72 – 7.251 = Rs.11.469 lakh. 113. The company’s existing profits can be calculated as follows: Million Rupees

Sales: (12,000 x 150 x 48) 86.40Less: Variable cost: 12,000 x 4200 = 50.4 12,000 x 50 x 48 = 28.8 Fixedcost: 1.2 80.40Profit 6.00

After the rupee appreciates, the company’s profit will be: Million Rupees

Sales: (12,000 x 150 x 47) 84.60Less : Variable cost : 12,000 x 4200 = 50.4 12,000 x 50 x 47 = 28.2 Fixed cost 1.2 79.80Profit 4.80

As a result of appreciation, the profits of the company have decreased despite of selling the same number of units at the same dollar price. Let the number of units that need to be sold for keeping the profits at the pre-depreciation level be ‘X’. Then,

60,00,000 = [ 150 x 47 x X ] – [(4,200 x X) + 50 x 47 x X + 12,00,000]

60,00,000 = 7,050X – 6,550X – 12,00,000; X = 72,00,000500

= 14,400 units

If the company exports 14,400 units, it can maintain the profits earned at pre-appreciation level of Rs.48 per dollar.

114. The company requires Rs.50 million Borrow in Dollars:

Amount of dollars required to be borrowed = 5048.50

= 1.030928 million

Amount to be repaid after 6 months = –1.030928 0.0414

⎛ ⎞+⎜ ⎟⎝ ⎠

= $ 1.041237 million

If covered through forward market, rupee outflow = 1.041237 x 49.05 = 51.0727

Annualized effective cost of borrowing = 51.0727 50 12x50 3

− = 8.58%

If kept open position, rupee outflow = 1.041237 x 48.95 = 50.96855.

Annualized effective cost of borrowing = 50.96855 50 12x50 3

− = 7.75%.

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168

Borrow in sterling:

Amount of sterling required to be borrowed = 5074.05

= £ 0.675219 million

Amount to be repaid after 3 months = 0.675219 0.0614

⎛ ⎞+⎜ ⎟⎝ ⎠

= £ 0.685347 million

If covered through forward market rupee outflow = 0.685347 x 75 = 51.401025

Effective cost of borrowing = 51.401025 50 12x50 3

− = 11.21%

If kept open position, rupee outflow = 0.685347 x 74.80 = 51.263956.

Effective cost of borrowing = 51.263956 50 12x50 3

− = 10.11%

So, it is better to borrow in dollars and keep open position.

115. i. Borrow dollars and invest pounds

Interest paid on dollar borrowing = 14,40,000 x 4 x 3100 x 12

= $14,400.

Interest earned on pounds 10,00,000 at 3% = 10.0,000 x 3 x 3100 x 12

= £7,500

This amount of £ 7,500 sold forward at 1.4330 to receive dollars

= $7,500 x 1.4330 = $10,747.5

Net cost of borrowing in dollars = $14,400 – $10,747.5 = $3652.5

ii. Swap pounds in to dollars

Sell pounds 1 million to obtain $1.44 million at spot rate of 1.4400

Dollar inflow = 10,00,000 x 1.4400 = $14,40,000

Buy pounds 1 million at 3 months forward rate of 1.4360

Dollar outflow = 10,00,000 x 1.4360 = $1,436,000

Net cost is = –$4,000

Alternative (ii) is better as it giving a gain of $4,000.

116. Rupee inflow on 1.1.2000 = 1,00,000 x 67.49 = Rs.67,49,000

Installment payments of interest I – £ 3,000

II – £3,000

III – £3,000

IV – £3,000

Principal repayment –1,00,000

Total exposure = £1,12,000

Date Cash flows (Rs.)

1.1.2000 + 67,49,000 (1,00,000 x 67.49) + 67,49,000

1.7.2000 – 76,27,200 (1,12,000 x 68.10) + 7,401,100 (1,09,000 x 67.90) – 2,26,100

1.1.2001 – 74,77,400 (1,09,000 x 68.60) + 72,50,400 (1,06,000 x 68.40) – 2,27,000

1.7.2001 – 73,03,400 (1,06,000 x 68.90) + 70,76,100 (1,03,000 x 68.70) – 2,27,300

1.1.2002 – 71,58,500 (1,03,000 x 69.50) – 71,58,500

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169

The effective cost of loan is given by r in the following equation:

67,49,000 = 2

2,26,100 2,27,000+r r1+ 1+2 2

⎛ ⎞ ⎛ ⎞⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠

+ . 4

2,27,300 71,58,500+r r1+ 1+2 2

⎛ ⎞ ⎛ ⎞⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠

= 2,26,100 x PVIF(r/2,1) + 2,27,000 x PVIF(r/2,2) + 2,27,300 x PVIF(r/2,3) + 71,58,500 x PVIF(r/2,4)

For r/2 = 4%, R.H.S. = 67,50,070

For r/2 = 6%, R.H.S. = 62,75,706

r2

∴ = 4% + (6 – 4)% x 67,50,070 67,49,00067,50,070 62,75,706

−−

= 4 + 2 x 1070474364

= 4.005%

r = 8.01%. 117. a. Profit at the current exchange rates

= 5000 [60 x 46.90 – (10 x 40.40 + 250 + 1250)]

= 500 [2814 – 1904] = 5000 – 910 = Rs.45.50 lakh

Profit after the change in exchange rate

= 5000 [60 x 47.90 – (10 – 41.25 + 250 + 1250)]

= 5000 [2874 – 1912.5] = 5000 x 961.5 = Rs.48.075 lakh

∴Gain due to transaction exposure = 48.075 – 45.50 = Rs.2.575 lakh.

b. Profit based on new exchange rate

= 5000 [2700 – (10 x 40.80 + 250 + 1250)] = Rs.39.60 lakh

Profit after change of exchange rate at the end of 6 month

= 5000 [2700 – (10 x 41.25 + 250 + 1250)] = Rs.39.375 lakh

∴Decline in profit due to transaction exposure = 39.60 – 39.375 = Rs.0.225 lakh

Current price of each unit in dollar term = 270046.90

= $57.57

After the change in exchange price per unit in dollar term = 270047.50

= $56.84

% reduction in price = 57.57 568457.57− = 1.27%

∴ Increase in demand due to reduction in price = 1.27 x 1.60 = 2.03%

∴ Size of the increased order = 5000 (1 + 0.0203) = 5102 units

∴Profit = 5102 [2700 – (10 x 41.25 + 250 + 1250)] = 5102 x 787.5 = Rs.40.18 lakh

∴ Increase in profit due to operating exporter = 40.18 – 39.60 = Rs.0.58 lakh.

International Project Appraisal 118. Interest on increased borrowing capacity = (0.15) (50) = Rs.7.5 million Tax shield generated per year = (0.4) (7.5) = Rs.3.0 million Present value of tax shields due to increased borrowing capacity = 3.0 PVIFA (i = 6%, n = 5) = 3.0 [(1.065 – 1)/(0.06)(1.06)5] = Rs.12.64 million.

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170

119.

Year Loan outstandings

(NZ$)

Principal repayment

(NZ$)

Interest repayment

(NZ$)

Present value of total repayment

(Discount rate = 0.10) 1 100 20 5 25/(1.10) = 22.72 2 80 20 4 24/(1.10)2 = 19.83 3 60 20 3 23/(1.10)3 = 17.28 4 40 20 2 22/(1.10)4 = 15.03 5 20 20 1 21/(1.10)5 = 13.03

Present value of the concessional loan which can be deducted from the cost of the project = (100 – 87.89)/(1.5) = $8.07 million.

120. Let i be the rate of interest charged on the concessional loan. Then, we can construct the following table.

Year Interest Principal Total repayment

(Rs. crore) (Rs. crore) (Rs. crore)

1 1400 i — 1400 i

2 1400 i 280 1400 i + 280

3 1120 i 280 1120 i + 280

4 840 i 280 840 i + 280

5 560 i 280 560 i + 280

6 280 i 280 280 i + 280 Present value of repayment

= 2 3 4 5 6

1400i 1400i + 280 1120i + 280 840i + 280 560i + 280 280i + 280+ + + +1.16 1.16 1.16 1.16 1.16 1.16

+

= Rs.(790.35 + 3810.33i) crore If the project is to be viable, present value of the saving on the concessional loan should be

≥ $70 million.

i.e. Rs. 70 x 3510

⎛ ⎞⎜ ⎟⎝ ⎠

crore = Rs.245 crore

Therefore, (Rs.1400 crore – PV of the repayment) should equal Rs.245 crore. PV of repayment = (1400 – 245) = 1155 790.35 + 3810.33i = 1155

i = (1155 790.35)3810.33− = 0.0957

Therefore, if the rate of interest can be negotiated at 9.57% or less, the project becomes viable.

121. Exchange Rate Schedule The exchange rate schedule is determined by using PPP.

Year 1 2 3 4 5 Exchange rate 1.57 1.64 1.71 1.79 1.87 (NR/IR)

Initial investment = (100)/(1.50) = IR 66.67 crore

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171

Cash flows generated from operations

Year Revenues Costs PBT PBT PAT PV NR NR NR IR IR k = .18

1 100 (45) (1.15) 48.25 30.73 19.97 16.92 2 100 (45) (1.15)2 40.49 24.69 16.05 11.53 3 100 (45) (1.15)3 31.56 18.46 12.00 7.30 4 100 (45) (1.15)4 21.29 11.89 7.13 3.68

5 100 (45) (1.15)5 9.49 5.07 3.04 1.33 40.76

Since there is a tax holiday in Nepal for three years, the tax rate for this period is that prevailing in India, i.e. 35%. For the subsequent two years, the higher of the two tax rates, i.e. 40% applies.

Terminal cash flows

PV = 5

(200 100) (0.6)1.87 (1.18)+ = 42.07

We assume that the terminal cash flows are characterized by the same degree of risk as cash flows from operations. Also, tax at the rate of 40% will have to be paid.

Tax shield due to depreciation

Year Depn. (NR) Depn. (NR) Tax shield (IR) PV (k = 0.10) 1 20 12.74 5.10 4.63 2 20 12.20 4.88 4.04 3 20 11.70 4.68 3.52 4 20 11.17 4.47 3.06 5 20 10.70 4.28 2.66

17.91 Tax shield has been calculated at the higher of the two tax rates, i.e. 40%. Tax shield due to increased borrowing capacity

(100) (0.18) (0.40) 5

5

(1.10 1)(0.10)(1.10)

− = Rs.27.29 crore

Benefit due to concessional loan

50 – 5

5

(10)(1.2 1)(0.2)(1.2)

− = Rs.27.29 crore = IR (20.09)/(1.50) = Rs.13.39 crore

APV = – 66.67 + 40.76 + 42.07 +17.91+ 27.29 + 13.39 = Rs.74.75 crore Since APV is +ve, the project can be taken up for implementation. 122. 1 2 3 4 5 Payment 100i 80i 60i 40i 20i (X) +20 +20 +20 +20 +20

PV = 2 3 4 2 3

100i + 20 80i + 20 60i + 20 40i + 20 80i + 20 60i + 20+ + + + +1.06 1.06 1.06 1.06 1.06 1.06

= 262.55i + 84.25

Benefit = $(100 – 262.55i – 84.25) = $(15.75 – 262.55i) = DM (1.8) (15.75 – 262.55i) = 15 or 15.75 – 262.55i = 15/1.8 i = 0.0282 = 2.82%

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123. Assume the concessional rate of interest to be ‘i’. Repayment schedule for the loan is:

Year Principal Interest Total (Rs. core)1 800 4000i 800 + 4000i 2 800 3200i 800 + 3200i 3 800 2400i 800 + 2400i 4 800 1600i 800 + 1600i 5 800 800i 800 + 800i

PV of the repayments

= 2 3 4 5

800+ 4000i 800 +3200i 800+ 2400i 800+1600i 800+800i+ + + +1.16 (1.16) (1.16) (1.16) (1.16)

⎧ ⎫⎨ ⎬⎩ ⎭

= 2619.43 + 8628.53i If the project is to be viable, APV ≥ 0 Current APV = S$ – 38m = Rs.–(3.8 x 25) crore = Rs.–95 crore. ∴ If the concessional financing can lead to an improvement in the APV by Rs.95 crore.

The project can become viable. ∴4000 – 2619.43 – 8628.53i = 95 8628.53i = 1285.57 i = 0.1490 = 14.9%. ∴The concessional rate of interest should be 14.9%. 124. Let the interest rate on concessional loan be ‘r’. Repayment schedule for the loan is

Year Principal Outstanding

Repayment Interest Total repayment

1 500 – 500r 500r 2 500 – 500r 500r 3 500 125 500r 500r + 125 4 375 125 375r 375r + 125 5 250 125 250r 250r + 125 6 125 125 125r 125r + 125

Present value of repayments = 500r x PVIF(10%,1) + 500r x PVIF(10%,2) + (500r + 125) x PVIF(10%,3) + (375r + 125) x PVIF(10%,4) + (250r + 125) x PVIF(10%,5)+ (125r + 125) x PVIF(10%,6) = 500r (0.909) + 500r (0.826) + (500r + 125) (0.751) + (375r + 125) (0.683) + (250r + 125) (0.621) + (125r + 125) (0.564) = 1724.875r + 327.375 If the project is to be accepted APV = 0 So [500 – (1724.875r + 327.375)] x 27.75 = 1000

or [172.625 – 1724.875r] = 100027.75

or 1724.875r = 172.625 – 36.036

or r = 136.5891724.875

= 7.92%.

So the interest on the concessional loan should be less than 7.92% to make the project viable.

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125. Let the interest rate on concessional loan be ‘r’ Repayable schedule for the loan is:

Day Principal Outstanding

Repayment Interest Total repayment

1 300 – 300r 300r 2 300 – 300r 300r + 75 3 225 75 225r 225r + 75 4 150 75 150r 150r + 75 5 75 75 75r 75r + 75

Present value of repayments = 300r x PVIF(8%,1) + (300r + 75) x PVIF(8%,2) + (225r + 75) x PVIF(8%,3) + (150r + 75) x PVIF(8%,4) + (75r + 75) x PVIF(8%,5) = 300r (0.926) + (300r + 75) (0.857) + (225r + 75) (0.794) + (150r + 75) (0.735) + (75r + 75) (0.681) = 874.875r + 230.025 If the project is to be accepted, APV ≥ 0 So, [300 – (874.874r + 230.025)] x 42.50 ≥ 1500

or, [69.97 5 – 874.875r] 150042.50

≥

or, 874.875r 69.975 – 35.294

or, r ≤ 34.681874.875

= 3.96%

So, the interest on concessional loan should be less than 3.96% to make the project viable.

International Equity Investments 126. Assume the investor wants to invest $100,000 Rupee investment = (35) (100,000) = Rs.3,500,000

Value of investment after one year = $(100,000) (1 + 0.5) = $150,000 = Rs.(36) (150,000) = Rs.5,400,000 Hence rupee returns = (5,400,000 – 3,500,000)/ (3,500,000) x 100 = 54.29%

The rupee returns are more than the dollar returns owing to appreciation of the dollar. 127. Suppose, the investor wants to buy stocks worth Rs.1,000,000. Dollar funds invested = (1,000,000)/(35) = $28,571.

Value of portfolio after one year = Rs.(1,000,000) (1.25) = Rs.1,250,000 = $ (1,250,000)/36 = $34,722

Return on investment = (34,722 28,571)(28,571)

− x 100 = 21.53%

The dollar returns are lesser than the rupee returns owing to depreciation of the rupee. 128. Expected returns in India = rf + B (rm – rf) = 0.10 + 1.50 (0.20 – 0.10) = 0.25 Suppose an investor buys Rs.100,000 worth of securities. Then the value of investment after one year = Rs.(100,000) (1.25) = 125,000 If spot rate was $ S/Re. at the beginning of the year, it is $0.95S/Re at the end of the year.

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So, dollar return on investment = (125,000)(0.958) (100,000)S(100,000)(S)

− = 0.1875

Thus expected rate of return = 18.75%

Variance i j ijW W∑ σ = 20 + 15 + (2) (0.20) (20) (15) = 41.93%

So, total risk = 41.93%. 129. To invests $100, the Indian investor needs Rs.1853. The net return can now be worked out for each case separately.

a. (1 0.5)(25.53) 18.5318.53

− − = –31.11%

or

Net Return = (50)(25.53) 18531853

− = –31.11%

b. Net Return = (75)(25.53) 18531853

− = 3.33%

c. Net Return = (150)(25.53) 18531853

− = 106.66%

d. Net Return = (125)(25.53) 18531853

− = 72.22%

130. We first calculate the expected spot rate after one year using the interest parity principle. Sn = (45) (1.05)/(1.04) = 45.43 Suppose the American investor has surplus funds of $100. $100 = Rs.4500 The investor can hence buy securities worth Rs.4500 in India. We can now calculate the returns for each scenario as follows:

a. [(4500)(1.1) /(45.43)] 100100

− x 100 = 8.96%

b. [(4500)(1.3) /(45.43)] 100100

− x 100 = 28.76%

c. [(4500)(1.5) /(45.43)] 100100

− x 100 = 48.58%

131. Alternative I Invest in £.

Returns after 3 months = £(1,000,000) (1 + 0.08/4) = £1,020,000

Profits = 1,020,000 – 1,000,000 = £20,000. Alternative II Invest in $ after converting £1,000,000 at the rate of $1.50/£. It can sell the $ returns forward at $1.40/£

Returns after 3 months = $(1,000,000) (1.5) (1 + 0.05/4) = $1,518,750

= £(1,518,750)/1.40 = £1,084,821.

So, profits = 1,084,821 – 1,000,000 = £84,821.

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Alternative III Invest in NZ$ after converting £1,000,000 into NZ$ at the rate of NZ$ (1.5) (1.50)/£ = NZ$ 2.25/£. The NZ$ returns can be sold forward at NZ$ (1.40)(1.45)/£ = NZ$ 2.03/£.

Returns after 3 months = (2.25) (1,000,000) (1 + 0.04/4) = NZ$ 2,272,500 = £(2,272,500)/(2.03) = £1,119,458.1 So, profits = 1,119,458.1 – 1,000,000 = £119,458.1

Investing in NZ$ hence yields the best returns. 132. Assume the investor had $1000

He gets $10001.76

= £ 568.18

He can invest in 568.18102

= 5.57 securities

Coupon income = 5.57 x 9 = £50.13

Capital gains = 5.57 (106 – 102) = £22.28

Total inflow on liquidation = £ 568.18 + 50.23 + 22.28 = £ 640.69

Inflow in $ = 640.69 x 1.62 = $ 1037.92

Return = 1037.92 10001000

− x 100 = 3.79%

133. Expected return from the scrip Morepen Lab Ltd., = rf + β (rm – rf)

= 0.065 + 1.65 (0.12 – 0.065) = 15.575%.

Robinson buys Rs.1 million worth of shares of Morepen Lab Ltd. The value of his investment after one year = 1000,000 (1.15575) = 1,155,750.

If the current spot rate of AUS $/Re is ‘x’, after one year, it is expected to be AUS$ 0.97x/Re.

Hence Australian $ return on Robinson’s investment in Morepen Lab Ltd.

= [(11,55,750)(0.97 x) 10,00,000x]1,00,000 x

− = 12.10775%

Say 12.11%

Variance of his returns = 25 + 10 + 2 x 0 x 25 x 10 = 35

Hence the expected return of Mr. Robinson is 12.11% with a risk of 35(%)2.

134. Expected return = rf + (rm – rf) = 8 + 1.20 (15 – 8) = 16.40%

Suppose the FII buy Rs.100 worth of stock.

Value of the investment after one year = 100(1.1640) = Rs.116.40

If spot $/Rs. rate is x at the time of investment, it will $/Rs.0.96x after one year

∴ Dollar return on investment = 116.40 x 0.96 x 100x100 x

− = 11.74%.

135. Expected return from the security = rf + β (rm – rf) = 0.06 + 1.40 (0.12 – 0.06) = 14.4%

Let the rupee dollar exchange rate after one year will be x

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1 148 x

148

−∴ = 0.04

or 1 148 x

− = 0.04 x 148

or = 1 148 x

− = 0.04 x 148

x 1 1 1= 0.04 xx 48 48

⎡ ⎤−⎢ ⎥⎣ ⎦x = 50.

The FII invested $10 million ‘m’ Indian security. The amount invested in rupees = 10 x 48 = Rs.480 million The value of investment after one year = 480 (1.144) = Rs.549.12 million

Value of investment in terms of dollars = 549.1250

= $10.9824

$ return on investment = 10.9824 1010

− = 9.824%

∴Expected return to FII = 9.824% Variance of domestic currency return on foreign investment = Var (rf) + Var (s) + 2 Cov (rf x S)

Variance of returns = (10)2 + (8)2 + 2 x 0.15 x 10 x 8 = 188 Total risk of investment = 13.71%. 136. Expected return from the security = Rf + β (Rm – Rf) = 0.08 + 1.20 (0.15 – 0.08) =16.4%.

Let the rupee-dollar exchange rate after one-year will be x

1 148 x

148

−∴ = 0.06

or, 1 146 x

− = 0.06 x 146

or, 1 1 1 10.06 xx 46 46 46

⎡ ⎤= − =⎢ ⎥⎣ ⎦ x 0.94

or, x = 46.000.94

= 48.94.

Suppose, the US investor invested $100 in the Indian security ∴ Amount invested in rupees = 100 x 46 = Rs.4,600 ∴ The value of investment after one year = 4,600 (1.164) = Rs.5,354.40

∴ Value of investment in terms of dollar = 5354.4048.94

= $109.41

$ return of investment = 5354.4048.94

= 9.41%

∴ Expected return to US investor = 9.41% Variance of return = (8)2 + (10)2 + 2 x 0.10 x 8 x 10 = 180(%)2 Total risk of investment = 180(%)2.

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Short-term Financial Management 137. a. Total cash requirement = S$ 35,000,000 + £ 3,000,000 = $ (35,000,000/1.75 + 3,000,000 x 1.60) = $ (20 + 4.8) million = $24.8 million In this case, the surplus available at the Swiss subsidiary is not available for

adjustment against the deficits of other subsidiaries. b. Total cash requirement = – SFr 15,000,000 + S$ 35,000,000 + £3,000,000 = $ (–15,000,000/1.5 + 35,000,000/1.75 + 3,000,000 x 1.60) =$14.8 million Centralized cash management helps in management of a given volume of business

with lower cash balance. 138. All the subsidiaries can convert their receivables and payables into dollars and determine

their net position.

The Swiss subsidiary Receives £ 24,390 = $ (24,390) (1.64) = $ 40,000receives S$ 504,000 = $ (504,000)/(1.68) = $ 300,000pays SFr 319,000 = $ (319,000)/(1.45) = $ 220,000 + $ 120,000The UK subsidiary receives SFr 29,000 = $(29,000)/(1.45) = $ 20,000receives S$ 134,000 = $(134,400)/(1.68) = $ 80,000pays £ 79,268 = $(79,268)(1.640) = $ 130,000 – $ 30,000The Singapore subsidiary receives $120,000 = $ 120,000pays S$ 638,400 = $(638,400)/(1.68) = $ 380,000 – $ 260,000The parent company receives SFr 290,000 = $(290,000)/(1.45) = $ 200,000receives £54,878 = $(54,878)(1.64) = $ 90,000pays $120,000 = $ 120,000 + $ 170,000

So, the Swiss subsidiary will receive $120,000 or SFr 174,000 from the netting center. The UK subsidiary pays $30,000 or £18,293 to the netting center. The Singapore subsidiary pays $260,000 or S$ 436,800 to the netting center. The parent company receives $170,000 from the netting center. 139. Alternative I Subsidiaries use netting. The German subsidiary pays S$ 1,000,000 to the Singapore subsidiary receives ∈500,000 or S$(500,000) (1.5) (1.5) = S$ 1,125,000. Hence, by netting, the German subsidiary will receive S$ (1,125,000 – 1,000,000) = S$ 125,000 from the Singapore subsidiary. The German subsidiary pays SFr1,000,000 to the parent company receives ∈500,000 = SFr(500,000) (1.5) = SFr750,000 from parent company.

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After netting, the German subsidiary pays SFr(1,000,000 – 750,000) = SFr250,000 to the parent company. The Indian subsidiary pays Rs.35,000,000 = SFr(35,000,000)/(35) = SFr1,000,000 to the parent company receives SFr1,000,000 from the parent company. Receivables and payables hence cancel out after netting. Thus, with centralized cash management, we are left with only the following transactions. a. German subsidiary receives S$ 125,000 from the Singapore subsidiary. b. German subsidiary pays SFr250,000 to the parent company. c. Singapore subsidiary pays SFr2,000,000 to the parent company. Thus, we have reduced the number of transactions from 7 to 3. Alternative II We use centralized cash management. German subsidiary Receipts = 500,000 + 500,000 = ∈ 1,000,000 Payments = S$1,000,000 + SFr1,000,000 = (1,000,000)/2.25 + (1,000,000)/1.5 = ∈1,111,111 So, net payable = ∈ 111,111. Thus, the UK subsidiary pays ∈ 111,111 to the netting center. Singapore subsidiary Receipts = S$ 1,000,000 Payments = ∈ 500,000 + SFr2,000,000 = S$ (500,000) (2.25) + S$ (2,000,000) (1.50) = S$ 1,125,000 + S$ 3,000,000 = S$ 4,125,000 So, net payable = S$ (4,125,000 – 1,000,000) = S$ 3,125,000 Thus, the Singapore subsidiary pays S$ 3,125,000 to the netting center. Indian subsidiary Receipts = SFr1,000,000 Payments = Rs.35,000,000 = SFr1,000,000. So, receivables and payables cancel out. Parent company Receipts = Rs.35,000,000 + SFr3,000,000 = SFr1,000,000 + SFr3,000,000 = SFr4,000,000 Payments = SFr1,000,000 + ∈500,000 = SFr1,000,000 + SFr750,000 = SFr1,750,000 So, net receivables = SFr(4,000,000 – 1,75,000) = SFr2,250,000. Thus, the parent company receives SFr2,250,000 from the netting center. 140. Loan in Germany Cost = 6 + 0.5 = 6.5% Loan from US Bank

Effective rate of interest = 51 0.1−

= 5.56

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Premium on USD = 1.061.05

– 1 = 0.0095 = 0.95%

Net Cost = 5.56 + 0.95 = 6.51%

Loan from Swiss Bank

Effective rate of interest = 21 0.1−

= 2.22

Premium on SFr = 1.061.02

– 1 = 0.0392 = 3.92%

Net cost = 2.22 + 3.92 = 6.14%

So, Swiss loan is the best.

141. i. Total cash requirement under centralized cash management

= + £1 million + JP ¥50 million – S$1 million – HK$2 million

= Euro 50 11 x 1.5025+ 2 x 0.119130 1.8910

⎡ ⎤− −⎢ ⎥⎣ ⎦

= Euro [1.5025 + 0.3846 – 0.5288 – 0.2380] = Euro 1.1203 million.

ii. Total cash requirement under decentralized cash management

= S$1 million + HK$2 million

= Euro 1 2 x 0.1191.8910⎛ ⎞+⎜ ⎟⎝ ⎠

= Euro 0.7668 million.

Surplus available at UK subsidiary and Japan subsidiary is not available for adjustment against the deficit of other subsidiaries.

142. All the subsidiaries and US Parent will convert their receivables and payables in US $ to determine their net position.

UK subsidiary

Pays £ 500,000 = $500,000 x 1.4226 = $711,300(–)

Receives Yen 10 million = $ 10million123.42

= $81,024 (+)

Pays £ 650,000 = $650,000 x 1.4226 = $924,690 (–)

Net Payment to netting center = $ 1,554,966

France subsidiary

Receives £ 500,00 = $500,000x 1.4226 = $711,300 (+)

Pays Euro 600,000 = $ 600,000 x 0.8815 = $528,900 (–)

Receives Yen 50 million = 50million

123.42 = $405,121 (+)

Pays Euro 500,000 = $500,000 x 0.8815 = $440,750 (–)

Net Payment to netting center $146,771

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Japan subsidiary

Pays Yen 50 million = $ 50million123.42

= $ 405,121 (–)

Receives AUD 400,000 = $ 400.001.9153

= $ 208,845 (+)

Pays Yen 10 million = $ 10million123.42

= $ 81,024 (–)

Pays Yen 80 million = $ 80million123.42

= $ 648,193 (–)

Net Payment to netting center = $925,493 Australia subsidiary

Receives Euro 600,000 = $600,000 x 0.8815 = $528,900 (+)

Pays AUD 750,000 = $ 750,0001.9153

= $391,584 (–)

Pays AUD 400,000 = $ 400,0001.9153

= $208,845 (–)

Net Payment to netting center = $71,529 US Parent

Receives AUD 750,000 = $ 750,0001,9153

= $391,584 (+)

Receives Yen 80 million = $ 80million123.42

= $ 648,193 (+)

Receives £ 650,000 = $650,000 x 1.4226 = $924,690 (+) Receives Yen 80 million = $600,000 x 0.8815 = $440,750 (+) Net Payment to netting center = $2,405,217

143. a. The break even size of investment in CD,

E = M ik dk

⎛ ⎞− −⎜ ⎟⎝ ⎠

Where M = Minimum lot of investment k = Interest rate on borrowed funds i = Interest rate on CD d = Interest rate on bank deposits.

= £ 294,118 0.14 0.090.14 0.055

−⎛ ⎞⎜ ⎟−⎝ ⎠

As the surplus fund is more than the break even size of investment, so the company should invest in CDs.

b. The company has decided to invest in a CD of size £500,000. The surplus fund available is £400,000. So the company should borrow £100,000 for 90 days and pay 14% interest on its overdraft.

Interest income from investment in CD = 500,000 x 0.09365

= £11095.89

Interest to be paid on borrowing = 100,000 x 0.14 x 90365

= £3452.05

∴ Net interest income = 11095.89 – 3452.05 = £7643.84 Interest income if the company has opted for bank deposits

= 400,000 x 0.055 x 90365

= £5424.66

∴ By investing in CD, the company is gaining £(7643.84 – 5424.66) = £2219.18.

Part III: Applied Theory (Questions) 1. Globalization is no more a choice for any country. Domestic markets of the economy are

forced to integrate with the global markets. What do you think are the factors that have contributed to the integration of financial markets across the world? What benefits can the domestic economy expect by integrating domestic financial markets with that of the world markets? What are the probable costs associated with this?

2. Two unique features of post World War II international trade are (i) significant decrease in trade barriers and (ii) regional trading arrangements. Regional trading arrangements have the approval of WTO, which treats this as an exception to the principle of non-discrimination in international trade. What are the various forms of regional trading arrangements? Discuss about two of these arrangements of your choice.

3. There is a growing concern about the widening trade deficit and the composition of capital inflows. What is the significance of various deficits in the balance of payments statement?

4. Fixed exchange rate system is favored by some experts on the arguments that it (i) leads to orderly foreign exchange market, (ii) imposes financial discipline on the domestic government and (iii) promotes international trade by reducing the cost of trading. Briefly discuss various forms of fixed exchange rate systems.

5. Many experts favor a flexible exchange rate system because of (i) its simplicity, (ii) its continuous adjustment, (iii) independent domestic macroeconomic policies and (iv) reduced need for international reserves. Briefly discuss various forms of floating exchange rate systems.

6. There are various forms of Purchasing Power Parity which explain exchange rate determination between two currencies. Discuss the reasons for departure from relative forms of PPP.

7. If the forward premium deviates substantially from the interest rate differential, covered interest arbitrage is possible, says the Interest Rate Parity theorem. Briefly discuss the reasons why the Interest Rate Parity may not hold good in reality.

8. There are various techniques available to hedge a foreign exchange exposure which can be categorized as internal and external hedging techniques. This classification is based on whether the hedging technique under consideration is internal to the firm or external to the firm. Explain how a firm can hedge transaction and translation exposures through external hedging techniques.

9. In the recent past, Indian government has liberalized the norms related to Foreign Direct Investment in its efforts to attract FDI. Briefly explain why companies undertake Foreign Direct Investment.

10. One of the prime concerns of a multinational company in its working capital management is to strike a right balance between centralization and decentralization in cash management. Discuss the advantages of centralized cash management and the problems associated with it.

11. During the South-East Asian currency crisis, why do you think the INR did not depreciate significantly when other Asian currencies were tumbling?

12. It is generally believed that depreciation of home currency benefits the exporter and hurts the importer. Explain how an exporter can be hurt despite a real depreciation of his home currency and an importer can be hurt despite a real appreciation.

13. Unanticipated changes in exchange rates expose a firm to foreign exchange exposure. What is foreign exchange exposure? Illustrate different types of exposure.

14. Translation exposure represents the exposure of an MNC’s consolidated financial statements to exchange rate movements. This consolidation of financial statements is only for reporting purpose and does not affect the cash flows of an MNC. However, many MNCs are concerned about translation exposure since consolidated earnings can affect stock prices. What are the important determinants of translation exposure? Discuss briefly.

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15. Governments can intervene directly in the foreign exchange market by buying and selling currencies, thereby affecting demand and supply conditions, and in turn affecting the equilibrium values of the currencies. What are the main reasons for government intervention in the foreign exchange market? Discuss.

16. Multinational corporations use various techniques like technical, fundamental, mixed etc. to forecast exchange rates. Many of the decisions by MNCs are influenced by exchange rate projections made by them. Discuss why MNCs forecast exchange rates.

17. Write short notes on the following: a. Theory of absolute advantage b. Theory of comparative advantage 18. There are various types of flexible exchange rate systems like Free float, Managed float

etc. Discuss what are the advantages of a flexible exchange rate system. 19. Write short notes on the following: a. Asset approach to exchange rate forecasting b. Portfolio balance approach to exchange rate forecasting 20. Though flexible exchange rate system is widely prevalent across the globe, many experts

put up various arguments against the flexible exchange rates. Briefly discuss them. 21. IMF has various schemes to lend it’s members in case of need. Briefly discuss them. 22. Write short notes on the following a. J-curve effect b. Fisher effect 23. Write short notes on the following: a. Leading and Lagging b. Cross-hedging 24. Write short notes on the following: a. GDR b. ADR 25. Write short notes on: a. Banker’s Acceptance b. Post-Shipment Credit 26. a. What is forfaiting? b. Describe with the help of a flow chart how forfaiting transaction is undertaken by

EXIM bank of India. 27. Almost a year after the Asian currency crisis began, the following were the short-term

interest rates prevailing in different countries in the last week of May, 1998.

Indonesia : 45.50%

Thailand : 21.00%

S. Korea : 17.70%

Philippines : 14.43%

Malaysia : 11.04%

Hong Kong : 8.05%

Taiwan : 7.15%

Singapore : 6.50%

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a. Explain the reasons for the wide divergence in interest rates across the countries.

b. Explain the linkage between the strength of a currency and interest rate.

c. According to interest parity principle, when interest rates are relatively high for a currency it should depreciate and vice versa. Yet, central banks offen raise interest rates to prop up a currency. Explain how the two positions are consistent.

d. Why do you think the Indian Rupee did not depreciate significantly when other Asian currencies were tumbling?

28. The Hong Kong dollar has remained at 7.78 to the dollar for the past 15 years, barring minor variations. This has been so despite huge inflows and outflows of capital in Hong Kong’s open economy. Explain how the Hong Kong dollar could have remained steady even as currencies of relatively closed economies such as India have been far more volatile.

29. The Euro, a common currency for 11 countries of the European community, was launched on January 1, 1999. With the introduction of the Euro, the existing national currencies of the 11 countries are withdrawn from circulation. The monetary policy for all the 11 countries is managed by the European Central Bank based in Frankfurt.

a. Explain the various benefits which the 11 European countries will enjoy as a result of the Euro.

b. What could be the difficulties arising after the introduction of the Euro?

30. Many economists have argued that our country needs a strong domestic financial system before capital account convertibility is introduced. Explain the linkage between the health of a country’s financial system and its ability to deal with heavy inflows and outflows of capital.

31. Explain the difference between floating rate and fixed rate mechanism.

32. If the common central bank manages the monetary policy of the EMU, what could be the disadvantages to individual countries?

33. What do you think are the other areas which may eventually have a common regulatory framework? Justify.

34. It is now almost six months since the launch of Euro which, at the time of launch, was expected to compete with US $ as another alternative for reserve currency. However the Euro has lost around 10% so far. Many of the expectations of the dealers regarding Euro did not come true. It has been a miserable experience for most of the dealers who have taken long position in Euro either in the currency or in financial assets denominated in Euro.

i. Why do you think that Euro has depreciated?

ii. What are the economic models available for forecasting exchange rates? Describe any two models.

35. RBI hiked the interest rates and CRR when forex markets experienced volatility resulting Rupee losing ground rather rapidly. The hike in interest rates has put upward pressure on Rupee and helped in Rupee appreciating against US $. How do you think the interest rates have played a role in this context? Explain whether this behavior is in tune with the concept of Interest Rate Parity?

36. Mediacon System Ltd., a company producing computers in India is facing competition from computers assembled from imported components. With continued depreciation of the rupee, the prices of the assembled computers are falling.

a. Is Mediacon Systems facing foreign exchange exposure? Identify the type of exposure faced, if any.

b. What are the ways for reducing the exposure identified in (a) above?

37. A revocable letter of credit can be revoked without the consent of the beneficiary. Therefore, it is almost of no use in international trade. Do you agree? Justify. Describe the other types of letters of credit that are in use in international trade.

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38. “While the trade deficit is burgeoning, the only consoling factor is the increase in the remittances by Indians working abroad which reduced the current account deficit to some extent. But as the dependence on the short-term capital is increasing, a balance of payments crisis can be expected in the near future.”

a. What are the factors that may result in a balance of payments crisis? b. What can be the impact of a balance of payments crisis on the economy? c. What are the measures that can be taken by the government to prevent it? 39. “Recognizing that liberalization of capital account needs to be treated as a continuous

process, the Indian approach is based on a careful and continuous monitoring of certain preconditions/signposts and certain important attendant variables identified from the lessons of the international experience and specifics of the Indian situation”, says the RBI Report on Currency and Finance 1998-99. Briefly discuss the factors that need to be closely monitored in moving towards Capital Account Convertibility.

40. There are various techniques of managing foreign exchange exposure so as to reduce or eliminate foreign exchange risk. These can be broadly classified as internal and external hedging techniques. How do you differentiate between internal and external hedging techniques? Briefly describe the internal hedging techniques.

41. Write short notes on the following: a. Imitation gap theory. b. Currency board. 42. Discuss the advantages of centralized cash management system and the problems involved

in centralizing the cash management system. 43. “India continues to be vulnerable to the withdrawal of three types of foreign liabilities, which are

of short duration, NRI bank deposits, investments by FIIs and the short-term debt”, said the latest report of Duff & Phelps Credit Rating (DCR) agency. Discuss the factors which affect the components of India’s balance of payment account. Also, discuss the implications of high short-term debt.

44. Write short notes on the following: a. Transfer Pricing b. International CAPM c. Exposure and Risk.

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Part III: Applied Theory (Answers) 1. Alongside the growing importance of international versus domestic trade, there has been a

parallel growth in the importance of foreign versus domestic investment in the money market, the bond market, the stock market, the real estate market and the market for operating businesses. Globalization is the integration across geographical boundaries. Integration of financial markets involves the freedom and opportunity to raise funds from and to invest anywhere in the world, through any type of instrument. In response to the expanding horizons of investors, there has been an explosion of internationally oriented financial products such as internationally diversified, global and single foreign country mutual funds. The popularity of these products is a sign of integration in financial markets. Financial markets were not as integrated as they are today. A number of factors are behind this change which are as follows:

• The development of new financial instruments in global financial markets like the instruments of the Euro-dollar market, interest rate swap, currency swap, options, future contracts, forward contracts, etc.

• Liberalization of regulations governing the financial markets led to an integration of financial markets. Institutions like WTO and GATT agreements have evolved a synergy in different financial markets in the global arena.

• Increased cross border investments led by lucrative and attractive returns in other countries have widely participated in the integration of financial markets.

• Increased cross penetration of foreign ownership has helped in the countries developing an international perspective while deciding on the various factors influencing the process of globalization.

Benefits of Integration of Financial Markets: Among the rewards of integrated financial markets have been an improvement in the global allocation of capital and an enhanced ability to diversify investment portfolios. The gain from the better allocation of capital arises from the fact that international investment reduces the extent to which investment opportunities with high returns in some countries are foregone for want of available capital while low return investment opportunities in other countries with abundant capital receive funding. The flow of capital between countries moves closer the rate of return in different locations, thereby offering investors overall better returns. There is an additional gain from increased international capital flows enjoyed via an enhanced ability to smooth in consumption over time by foreign lending and borrowing as countries can borrow abroad during bad years and pay back in good years.

Costs of Integration of Financial Markets: The price paid for getting the benefits of integrated financial markets is the addition of exchange rate risk and country risk in the transactions involved.

Unanticipated changes in exchange rates cause uncertainty in investors’ home currency values of assets and liabilities. Currency risk is the risk arising out of the change in the value of investments denominated in some other country’s currency due to the change in the exchange rates. This change can increase the value of a foreign liability in terms of domestic currency.

Country risk is the risk of not being able to disinvest at will due to sudden change in the country’s foreign policies regarding foreign investors and repatriation of their profits, or because of certain other factors such as war revolution, etc.

One additional risk that integration of financial markets has brought to the fore is that, while the markets grow together, they usually also go down together in times of downturn in an economy or in case of any panic among the investors as we have seen with the South-East Asian Currency Crisis.

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2. As the trade among nations grew, a new phenomenon of countries of the same region coming together to form close trading ties, has emerged. For liberalizing and freeing the trade among themselves, the countries form trading groups known as trading blocks. These blocks differ in respect of the degree of economic co-operations between member countries. The different forms of trading blocks are

• Free trade area • Customs union • Common market • Economic union.

Free trade area: A free trade agreement is in some ways the lowest level of economic integration. While tariffs are removed on trade among members, each nation retains the freedom to set its own tariffs to outsiders. Measures like insisting for “certificate of origin" are used to avoid the possibility of diversion of trade within the free trade area from high-external-barriers countries to low-external-barriers countries.

Customs union: The next level of economic integration is a customs union. The member countries have no tariffs among them and common tariff rates for outsiders. The internal trade barriers among the member nations and the external barriers for non-members are common.

Common market: A common market allows free flow among member nations of not only goods, but also factors of production like labor and capital.

Economic Union: The member nations of an economic union have completely co-ordinated economic and social policies. There is a unified central bank and a common currency, which helps in developing well co-ordinated fiscal as well as monetary policies. The policies on agriculture, industry, research, welfare, regional development, competition, etc. are the same across member nations.

The North American Free Trade Area (NAFTA) is the most well known free trade area. The United States of America and Canada entered into a free trade agreement in 1988, which was joined by Mexico in 1993 to form the NAFTA. With a combined population of over 350 million, the NAFTA provides a large market where the tariffs are being reduced to create a borderless trading area.

The European Union (EU) was previously known as European committee. It was established in March 1957 by the signing of the treaty of Rome. Belgium, France, Germany, Italy, Luxembourg and the Netherlands initially signed the treaty. Later Denmark, Ireland and U.K in1973 joined it. The membership now stands at fifteen with Austria, Finland, Greece, Portugal, Spain, and Sweden joining at different points of time. The EU operated as a customs union for some time, transforming itself into a common market with effect from Jan 1, 1993. With a common central bank created in 1998 and a common currency (Euro) launched on Jan 1, 1999, this union is now known as European and Monetary Union (EMU).

3. By definition, the BoP account always balances. Yet, the individual components may or may not balance. This in reality gives rise to the widely discussed deficits or surplus arising in the BoP account. A net inflow on account of merchandise trade results in a trade surplus, while a net outflow results in a trade deficit. In the same way, a net inflow after taking all entries in the current account into consideration is referred to as the current account surplus, and a net outflow as current account deficit.

The capital account records movements on account of international purchase or sale of assets. Assets include any form in which wealth may be held – money held as cash or in the form of bank deposits, shares, debentures, other debt instruments, real estate, land, factories, antiques, etc. Any purchase of a foreign asset by a resident is entered as a debit item in that country’s BoP account, while any purchase by a foreign resident of a domestic asset is recorded as a credit item. The excess of the credits over debits in the capital account over a particular period is referred to as the capital account surplus. The excess of debits over credits is known as capital account deficit.

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When Current account + Capital account shows a surplus, it is defined as overall BoP surplus and if the sum is a deficit, it is overall BoP deficit. Overall BoP surplus results in an increase in the forex reserves of the country and a deficit to a decline in the forex reserves.

From national income accounting we know that

Private Savings + (T – G) = I + (X – M).

If government deficit increases, all other things remaining the same, it directly effects (X – M), the current account deficit. Therefore, an increase in the government deficit increases the current account deficit.

4. Under the fixed exchange rate system, the governments are committed to maintaining target exchange rates. Each central bank actively buys or sells its currency in foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-upon percentage. The variations of the fixed rate system are as follows.

Currency board system: Under the currency board system, a country fixes the rate of its domestic currency in terms of a foreign currency, and its exchange rate in terms of other currencies depends on the exchange rates between the domestic currency and the currency to which it is pegged. The monetary policies and the economic variables are kept in line with that of the reference country by the central monetary authority, called the currency board. The currency board maintains reserves of the anchor currency up to 100% or more of the domestic currency in circulation. Currency board commits to convert its domestic currency on demand into the anchor foreign currency to an unlimited extent, at the fixed exchange rate.

Target zone arrangement: A group of countries agree to maintain the exchange rate between the currencies within the certain band around fixed central exchange rates. The system is called the target zone arrangement in which convergence of economic policies of the participating countries are a prerequisite for this system.

Monetary union: Under this system the member nations of monetary unions agree to use a common currency, instead of their individual currencies. This wipes out the fluctuations of exchange rates and the attendant inefficiencies completely. A common central bank of member countries is set up, which has the sole authority to issue currency and to determine the monetary policy of the group as a whole. The central bank has the power to alter economic variables of member nations to maintain the same inflation rate in all the member nations.

European monetary union is an example of a monetary union. It has its own common currency (Euro) and has a common central bank.

5. Floating exchange rate system is the system in which exchange rates are determined by the demand and supply of the currencies in the international markets and so the exchange rate is variable. The rates depend on the flow of money between the countries, which may either result due to international trade in goods or services, or due to purely financial flows. Hence in case of a deficit or surplus in the balance of payment, the exchange rates get automatically adjusted and this leads to a correction of the imbalance. Floating exchange rates can be of two types:

Free float: Under the free float, market exchange rates are determined by the interaction of currencies’ supply and demand. The supply and demand schedules, in turn, are influenced by price level changes, interest differentials and economic growth. As these economic parameters change, market participants will adjust their current and expected future currency needs. There is no intervention either by the government or by the central bank.

Managed float: In the free float, there is always an uncertainty in exchange rate movements that reduces economic efficiency by acting as a tax on trade and foreign investments. In order to reduce the volatility associated with the free float, the central bank generally intervenes in the currency markets to smoothen the fluctuations. Such a system of managed exchange rates is referred to as a managed float or a dirty float.

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There are three approaches to manage the float: i. Smoothing out daily fluctuations: The central bank may occasionally enter the

market on the buy or sell side to ease the transition from one rate to another, rather than resist fundamental market forces, tending to bring about long-term currency appreciation or depreciation.

ii. “Leaning against wind”: This approach is an intermediate policy designed to moderate or abrupt short and medium-term fluctuations brought about by random events whose effects are expected to be only temporary. Intervention may take place to prevent these short and medium-term effects, while letting the markets find their own equilibrium rates in the long-term, in accordance with the fundamentals.

iii. Unofficial pegging: In the third variation, though officially the exchange rate may be floating, in reality the central bank may intervene regularly in the currency market, thus unofficially keeping it fixed.

6. According to the PPP theory, the changes in spot rates over a period of time reflect the changes in price levels over the same period in the concerned economies.

Reasons for departure from PPP: • Restriction on movement of goods • Price indexes and non-traded outputs • Statistical problems in evaluating PPP.

Restrictions on movement of goods: Whether it be transportation costs or tariffs that must be paid, they explain departures from PPP only in its absolute or static form. If one country has, for example, a 15% import tariff, prices within the country will have to move more than 15% above those in the other before it pays to ship and cover the tariffs that are involved. The effect of tariffs is different from the effect of transportation costs. Tariffs do not have a systematic effect. As a result of tariffs, prices can move higher only in the country, which has the import tariffs.

The existence of cost of transportation allows prices to differ between two countries. The possibility of two-way arbitrage allows prices to differ between markets by up to the cost of transportation.

One factor, which effects both absolute as well as relative PPP, is the presence of quotas imposed on the amount of goods that may be exported from or imported to a country. As this restricts the quantity of goods, arbitrageurs cannot move from one place to another and, it allows for deviations from prices. Hence PPP may not hold good.

Price indexes and non-traded outputs: Many of the items that are included in the commonly used price indexes do not enter into international trade. Most difficult to arbitrage between countries are immovable items such as land and building, highly perishable commodities such as fresh milk, fruits, etc. and also services such as hotel accommodations and repairs. These untraded items can allow departures from PPP to persist when we measure inflation from conventional market-bundle price indexes.

Statistical problems of evaluating PPP: The major ways in which the statistical method can affect the results of an empirical study are – through incorrect measurement of the difference in the inflation rates in the two economies. The second is through ignoring the fact that there is a two-way link between the spot exchange rate and the inflation rates. While the inflation rates affect the exchange rates, any change in the latter also affects the former. Any statistical method, which fails to recognize this two-way cause-effect flow, is likely to produce erroneous results.

7. The failure to achieve exact covered interest parity could occur because in actual financial markets there are • Transaction costs • Political risks • Potential tax advantages to foreign exchange gains versus interest earnings • Liquidity differences between foreign securities and domestic securities.

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Transaction costs: The cost of transacting in foreign exchange is reflected in the bid-ask spread in exchange rates. The bid-ask spread represents the cost of two foreign exchange transactions, a purchase and a sale of foreign currency. That is, if a person buys and then immediately sells a foreign currency, the cost of these two transactions is the difference between the buying and selling prices of the currency, which is the bid-ask spread. Interest arbitrage also involves two foreign exchange transaction costs, since the borrowed currency is sold spot and then bought forward. However, there are additional transaction costs of interest arbitrage due to interest rate spreads. This is because the borrowing interest rate is likely to exceed the investment interest rate.

Political risk: When securities, which are denominated in different currencies, trade in different countries, deviations from interest parity can result from political risk. Political risk involves uncertainty. When funds are invested in a foreign country, they may be frozen, become inconvertible into other currencies, or be confiscated. Even if such extremes do not occur, investors might find themselves facing new or increased taxes in the foreign country. This additional risk makes the investors require a higher return on foreign investments than warranted by the interest parity. This factor allows deviations from the parity to take place.

Taxes: If tax rates depend on the currency or the country in which funds are invested or borrowed, the interest parity condition can be affected. There are two ways in which taxes could conceivably affect the parity condition.

• Withholding tax – One might think that a potential cause of higher taxes on foreign earnings than on domestic earnings, and hence of a band around the interest parity line, is the foreign resident withholding tax. Withholding taxes is a tax applied to foreigners at the source of their earnings.

• Capital gains vs. income taxes – Taxes can affect the investment and borrowing criteria and the interest parity condition if investors pay different effective tax rates on foreign exchange earnings than on interest earnings. This can be the tax situation of investors who only infrequently buy or sell foreign exchange, because such investors can obtain capital account treatment of their foreign exchange gains or losses.

Liquidity differences: The liquidity of an asset can be judged by how quickly and cheaply it can be converted into cash. Transaction costs are faced when investors convert the foreign exchange from the hedged foreign currency security on the spot market. These costs would not have been faced had the security been held to maturity and the proceeds converted according to the original forward contract.

The extra spot and forward exchange transaction costs from the premature sale of a foreign currency investment require an initial covered advantage of foreign investment to make the initial investment worthwhile. The higher the expectation that the investment may have to be liquidated before maturity, the higher will be the required premium. Liquidity preference is hence another reason for interest parity not holding good in reality.

8. The various external hedging techniques used for hedging transaction and translation exposures are

• Forward Market: In a forward market hedge, a company that is long on a foreign currency will sell the foreign currency forward, whereas a company that is short on a foreign currency will buy the currency forward. In this way the company can fix the domestic currency value of future foreign currency cash flow, regardless of what happens to the future spot rate.

• Futures Market: To hedge in the futures market, go short in futures if you are long in the currency and vice versa. Hedging through futures has an effect similar to hedging through a forward contract. As the loss/gain on the underlying transaction has an offsetting impact the gain/loss on the futures contract, the exposure gets almost eliminated.

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• Options Market: Hedging through options is much more beneficial than hedging through futures or forwards. This is because in an option contract, the loss is limited whereas the profit is unlimited. Since the firm has the right to buy or sell the foreign currency but not the obligation, it can let the option expire by not exercising its right in case the exchange rates move in its favor, thereby making the profits it would not have made had it hedged through forwards or futures. If there is a receivable, buy a put option. In the case of a payable, buy a call option.

• Money Market: A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the domestic currency value of a future foreign currency cash flow. By doing this, the firm knows its total cost in advance in the form of principal and interest it needs to repay in the domestic markets. For example, a firm has a dollar payable after three months. It can borrow in the domestic currency now, convert it at the spot rate into dollars, invest these dollars in the money markets and use the proceeds to pay the payable after three months.

9. Companies undertake FDI for a number of reasons. The important ones are • Availability of raw materials • Integrating operations • Non-transferable knowledge • Protecting reputations • Exploiting reputations • Protecting secrecy • Product life cycle hypothesis • Capital availability • Organizational factors • Avoiding tariffs and quotas • Production flexibility • Other Strategic reasons.

Availability of raw materials: Many industrial firms, particularly mining companies, have little choice but to locate at the site of their raw materials. If copper or iron-ore is being smelted, it often does not make sense to ship the ore when a smelter can be built near the mine site. The product of the smelter – the copper or iron bars, which weigh much less than the original ore – can be shipped out to the market.

Integrating operations: When there are advantages to vertical integration in terms of assured delivery between various stages of production and the different stages can be performed better in different locations, there is a good reason to invest abroad.

Non-transferable knowledge: Sometimes a firm that has a production process or product patent can make a larger profit by doing the foreign production itself. This is because there are some kinds of knowledge which cannot be sold and which are the result of years of experience.

Protecting reputations: Products develop good or bad names, and these are carried across international boundaries. Therefore, it is important for multinational corporations to maintain homogenous quality to protect their reputations. There can be valid reasons for direct investment rather than licensing in terms of transferring expertise and ensuring the maintenance of a good name.

Exploiting reputations: FDI may occur to exploit rather than protect a reputation. One of the reasons why banking has become an industry with mammoth multinationals is that an international reputation can attract deposits; many associate the size of a bank with its safety.

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Protecting secrecy: Direct investment may be preferred to the granting of a license for a foreign company to produce a product if secrecy is important.

Product life cycle hypothesis: It has been argued that opportunities for further gains at home eventually dry up. To maintain the growth of profits, the firm must venture abroad to where markets are not as well penetrated and where there is less competition. This makes direct investment the natural consequence of being in business for a long enough time and doing well at home.

Capital availability: Access to capital markets can be a reason why firms themselves move abroad. The smaller one-country licensee does not have the same access to cheaper funds as the larger firms, and so larger firms are able to operate within foreign markets with a lower discount rate.

Organizational factors: The organization-theory view of direct investment emphasizes broad management objectives in terms of the way management attempts to shift risk by operating in many markets, achieve growth in sales, and so on, as opposed to concentrating on the traditional economic goal of profit maximization.

Avoiding tariffs and quotas: Another reason for producing abroad instead of producing at home and shipping the product concerns the import tariffs that might have to be paid. If import duties are in place, a firm might produce inside the foreign market in order to avoid them.

Production flexibility: A manifestation of departures from PPP is that there are periods when production costs in one country are particularly low because of a real depreciation of its currency. Multinational firms may be able to relocate production to exploit the opportunities that real depreciations offer. This requires that necessary technology can be transferred between countries and that trade unions or governments do not make the shifting of production too difficult.

Other Strategic Reasons: Companies enter foreign markets to preserve market share when this is being threatened by the potential entry of indigenous firms or multinationals from other countries. This strategic motivation for FDI has always existed, but it may have contributed to the multinationalization of business as a result of improved access to capital markets.

10. Advantages of centralized cash management system are

• Netting

• Currency diversification

• Pooling

• Security availability and Efficiency of collections.

Netting: It is extremely common for multinational firms to have divisions in different countries, each having accounts receivables and accounts payables, as well as other sources of cash inflows and outflows, denominated in a number of currencies. If the divisions are left to manage their own cash, it can happen, for example, that one division is hedging a long pound position while at the same time another division is hedging a short pound position of the same maturity. This situation can be avoided by netting, which involves calculating the overall corporate position in each currency. This calculation requires some central coordination of cash management.

Currency diversification: When cash management is centralized it is possible not only to net inflows and outflows in each separate currency, but also to consider whether the company’s foreign exchange risk is sufficiently reduced via diversification that the company need not hedge all the individual positions. The diversification of exchange rate risk results from the fact that exchange rates do not all move in perfect harmony. Consequently, a portfolio of inflows and outflows in different currencies will have a smaller variance of value than the sum of variances of the values of the individual currencies.

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Pooling: Pooling occurs when cash is held as well as managed in a central location. The advantage of pooling is that cash needs can be met wherever they occur without having to keep precautionary balances in each country. Uncertainties and delays in moving funds to where they are needed require that some balances be maintained everywhere, but with pooling, a given probability of having sufficient cash to meet liquidity needs can be achieved with smaller cash holdings than if holdings are decentralized. The reason pooling works is that cash surpluses and deficiencies in different locations do not move in a perfectly parallel fashion. As a result, the variance of total cash flows is smaller than the sum of the variances of flows for individual countries.

Security availability and Efficiency of collections: If the centralization occurs in a major international financial center such as London or New York, there are additional advantages in terms of a broader range of securities that are available and an ability to function in an efficient financial system. It is useful for a firm to denominate as many payments and receipts as its counterparties will allow in units of a major currency and to have bills payable in a financial center.

Disadvantages: It is rarely possible to hold all cash in a major international financial center. This is because there may be unpredictable delays in moving funds from the financial center to other countries. If an important payment is due, especially if it is to a foreign government for taxes or to a local supplier of a crucial input, excess cash balances should be held where they are needed, even if these mean opportunity costs in terms of higher interest earnings available elsewhere. When the cash needs in local currencies are known well ahead of time, arrangements can be made in advance for receiving the needed currency, but substantial allowances for potential delay should be made.

Complete centralization of management is difficult because local representation is often necessary for dealing with local clients and banks. Even if a multinational bank is used for accepting receipts and making payments, problems can arise that can only be dealt with on the spot. Therefore, the question a firm must answer is the degree of centralization of cash management that is appropriate, and in particular which activities can be centralized and which should be decentralized.

11. South-East Asian Currency Crisis was a very difficult time for the South-East Asian countries, except India.

The INR standing strong in the crisis was because of one reason – capital account convertibility was still not introduced in India. This did not allow speculation. This means that foreigners could not invest and divest here freely. There were norms governing the inflows and outflows on capital account, whereas in other South-East Asian countries, capital account convertibility had been introduced.

There are two fronts of a country’s BOP – capital account and current account. These are divided into capital expenditure, revenue expenditure, capital receipts and revenue receipts. Revenue expenditure consists of remittances abroad, imports, etc. whereas revenue receipts consists of inward remittances and exports. Capital expenditure consists of investments made abroad, loans granted to foreign countries while capital receipts consists of the same things inward.

In the South-East Asian countries, the capital receipts were being used for revenue purposes. For example, a loan taken from abroad by Indonesia was used for paying the interest charges of a previous loan. This kept on eroding the capital until it led to a crisis.

Another reason attributable to the crisis is the non-existence of bankruptcy laws. Unlike India and the US where a bankrupt firm has to close down after liquidation, in Japan, Indonesia and other South-East Asian countries, in the case of a bankruptcy, the firm had to carry on with additional loans and grants. This, in the long run, led to an economic collapse.

Also, the financial reforms in these countries were half-hearted, making the financial institutions vulnerable.

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12. Under normal circumstances, when there is depreciation in the home currency, the exporter will benefit. This is because he can buy more number of units of the home currency for the same amount of the foreign currency receivable. On the other hand, an importer has to pay more in terms of domestic currency for the same amount of foreign currency.

But, an exporter can be at a loss even when the home currency is depreciating. This can happen when the exporter imports inputs and home currency depreciates to a greater extent against the currency in which imports are invoiced than against the currency in which exports are invoiced. Further depreciation of home currency gets reflected in the domestic inflation leading to erosion of export competitiveness.

Suppose an Indian company imports raw diamonds from South Africa, cut-polish them and export to America. Its imports are invoiced in South African Rand (R) and exports in US $.

If the rupee depreciation against R is greater than the depreciation against US $, the exporter will be hurt despite depreciation of rupee.

In the same way an importer can be hurt if appreciation of domestic currency is more against the currency in which exports are invoiced than against the currency in which imports are invoiced.

13. Foreign exchange exposure is the sensitivity of changes in the real domestic-currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates.

Exposure is a measure of the sensitivity of domestic currency values. That is, it is a description of the extent or degree to which the home-currency value of something is changed by exchange rate changes. It is concerned with real domestic currency values.

The different types of exposure are

• Transaction exposure

• Translation exposure

• Operating exposure.

Transaction exposure: Transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency. A company’s transaction exposure is measured currency by currency and equals the difference between contractually fixed future cash inflows and outflows in each currency. Some of these unsettled transactions, including foreign-currency-denominated debt and accounts receivable, are already listed on a firm’s balance sheet. But other obligations, such as contracts for future sales or purchases, are not.

Accounting or Translation exposure: Accounting exposure arises from the need, for purposes of reporting and consolidation, to convert the financial statements of foreign operations from the local currencies involved to the home currency. If exchange rates have changed since the previous reporting period, this translation, or restatement, of those assets, liabilities, revenues, expenses, gains and losses that are denominated in foreign currencies will result in foreign exchange gains or losses. The possible extent of these gains or losses are influenced by the translation exposure figures.

Economic or Operating Exposure: Economic exposure is defined as the extent to which the value of the firm – as measured by the present value of its expected cash flows – will change when exchange rates change. Moreover, these items are not adjusted to reflect the distorting effects of inflation and relative price changes on their associated future cash flows. The definition of exposure based on market value assumes that management’s goal is to maximize the value of the firm.

14. Translation exposure is dependent on

• The degree of foreign involvement by foreign subsidiaries.

• The locations of foreign subsidiaries.

• The accounting methods used.

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Degree of Foreign Involvement: The greater the percentage of an MNC’s business conducted by its foreign subsidiaries, the larger will be the percentage of a given financial statement item that is susceptible to translation exposure. For example, the foreign involvement of some MNCs may be mostly in the form of exporting. These MNCs do not have much of their business conducted by foreign subsidiaries. Thus, the consolidated financial statements will not be substantially affected by exchange rate fluctuations (although such firms may exhibit a high degree of transaction and economic exposure).

Locations of Foreign Subsidiaries: The locations of the subsidiaries can also influence the degree of translation exposure, since the financial statement items of each subsidiary are typically measured by that country’s home currency. For example, consider the reporting situation of a US MNC with an Indian subsidiary. The Indian subsidiary’s assets, liabilities, earnings, etc. are measured in Indian rupees. The MNCs must develop consolidated quarterly financial statements that require translation of the Indian subsidiary figures into US dollar terms. If the subsidiaries are located in countries such as Canada, where the currency is somewhat stable against the US dollar, then translation risk will be lower.

Accounting Methods: Finally, the MNC’s degree of accounting exposure can be greatly affected by the accounting procedures it uses to translate when consolidating financial statement data.

15. Each country has a government agency that may intervene in the foreign exchange markets to control its currency’s value. In the United States, for example, the central bank is the Federal Reserve System (the Fed) and in India it is RBI. Central banks have more duties than intervention in the foreign exchange market. They attempt to control the growth of money supply in their respective countries in a way that will favorably affect economic conditions.

The degree to which the home currency is controlled, or “managed,” varies among central banks. Three common reasons for central banks to manage exchange rates are • To smooth exchange rate movements • To establish implicit exchange rate boundaries • To respond to temporary disturbances.

Smooth Exchange Rate Movements: If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time. Its actions may keep business cycles less volatile. It may also increase international trade by reducing exchange rate uncertainty. Furthermore, smoothing currency movements may reduce fears in the financial markets and speculative activity that could cause a major decline in a currency’s value.

Establish Implicit Exchange Rate Boundaries: Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries. Analysts are commonly quoted as forecasting that a currency will not fall below or rise above a particular benchmark value because the central bank would intervene to prevent that.

Respond to Temporary Disturbances: In some cases, a central bank may intervene to insulate a currency’s value from a temporary disturbance. In fact, many times RBI resorted to direct intervention where rupee fluctuated widely on Account of FIIs selling/buying pressure or Public sector oil companies demand for dollar.

16. Virtually every operation of an MNC can be influenced by changes in exchange rates. Several corporate functions for which exchange rate forecasts are necessary follow: 1. Hedging decision: MNCs are constantly confronted with the decision of whether to

hedge future payables and receivables in foreign currencies. Whether a firm hedges may be determined by its forecasts of foreign currency values. As a simple example, consider an Indian firm that plans to pay for imports from Mexico in 90 days. If the forecasted value of the peso in 90 days is sufficiently below the 90-day forward rate, the MNC may decide not to hedge.

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2. Short-term financing decision: When large corporations borrow, they have access to several different currencies. The currency they borrow will ideally (1) exhibit a low interest rate and (2) weaken in value over the financing period. If, for example, a US firm borrowed Japanese yen, and the yen depreciated against the US dollar over the financing period, the firm could pay back the loan with fewer dollars (when converting those dollars in exchange for the amount owed in yen). This financing decision should therefore, be influenced by exchange rate forecasts of any currencies available for financing.

3. Short-term investment decision: Corporations sometimes have a substantial amount of excess cash available for a short time period. Large deposits can be established in several currencies. The ideal currency for deposits would (1) exhibit a high interest rate and (2) strengthen in value over the investment period. Consider, for example, a Japanese corporation that has excess cash deposited into a British bank account, and assume the British pound has appreciated against the yen by the end of the deposit period. As the British pound are withdrawn and exchanged for yen, more yens will be received, due to the pound’s appreciation against the yen. Exchange rate forecasts of the currencies denominating available deposit accounts should therefore be considered when determining where to invest the short-term cash.

4. Capital budgeting decision: When an MNC attempts to determine whether to establish a subsidiary in a given country, a capital budgeting analysis is conducted. Forecasts of the future cash flows used within the capital budgeting process will be dependent on future currency values. Accurate forecasts of currency values will improve the estimates of the cash flows and therefore enhance the MNC’s decision-making abilities.

5. Long-term financing decision: Corporations that issue bonds to secure long-term funds may consider denominating the bonds in foreign currencies. As with short-term financing, corporations would prefer the currency borrowed (denominating the debt) to depreciate over time against the currency they are receiving from sale. To estimate the cost of issuing bonds denominated in a foreign currency, forecasts of exchange rates are required.

6. Earnings assessment: When earnings of an MNC are reported, subsidiary earnings are consolidated and translated into the currency representing the parent firm’s home country. Forecasts of exchange rates play an important role in the overall forecast of an MNCs consolidated earnings.

17. a. Theory of absolute advantage: A country would engage itself in the production of only those products in the production of which, it has an absolute advantage. Adam Smith gave this theory. It focuses on how efficiently a country can produce a product. For example, country “A” takes 100 labor hours and country “B” takes 150 labor hours to produce an aircraft. On the other hand, country “A” takes 40 labor hours and country “B” takes 35 labor hours to produce an automobile. In such a scenario, country “A” will produce only aircrafts and country “B” will produce only automobiles, because both of them have an absolute advantage in the production of their respective products, as they can be produced efficiently.

b. Theory of comparative advantage: David Ricardo propounded the Theory of Comparative Advantage. The principal reward of international trade is that it has brought about increased prosperity by allowing nations to specialize in producing those goods and services at which they are relatively efficient. The relative efficiency of a country in producing a particular product can be described in terms of the amounts of other, alternative products that could be produced by the same inputs. When considered this way, relative efficiencies are described as comparative advantages. All nations can and do simultaneously gain from exploiting their comparative advantages, as well as from the larger-scale production and broader choice of products that are made possible by international trade.

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18. Many experts favor the flexible exchange rate mechanism on the following arguments:

• Better adjustment

• Better confidence

• Better liquidity

• Gains from freer trade

• Increased independence of policy

a. Better adjustment: One of the most important arguments for flexible exchange rates is that they provide a less painful adjustment mechanism to trade imbalances than do fixed exchange rates. For example, an incipient deficit with flexible exchange rates will merely cause a decline in the foreign exchange value of the currency, rather than requiring a recession to reduce income or prices as fixed exchange rates would. It should be clear that a decline in the value of a currency via flexible exchange rates is an alternative to a relative decline in local-currency wages and prices to correct payments deficits. The preference for flexible exchange rates on the grounds of better adjustment is based on the potential for averting adverse worker reaction by only indirectly reducing real wages.

b. Better confidence: It is claimed as a corollary to better adjustment that if flexible exchange rates prevent a country from having large persistent deficits, then there will be more confidence in the country and the international financial system. More confidence means fewer attempts by individuals or central banks to readjust currency portfolios and this gives rise to stable forex markets.

c. Better liquidity: Flexible exchange rates do not require central banks to hold foreign exchange reserves since there is no need to intervene in the foreign exchange market. This means that the problem of insufficient liquidity does not exist with truly flexible rates, and competitive devaluations aimed at securing a larger share of an inadequate total stock of reserves will not take place.

d. Gains from freer trade: When deficits occur with fixed exchange rates, tariffs and restrictions on the free flow of goods and capital invariably abounds. If, by maintaining external balance, flexible rates avoid the need for these regulations, which are costly to enforce, then the gains from trade and international investment can be enjoyed.

e. Increased independence of policy: Maintaining a fixed exchange rate can force a country to follow the same economic policy as its major trading partners. For example, if the United States allows a rapid growth in the money supply, this will tend to push up US prices and lower interest rates in the short run, the former causing a deficit or deterioration in the current account and the latter causing it in the capital account.

19. a. Asset approach to exchange rates: A theory which emphasizes that monies are assets and, therefore, have values according to what market participants think the monies will be worth in the future. The asset approach to exchange rates looks at the current spot exchange rate as a reflection of the market’s best evaluation of what is likely to happen to the exchange rate in the future. All relevant available information about the future is incorporated into the current spot rate. Because new information is random, and could as easily be good as bad for one currency versus the other, the path of the exchange rate should contain a random component. This random component fluctuates around the expected change in the exchange rate. The expected change can reflect the implications of PPP – with more rapid inflation implying depreciation – or any other influence on exchange rates reflected in the balance of payments account.

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b. Portfolio balance approach to exchange rates: A theory basing exchange rates on the supply of and demand for money and bonds. The situation for money/bond supply and demand in one country versus another country determines the exchange rate between the two countries’ currencies. People are assumed to hold both countries’ money and bonds but prefer to hold their own. Exchange rates are such that all money and bonds are held. The portfolio balance approach recognizes that people might want to hold both, their own country’s currency and the foreign country’s currency, although they might have a preference for one country’s money, probably their own. This approach makes the same argument for bonds. That is, it assumes that people in both countries demand domestic and foreign bonds or, more generally, that people prefer diversified portfolio of securities. However, this approach does not have demand equation for different monies and bonds in each country, showing how these demands are related to incomes, interest rates and so on. Rather, it recognizes that supplies and demands for monies and bonds must balance, that is, markets must clear.

20. Various arguments against the flexible exchange rates by experts are discussed below:

a. Flexible exchange rates cause uncertainty and inhibit international trade and investment: It is claimed by proponents of fixed rates that if exporters and importers do not know the future exchange rate, they will stick to local markets. This means less enjoyment of the advantages of international trade and of making overseas investments, and it is a burden on everyone.

b. Flexible rates cause destabilizing speculation: A highly controversial argument is that under flexible exchange rates, speculators will cause wide swings in the values of different currencies. These swings are the result of the movement of “hot money”. This expression is used because of the lightning speed at which the money moves in response to news items.

c. Flexible rates will not work for open economies: This argument begins by noting that a depreciation or devaluation of currency will help the balance of trade if it reduces the relative prices of locally produced goods and services. However, a depreciation or devaluation will raise the prices of tradable goods. This will increase the cost of living, which will put upward pressure on wages. In such a case, a country may as well fix the value of its currency to the currency of the country with which it trades most extensively.

d. Flexible rates are inflationary: Rigid adherence to the gold standard involved a constraint on monetary authorities. They had to keep their money supplies and inflation under control. It is claimed by proponents of fixed rates that Bretton Woods and dollar standards also involved discipline, since inflation would eventually force devaluation. This gave the central bank public support for strong action to keep inflation under control. On the other hand, flexible exchange rates allow inflation to occur without any eventual crisis. Therefore, there is less motivation for governments to combat inflation.

e. Flexible rates can cause structural unemployment: After the discovery and development of vast supplies of natural gas off the Dutch coast, the Dutch Guilder appreciated substantially. This made traditional Dutch exports expensive, causing unemployment in these industries. The gas industry is far less labor-intensive than the traditional Dutch export industries, making it difficult for the displaced workers to find alternative employment. There are clearly valid arguments on both of the ledger for fixed and flexible exchange rates. Therefore, in the absence of any new, as-yet-untried dominant approach, we can expect the international financial system to respond to circumstances. Rising trade imbalances could push the system towards flexibility, whereas increased volatility from political events could push the system in the other direction.

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21. The lending facilities of the IMF have been expanded over the years. Standby arrangements were introduced in 1952, enabling a country to have funds appropriated ahead of the need so that currencies would be less open to attack during the IMF’s deliberation of whether help would be made available.

SDR’s were a new kind of reserve, which the IMF would distribute to member countries in proportion to their quotas. These reserves were created to maintain the proportion of international reserves to world trade. They were originally valued at US$1, the weighted average of 16 currencies at the time of introduction, but are now valued at the weighted average of a basket of five major currencies, the US dollar, the Japanese yen, French franc, Deutschmark, and the pound sterling. SDR’s could be used by the holder to acquire foreign currency from other country by depositing them via the IMF special drawing account. Other extensions of the IMF’s lending ability took the form of:

a. The Compensating Financing Facility (CFF), introduced in 1963 to help countries with temporarily inadequate foreign exchange reserves as a result of events such as crop failures.

b. The Extended Fund Facility (EFF) of 1974, providing loans for countries with structural difficulties that take longer to correct.

c. The trust fund from the 1976 Kingston agreement to allow the sale of gold, which was no longer to have a formal role in the international financial system. The proceeds of gold sales are used for special development loans.

d. The supplementary financing facility, gives standby credits and replaces the 1974-1976 oil facility, which was established to help countries with temporary difficulties resulting from oil price increases.

e. The buffer stock facility, which grants loans to enable countries to purchase crucial inventories.

22. a. J-curve effect: It takes time for people to adjust their preferences towards substitutes. Therefore, it is generally believed that demand is more inelastic in the short run than in the long run. This belief is particularly strong with regard to the elasticity of demand for imports, because the demand curve for imports is derived from the difference between the demand curve for a product in a country and the domestic supply curve of the product. After a depreciation and consequent increase in import prices, a country’s residents might continue to buy imports both because they have not adjusted their preferences toward domestically produced substitutes and because the domestic substitutes have not yet been produced. Only after producers begin to supply what was previously imported and after consumers decide to buy import substitutes can import demand fully decline after a depreciation. Similarly, exports expand from depreciation only after suppliers are able to produce more for export and after foreign consumers switch to these products. If import demand and export supply are more inelastic in the short run than the long run, we may find that depreciation worsens the balance of trade in the short run but subsequently improves it. Only later, when import and export elasticities increase, does the balance of trade turn around and eventually improve. This phenomenon of a worsening and subsequent improvement of the trade balance after depreciation is known as the J-Curve effect.

b. Fisher effect: The interest rates that are quoted in the financial press are nominal rates. That is, they are expressed as the rate of exchange between current and future rupees. For example, a nominal interest rate of 8% on a one year loan means that Rs.1.08 must be repaid in one year for Rs.1.00 loaned today. But what really matters to both the parties to a loan agreement is the real interest rate, the rate at which current goods are being converted to future goods.

Looked at one way, the real rate of interest is the net increase in wealth that people expect to achieve when they save and invest their current income. Alternatively, it can be viewed as the added future consumption promised by a corporate borrower to a lender in return for the latter’s deferring current consumption. From the company’s standpoint, this exchange is worthwhile as long as it can find suitably productive investments.

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However, because virtually all financial contracts are stated in nominal terms, the real interest rate must be adjusted to reflect expected inflation. The Fisher effect states that the nominal interest rate `r’ is made up of two components – a real required rate of return `a’, and an inflation premium equal to the expected amount of inflation `i’. Formally, the Fisher effect is

1 + Nominal rate = (1 + real rate) (1 + expected inflation rate)

1 + r = (1 + a)(1 + i) or r = a + i + ai

or

r = a + i approximately, since ai will be negligible

The Fisher equation says, for example, that if the required real rate is 3% and expected inflation is 10%, then the nominal interest rate will be about 13%.

23. Leading and Lagging: The act of leading and lagging represents an adjustment in the timing of payment request or disbursement to reflect expectations about future currency movements. For example, consider a multinational corporation based in the United States that has subsidiaries dispersed around the world. The focus here will be on a subsidiary within the UK that purchases some of its supplies from a subsidiary in Hungary. Assume these supplies are denominated in Hungary’s currency (the forint). If the British subsidiary expects that the pound will soon depreciate against the forint, it may attempt to accelerate the timing of its payment before the pound depreciates. This strategy is referred to as leading.

As a second possibility, consider a scenario in which the British subsidiary expects the pound to appreciate against the forint soon. In this case, the British subsidiary may attempt to stall its payments until after the pound appreciates. In this way it could use fewer pounds to obtain the forint needed for payment. This strategy is referred to as lagging. General Electric and other well-known MNCs commonly use leading and lagging strategies in countries that allow them.

Some countries’ governments limit the length of time involved on leading and lagging strategies, so that the flow of funds into or out of a country is not disrupted. Consequently, a multinational corporation must be aware of government restrictions of any countries in which it conducts business before using these strategies.

Cross-Hedging: Cross-hedging is a common method of reducing transaction exposure when the currency cannot be hedged. Assume a US firm has payables in currency X 90 days from now. Because it is worried that Currency X may appreciate against the US dollar, it may desire to hedge this position. If forward contracts and the other hedging techniques are not possible for this currency, the firm may consider cross-hedging in which case it needs to first identify a currency that can be hedged and is highly correlated with currency X. It could then set up a 90-day forward contract on this currency. If two currencies are highly correlated relative to the US dollar (that is, they move in a similar direction against the US dollar), then the exchange rate between these two currencies should be somewhat stable over time. When purchasing the one currency 90 days forward, the US firm can then exchange that currency for currency X. The effectiveness of this strategy depends on the degree to which these two currencies are positively correlated. The stronger the positive correlation, the more effective will be the cross-hedging strategy.

To illustrate a second use of cross-hedging, consider a Japanese firm that has net inflows denominated in Danish Kroner and net outflows denominated in Swiss francs. Because these two currencies often move in tandem against the Yen cross-hedge exists. If by chance the krone depreciates, the firm will obtain fewer yen when exchanging those kroner received. Of course, the Swiss franc will probably also have depreciated (though not necessarily by the same degree) against the yen. Thus, fewer yen will be needed to obtain francs when sending outflow payments. Regardless of whether these currencies depreciate or appreciate against the yen, the Japanese firm in this example will be somewhat insulated from the exchange rate fluctuations if the two currencies are highly positively correlated.

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24. a. Global Depository Receipts: GDR’s are essentially those instruments, which possess a certain number of underlying shares in the custodial domestic bank of the company. That is, a GDR is a negotiable instrument, which represents publicly traded local-currency-equity share. By the law, GDR is any instrument in the form of a depository receipt or certificate created by the overseas depository bank outside India and issued to non-resident investors against the issue of ordinary shares or foreign currency convertible bonds of the issuing company. GDR’s may be – at the request of the investor – converted into equity shares by cancellation of GDR’s through the intermediation of the depository and the sale of underlying shares in the domestic market through the local custodian. GDR’s are entitled to dividends and voting rights since the date of its issuance.

b. American Depository Receipts: ADR is a dollar denominated negotiable certificate, it represents non-US company’s publicly traded equity. It was devised in late 1920’s to help Americans invest in overseas securities and to assist non-US companies wishing to have their stock traded in the American markets. ADR’s are divided into three levels based on the regulation and privilege of each company’s issue.

i. ADR level-1: It is often the first step for an issuer in the US public equity market. Issuer can enlarge the market for existing shares and thus diversify the investor base. In this instrument, only minimum disclosure is required to the SEC and the issuer need not comply with the US GAAP. The issuer is not allowed to raise fresh capital or list on any one of the national stock exchanges.

ii. ADR level-2: Through this level of ADR the company can enlarge the investor base for existing shares to a greater extent. However, significant disclosures can be made to the SEC. The company is allowed to list on the American stock exchange or the New York stock exchange, which implies that the company must meet the listing requirements of the particular exchange.

iii. ADR level-3: This level of ADR is used for raising fresh capital through public offering in the US capital markets. The company has to be registered with the SEC and comply with the listing requirements of AMEX/NYSE while following the US-GAAP.

25. a. Short-term Financing: Banker’s Acceptances: When an exporter gives credit to a foreign buyer by issuing a draft for some date in the future, the draft itself can be used by the exporter for short-term financing. The procedure depends on whether the draft is issued in conjunction with a letter of credit.

If the exporter’s draft is drawn in conjunction with a letter of credit, the draft will be sent to the bank that issued the letter of credit. When this draft is stamped “accepted” by the bank and signed by an officer of the bank, it becomes a banker’s acceptance. The exporter can sell the banker’s acceptance in the money market at a discount that is related to the riskiness of the accepting bank. We note that it is the importer who determines which bank will accept the draft. The exporter can have the draft reaccepted or confirmed if the fee for confirmation improves the price received for the accepted draft by more than the cost of the reacceptance.

If the exporter’s draft is drawn without an importer’s letter of credit, the draft is a trade draft. This can be sold in the money market, but because it is only a commercial rather than a bank obligation, the draft will face a higher discount than would a banker’s acceptance. However, the exporter can pay a bank to accept the draft, and then sell this at a lower discount. The acceptance charge can be compared to the extra value received on the discounted draft. All documents including shipping documents will normally be provided to the bank accepting the draft.

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When an exporter draws up a time draft, the exporter is granting the importer credit which the exporter may finance by selling the signed draft. When an exporter draws up a sight rather than a time draft, the exporter is not granting credit to the importer; there is no delay in payment. Nevertheless, a banker’s acceptance may be created in this situation. This will happen if the importer draws up a time draft in favor of a bank, signs the draft, and has it accepted by the bank. The bank will then either sell the draft or hold it for collection. An importer might take this step to finance goods purchased from abroad before they are sold.

The time after sight on a banker’s acceptance, whether created by the exporter or by the importer, is typically 30, 90 to 180 days. Consequently, banker’s acceptances are only a mechanism for short-term trade financing.

b. Post-shipment Credit: After shipment of goods, the exporter tenders the export documents to a bank either for negotiation or for purchase or discount. Post-shipment credit is made available to the exporter in the following ways:

a. against export documents drawn up under foreign letters of credit

b. purchase of export bills (drafts) drawn under confirmed contracts

c. advance against drafts sent for collection

d. advance against goods shipped on consignment basis

e. advance against cash assistance and duty drawback to which the exporter is entitled.

The documents tendered are scrutinized by the bank to ensure that they have been drawn up in conformity with exchange/trade control regulations. FEDAI rules and the terms and conditions stipulated by the bank for negotiation of documents. The exporter should obtain the requisite post-shipment policy of the ECGC. The bank, in turn should cover itself by a suitable post-shipment guarantee of the ECGC. Marine Insurance cover is provided by the subsidiaries of General Insurance Corporation (GIC).

Further, banks have to verify whether the correct types of documents in the required sets/copies have been submitted. Documents have to be duly endorsed and stamped. Physical description of goods mentioned in the documents, should conform to the description given in the letter of credit. Draft has to be drawn according to the terms stipulated in the credit. After verifying these points, the bank scrutinizes in detail the draft, insurance policy and other documents.

26. a. Forfaiting is a device used in Europe for medium-term export financing, particularly capital equipment exports to erstwhile Eastern Block countries. Under this arrangement, the importer gives a bundle of promissory notes falling due at various dates in the future according to an agreed-upon schedule. The exporter can discount the entire package, without recourse, with a specialized finance firm (usually a subsidiary of a large European bank) called the Forfaiter. The political and other risks of non-payment by the importer are carried by the Forfaiter. The importer’s notes are endorsed by a reputed bank in his country (which in the case of East European countries and erstwhile USSR used to be a government bank). The forfaiter “unbundles” the package and sells the notes separately to investors at a discount lower than that charged to the exporter.

b. Forfaiting is a common form of financing export related receivables. It is similar to Bill Rediscounting Scheme. EXIM Bank has introduced this scheme for the Indian exporters. Under this scheme the exporter after finalization of the sale (or contract) with a prospective buyer furnishers all the necessary details regarding the contract to the EXIM Bank through which a contract of forfaiting is finalized by the exporter with the overseas forfaiting agency. The exporters draw a series of bills of exchange on the overseas buyers which will be sent along with the shipping documents to the buyers bank for overseas buyer’s acceptance of the buyer and signature of `avail’ or the guaranteeing bank. The exporter will submit to his bank to be forwarded to EXIM Bank which passes the documents to the forfaiting agency. Proceeds of the bills are passed from the overseas forfaiting agency to the exporter through the EXIM Bank.

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1. Commercial contract between the foreign buyer and the Indian exporter. 2. Commitment to forfait bills of exchange/promissory notes (`debt

instruments’). 3. Delivery of goods by the Indian exporter to the foreign buyer. 4. Delivery of debt instruments. 5. Endorsement of debt instruments without recourse in favor of the forfaiter. 6. Cash payment of discounted debt instruments. 7. Presentation of debt instruments on maturity. 8. Payment of debt instruments on maturity.

27. a. The differences in interest rates reflect the differences in degrees to which the

countries have been affected by the currency crisis. Countries worst effected by the currency crisis have had to steeply hike their interest rates not only to stop further slide of the domestic currency but also to control the resulting inflation.

b. A strong currency is likely to appreciate in the near term. As such, interest rate would be relatively low to ensure that returns are equalized across currencies. Another way of arguing is that a strong currency needs to pay only a small interest rate to attract investors.

A weak currency is expected to depreciate. As such, high interest rate is the compensation which prospective investors would be looking for.

c. When interest rates are raised, the most likely phenomenon would be investors attempting to park surplus funds in that currency. This would mean buying the currency as a result of which it would appreciate. Since investors would cover their risk, they would presumably sell the currency forward. As a result, the forward discount will adjust. Thus, the currency will appreciate in the spot market but trade at a forward discount so that arbitrage profits are ruled out. What has been explained is the general case.

In some cases, central banks may raise interest rates to curb inflation. If the markets are not convinced that the hike is adequate, the currency may actually be driven down even after the hike the interest rate is announced.

d. There are several restrictions on trading in India. The RBI has a strangle hold on the market. Free repatriation of foreign capital is not allowed in India. As such, the rupee did not really face the full fury of the storm in East Asia.

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28. Hong Kong follows the currency board system which is similar to the erstwhile gold standard which prevailed in the early part of the 20th century. Under the system, the Hong Kong Monetary Authority increases domestic money supply when dollars flow in and vice-versa. Because of this mechanism, the demand supply balance between Hong Kong Dollars and US Dollars is maintained at a parity level of 7.78, leaving aside minor variations. Suppose, there is a downward pressure on HK $. The Monetary Authority would contract money supply thereby allowing interest rates to go up. This would once again attract investors back into Hong Kong’s currency. When the HK $ tends to appreciate, the policy measure used would be to expand money supply and lower interest rate.

29. The benefits from a single currency are: i. Currency risk will be eliminated in transactions between the members. ii. Transaction costs will be reduced between the members. iii. Elimination of currency risk and reduction in transaction costs will increase capital

flows. iv. The currency will be more stable. v. Gains of seigniorage. vi. With the establishment of the System of Central Banks, member countries, that

could not so far influence the policies of the Bundes Bank, can have their say. vii. Movement of labor across the member countries may improve. The disadvantages likely to arise from the single currency are: i. Member countries lose their control over monetary, exchange rate and fiscal

policies. The difficulty due to the loss of control will get accentuated if, for example, a member country faces high inflation and the Union wants to follow an expansionary policy.

Similarly, if one of the member countries is facing high unemployment, it needs policies that generate more number of jobs than jobs that support a specified standard of living. If the country does not have the freedom to alter the policies, social unrest may arise. This problem may, theoretically speaking, be solved by the movement of labor from one industry to another and one country to another. But, considering that the European labor force is not very mobile, the problem may lead to differences among members before long.

ii. Conversion to Euro means maintenance of a fixed exchange rate between the present currencies by the member countries. Supporting such a fixed exchange rate calls for a considerable amount of co-ordination in the macroeconomic policies of the members, which is difficult to establish.

30. Inflow of foreign capital is generally in two forms: long-term investments such as funding of industrial projects and short-term investments, such as portfolio investments in financial assets.

When capital account convertibility is introduced, the inflows are likely to be mostly short-term. The reason lies in the political risk perception of the foreign investors. That is, a long-term investment can be made in a foreign country only if it is reasonably certain that the country remains investment-worthy in the long run. Since that is difficult to judge and the outlook is not very positive for India, the inflows will be short-term.

Another reason that makes short-term investments attractive is that they start generating returns almost immediately, contrary to long-term investments, which have long gestation periods. Short-term capital is generally very volatile. They are withdrawn at the first sight of a crisis. Thus, the characteristic feature of short-term capital flows is that both inflow as well as the outflow will be very quick.

The inflows being immediate increase the money supply immediately. The financial system of the country should be able to absorb this. If not, excessive money supply will lead to inflation. And, high demand for the local currency may lead to its appreciation, affecting exports. Sudden inflows of huge amounts of capital may push up the prices of financial assets creating aberrations in the markets.

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When short-term investments are withdrawn, they cause a sharp fall in the market values of financial assets. Heavy demand for foreign currencies will result in a sharp fall in exchange rate of the local currency. If these two should not happen, the markets for financial assets should be strong enough to absorb such volatility in capital flows. In case the economy as such is not in a position to withstand, the reserve position of the Central Bank should be strong enough to launch a defense of the currency.

Foreign Capital Inflows can affect the health of the financial system if the following mistakes are committed:

i. Lending for non-productive uses such as consumption loans. Such loans do not increase the income of the borrower and the risk is higher.

ii. Directed lending at lower rates. iii. Lending to individuals who are not creditworthy. iv. Lending heavily to real estate sector. v. Investments are allowed through secondary markets. Though there is nothing wrong per se in lending for consumption or lending to real estate

sector, problems arise when the amount lent becomes excessive. Outflow of foreign capital precipitates a banking crisis if the above mistakes are committed, because banks become weak in the long run and will not be in a position to withstand withdrawal of capital.

31. The differences between the floating rate mechanism and fixed rate mechanism are a. In the floating rate mechanism, the exchange rate is determined by the market

forces, while in fixed rate mechanism, the exchange rate is determined by the government. Therefore, in floating rate mechanism, the exchange rate depends on the perception of the market about the relative worth of various currencies while in the fixed rate mechanism, the rate depends on what the government wants it to be.

b. In fixed rate mechanism, the government needs large amounts of reserves to be able to maintain the currency at the level it wants. In the floating rate system, the government does not interfere in the market.

c. In some variations of the fixed rate mechanism, the value of the currency is adjusted upwards or downwards depending on the values of certain key parameters such as money supply.

d. The fixed rate system though useful for maintaining a stable exchange rate, may give rise to market distortions in the long run. The floating rate system, on the other hand, may result in wide fluctuations in the exchange rates over short time intervals but is expected to settle down at its true value.

32. The following are the major disadvantages to individual countries if the monetary policy is managed by the EMU:

a. Recession: Suppose one of the countries is facing recession and wants to increase the investment by increasing money supply and bringing interest rates down. It will not be able to do so as money supply is controlled by the EMU.

b. Inflation: Again, as they do not have any control on the money supply, individual countries will not be able to increase or decrease inflation on their own. If the level of inflation decided by the EMU does not match the economic condition of the individual countries, they can only request the EMU for a change in policy and cannot do anything on their own.

c. Unemployment: Unemployment can be reduced by generating employment opportunities, which in turn are dependent on creation of investment. For stimulating investment, money supply and interest rates have to be altered. Once again, individual countries will have to wait for the Union to act and will not be able to do anything to improve the situation on their own. This may have political consequences.

d. If the Union is running a deficit, individual countries will not be able to alter this by planning their trade and will have to suffer until things are set right by the Union.

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e. Fiscal Problems: Populist policies such as subsidies give rise to deficits in the long run. They may also result in crowding out of private investment. There are certain monetary tools with which these problems can be overcome. Lack of control over monetary policy will, again, mean that member countries will have to wait until the EMU acts.

33. After the currency union, it is expected that there will be greater movement of goods, labor and capital across the member countries enhancing the allocational efficiency of their economies. If the movement of these three becomes as free as expected, then, over a period of, say, half a decade, the regulatory norms in these countries will become uniform. Why should it be so? When movement across the countries is freely allowed, goods, labor as well as capital will move to the place where they find the conditions most congenial, forcing other countries also to change the conditions. More specifically, uniformity in regulations may be seen in the following areas:

a. Quality Specifications and Consumer Grievances: Movement of goods can take place freely only if the regulations regarding the quantities in which packaging can be made, the containers in which packaging has to be made, and the minimum quality standards, regulations regarding their movement and stocking are similar. Similarly, uniform norms regarding the minimum quality of food grains will evolve.

b. Financial Markets: If in one of the countries dividends paid to foreign investors are taxed at 10% and in another country there is no tax, companies desirous of raising capital from different countries will prefer the latter country. There is also a likelihood of uniform entry norms for both residents and non-residents to raise capital.

c. Credit Rating: If companies raising capital are allowed to make issue in any country of the Union as they please, they will naturally choose the country in which the credit rating norms are least strict. As companies flock to countries with less strict norms, the remaining countries may also relax their norms to attract the companies or pressurize the other countries to tighten their norms. Thus, over a period of time, the credit rating norms in the entire region may become uniform.

d. Environmental Regulations: If environmental regulations in different countries are not similar, firms will choose the countries where they are most lax. But then, those countries may attract hazardous industries and may want to tighten the regulations. Similarly, the countries which do not attract industries may want to relax their regulations. Ultimately, the regulations of all the countries will become similar.

Apart from the above, there can be many other areas in the real sector and financial sector where uniformity is expected.

34. i. The countries which were to join Euroland were required to meet certain economic criteria (called the convergence criteria). These criteria were very stringent and difficult to meet. One of the countries, Greece could not meet them and was therefore not allowed to join in. Later, as the economic performance of the countries that joined too did not meet the expectations, the confidence of the players in the market on Euro decreased, leading to its fall.

During the period of run-up to the Euro, expectations regarding the performance of these countries were high and led speculators to expect appreciation of the Euro and build substantial long positions in it. As the expectations about the performance of the countries did not come true and the Euro started depreciating, they have liquidated their positions, accentuating the fall.

The performance of the US economy also contributed to the fall of the Euro. As the US economy performed well, in contrast to expectations of a recession, the dollar appreciated against the Euro.

ii. The economic models for forecasting exchange rates are:

(1) Flow Models of Exchange Rate Determination

(2) Current Account Monetary Model

(3) Capital Account Monetary Model

(4) Portfolio Balance Model

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Current Account Monetary Model: The ideas of this approach can be summarized as follows: a. There is only one asset i.e. money. b. Purchasing power parity holds. c. In each country, there is a stable demand-for-money function. d. Fully flexible exchange rates keep balance of payments in continuous equilibrium.

Consequently, there are no changes in foreign exchange reserves. The model says that domestic residents, when faced with a discrepancy between the stock

of money they wish to hold with and the actual stock of money created by the monetary authority, will attempt to correct it by running a balance of payments deficit or surplus. If there is excess supply of money, they will try to get rid of it by purchasing domestic goods as well as importing foreign goods and services and vice versa. This will instantaneously lead to a pressure on the domestic price level and depreciation and appreciation of the exchange rate.

An increase in domestic interest rate by the monetary authority will result in just the opposite. This will prevent the currency from depreciation and hope to attract foreign capital, which may lead to appreciation of the exchange rate.

Capital Account Monetary Model: The main ingredients of the model are: a. PPP holds in the long run. b. There is a stable demand for money. c. Uncovered interest parity and Fisher open conditions hold. d. Expected change in the exchange rate in the short run depends upon perceived

departures from long run equilibrium exchange rate and expected inflation differentials.

The model predicts that an increase in money supply will depreciate the exchange rate in the long run, while an increase in real income will lead to appreciation. The effect of increase in interest rate if caused by `monetary tightening’ will result in the home currency appreciation, while if it is due to upward revision of inflationary expectations will result in home currency depreciation.

35. The role played by the interest rates is as follows: When interest rates are raised the existing equilibrium (the interest parity condition) gets

disturbed. As the rupee interest rates are higher than they should be at the equilibrium condition, arbitrageurs get an opportunity to profit from it. Consider the following graph:

F(Rs./ $) S(Rs./ $)S(Rs./ $)

− (1 + r$)

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Let us say that until now, the interest rate differential between the US and India and also the forward discount on the rupee are equal to 3%. It is indicated by point A on the graph. Now, if the interest rates in India are increased, say by 1%, the interest differential increases by 1% to 4%. Then the point will plot at B in the above graph, because the forward discount on the rupee is still at 3%. Arbitrageurs can borrow in dollars, sell the dollar spot for Rupees, invest the Rupees and sell the rupee proceeds from investment in the forward market for dollars. Thus, there is a selling pressure on the dollar in the spot market (buying pressure on the Rupee in the spot market) and selling pressure on the rupee in the forward market (buying pressure on the dollar in the forward market). Therefore, the rupee will appreciate in the spot market and depreciate in the forward market. Because of this, the forward discount on the rupee increases, until it reaches 4% and the arbitrage opportunity is eliminated. Thus, the influence of the interest rate hike is to increase the spot exchange rate and decrease the forward exchange rate and it is perfectly in accordance with the interest parity principle.

36. a. The prices and quantities of inputs and outputs are not fixed for the company and these subjected to change when exchange rate changes. The firms profit margin is influenced exchange rates. Hence, the company is facing operating exposure.

b. Operating exposure depends upon choice of price and elasticity of demand. In the area of marketing, improved knowledge of customers’ price sensitivity, competitive response, effect of non-price variables on sales, etc. are of great importance. The firm can reduce the adverse effects of exchange rate changes on its revenue by moving into product lines which are less price sensitive and by countering the effect of increased prices by means of other competitive weapons such as local advertising and promotion. Note that shifting product-market combinations is a long-term strategic decision. • If inputs are purchased in markets where the local content in their costs is

high, exchange rate changes will significantly alter the relative costs of sourcing from alternative sources. When the input markets are global in scope e.g. crude petroleum and petroleum products, sourcing decisions are relatively less important. In some cases, use of commodity options and futures may enable the firm to hedge commodity price risk.

• Shifting the location of production to countries whose currencies have depreciated in real terms can reduce the adverse impact of exchange rate changes provided production costs in different locations have a large local content (e.g. labor) and economies of scale are relatively less important.

37. Though the essential character of a credit – the substitution of the bank’s name for the merchant’s – is absent with a revocable credit, this type of L/C is useful in some respects. Just the fact that the bank is willing to open a letter of credit for the importer gives an indication of the customer’s creditworthiness. Thus, it is safer than sending goods on a collection basis, where payment is made by a draft only after the goods have been shipped. Of equal, if not greater, importance is the probability that imports covered by letters of credit will be given priority in the allocation of foreign exchange, should currency controls be imposed.

To cater to the wide variety of transactions and customers, different types of letters of credit have evolved. A revocable L/C is issued by the issuing bank and contains a provision that the bank may amend or cancel the credit without the approval of the beneficiary. It provides least protection to the exporter. An irrevocable L/C cannot be so amended or canceled without the exporter’s prior approval. A confirmed, irrevocable L/C contains an extra protection; in addition to the issuing bank’s commitment, a confirming bank adds its own undertaking to pay provided all conditions are met. The confirming bank (which may be but need not be the same as the advising bank) will pay even if the issuing bank cannot or will not honor the exporter’s draft. A revolving L/C is used when the exporter is going to make shipments on a continuing basis and a single L/C will cover several shipments. A transferable L/C permits the beneficiary to transfer a part or whole of the credit in favor of one or more secondary beneficiaries. This type of L/C is used by trader exporters who act as middlemen between the importer and the suppliers of the goods. The trader intends to

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profit from the difference between the original amount of credit and the amount transferred to the secondary beneficiaries. In a back-to-back L/C the beneficiary of the original L/C requests a bank (usually the advising bank to the original L/C) to open an irrevocable L/C in favor of another party who may be the ultimate manufacturer/supplier of the goods. The original L/C is a guarantee against the second L/C. In a red-clause L/C a clause printed in red ink on a normal L/C authorizing the advising bank to make clean advances to the exporter which are offset against the export proceeds when the documents are finally presented. In effect the importer makes unsecured loans to the exporter in the latter’s currency. This type of L/C is used when there exists a close relationship between the importer and the exporter. When the currency of invoice in a transaction is neither the exporter’s nor the importer’s home currency, a bank in the importer’s country may request a third country bank to advise the exporter that the exports will be paid for in the third country’s currency by that bank. Thus a Dutch importer of cocoa from Ghana would ask his bank to request an American bank to advise the exporter that the draft will be settled in dollars at the American bank.

Both the exporter and the importer must take care that all the relevant and significant details pertaining to the transaction are clearly spelt out in the L/C and all the documents including the draft are prepared exactly as specified in the L/C since the banks will be guided strictly by what is stated in the L/C.

38. a. The factors which may result in balance of payments crisis: i. Insufficient savings in the population of a country, which may be due to the

low level of income in the economy, high taxes or rising price levels. ii. Insufficient savings by the government, which may be due to the high

government expenditure on development projects, higher outgo on social welfare schemes, payment of salaries by printing money, payment of interest on public debt, high expenditure on defense, high level of subsidies.

iii. High level of import bill for oil, capital equipment, foods, electronic goods, computer peripherals.

iv. Uncompetitive exports of the country. b. The impact of balance of payments crisis on the economy: In the short run BoP crisis may have an immediate impact on the exchange rate. If

the exchange rate is market-determined, the BoP crisis will immediately depreciate the value of a currency. If the exchange rate is controlled by the government, then in the long run the monetary authority have to devalue the currency to keep its exports competitive.

As a result of BoP crisis the price level will rise, as the monetary authority will print money to cover its deficits.

Negative BoP means that investment requirement of an economy is exceeding the savings generated by the economy. So due to insufficient capital the economy will not be able to produce required amount of goods and services to keep itself in a growing track. As a result the country may resort to external borrowings, thus increasing the probability of falling into a debt-trap.

c. The measures that can be taken by the central bank are i. A country facing a BoP crisis may raise the interest rates to attract short-term

capital inflows to prevent depreciation of its currency. ii. Monetary authority may impose some sanctions for remitting foreign

exchange outside the country. iii. If the exchange rates are controlled by the monetary authority, then the

monetary authority will purchase the domestic currency against the foreign currency to keep the value of domestic currency intact.

iv. If the economy is affected by inflation, the monetary authority must step in to curb the expansion in money supply by either contracting its lending to the banking system or increase the reserve requirement of banks.

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39. Capital account convertibility is defined as a freedom from restrictions on transactions in the capital and financial accounts of the balance of payments. It entails the removal of exchange and other control but not necessarily all tax-like instruments imposed on the underlying transactions. The external payment difficulties of early 1990s highlighted the weakness of debt-dominated capital account financing and brought out a need for a more balanced approach to capital flows in the form of non-debt creating flows, particularly direct investment flows, on account of their positive impact both in terms of technology and the stabilizing role in external sustainability. In India the focus of the policy is to gradually liberalize capital account, by considering capital account convertibility as a process rather than as a single event.

The factors need to be closely monitored in moving towards Capital Account Convertibility are as follows:

Strengthening of the financial system: For a vibrant economy and for greater control of monetary authority on the financial system, the financial system should be strengthened. The market should be institutionalized and intermediated. The disclosure norms should be stringent.

Mandated inflation rate: The monetary authority targets an inflation rate and designs monetary policies to attain the goal. Containment and targeting of inflation rate is valuable as it has vital linkages for the interest rates, exchange rates and external sectors.

Fiscal consolidation: Containment of inflation for a developing country like India requires stringent fiscal consolidation. Deficits should be curtailed and non-productive expenditures on part of the government should be minimized.

Monitoring of attendant macroeconomic indicators: Different macroeconomic variables like exchange rate, balance of payments, adequacy of reserves of the financial intermediaries should be monitored and to be kept at an acceptable level for the smooth functioning of the economy.

The above factors should be closely monitored while determining the appropriate timing and sequencing of Capital Account Convertibility. The process of capital account liberalization needs to be embarked as part of the overall economic reforms with proper assessment of the emerging economic scenario relating to international economic and financial architecture.

40. The basic instruments that can be used for managing foreign exchange exposure can broadly be classified as internal and external instruments. Internal instruments are those which are a part of the day-to-day operations of a company, while external instruments are the ones which are not a part of the day-to-day activities and are especially undertaken for the purpose of hedging exchange rate risk. Here, it needs to be noted that the term internal does not denote that no external party is involved. It only denotes that it is a normal activity for the company.

The various internal hedging techniques are: • Exposure netting • Leading and lagging • Choosing the currency of invoice • Sourcing.

Exposure Netting: Exposure netting involves creating exposures in the normal course of business which offset the existing exposures. The exposures so created may be in the same currency as the existing exposures, or in any other currency, but the effect should be that any movement in exchange rates that results in a loss on the original exposure should result in a gain on the new exposure. This may be achieved by creating an opposite exposure in the same currency or a currency which moves in tandem with the currency of the original exposure. It may also be achieved by creating a similar exposure in a currency which moves in the opposite direction to the currency of the original exposure.

Leading and Lagging: Leading and lagging can also be used to hedge exposures. Leading involves advancing a payment, i.e. making payment before it is due. Lagging, on the other hand, refers to post-poning a payment. A company can lead payments required to be made in a currency that is likely to appreciate, and lag the payments that it needs to make in a currency that is likely to depreciate.

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Hedging by Choosing the Currency of Invoicing: One very simple way of eliminating transaction and translation exposure is to invoice all receivables and payables in the domestic currency. However, only one of the parties involved can hedge itself in this manner. It will still leave the other party exposed as it will be dealing in a foreign currency. Also, as the other party needs to cover its exposure, it is likely to build in the cost of doing so in the price it quotes/it is willing to accept.

Another way of using the choice of invoicing currency as a hedging tool relates to the outlook of a firm about various currencies. This involves invoicing exports in a hard currency and imports in a soft currency. The currency so chosen may not be the domestic currency for either of the parties involved, and may be selected because of its stability (like the dollar, which serves as an international currency).

Another way the parties involved in international transactions may hedge exposures is by sharing the risk. This may be achieved by denominating the transaction partly in each of the domestic currencies of the parties involved. This way, the exposure for both the parties gets reduced.

Hedging through Sourcing: Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials in the same currency in which it sells its products. This results in netting of the exposure, at least to some extent. This technique has its own disadvantages. A company may have to buy raw material which is costlier or of lower quality than it can otherwise buy, if it restricts the possible sources in this manner. Due to this, this technique is not used very extensively by firms.

41. a. This theory, given by Posner, considers the possibility of trade between two countries having similar factor endowments and consumer tastes. According to this, improvement in technology is a continuous process and the resulting inventions and innovations in existing products give rise to trade between such countries.

The degree of trade between two countries will depend upon the difference between the demand lag and imitation lag. Demand lag is the difference between the time a new or an improved product is introduced in one country, and the time when consumers in the other country start demanding it. Imitation lag is the difference between the time of introduction of the product in one country, and the time when the producers in the other country start producing it.

If the imitation lag is shorter than the demand lag, no trade will take place between the two countries. However, normally demand lag can be expected to be shorter than imitation lag. In such a case, the country coming out with the innovation will be able to start exporting to the second country as the consumers there become aware of its product, and the exports will keep growing as more and more consumers become aware. These exports will continue to increase till the demand lag is over, i.e. till all the consumers react to the innovation. If the local producers can start producing the same product before this time period, they can arrest the growth of these imports into their country, otherwise the exports will continue and will stabilize at a particular level. At the end of the imitation lag, the trade will start coming down and will be finally eliminated.

b. A country fixes the rate of its domestic currency in terms of a foreign currency, and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged. Due to the pegging, the monetary policies and economic variables of the country of the reference currency are reflected in the domestic economy. If the fundamentals of the domestic economy show a wide disparity from that of the reference country’s, there is a pressure on the exchange rate to change accordingly. This may result in a run on the currency, thus forcing the authorities to either change, or altogether abandon the peg. To prevent such an event, the monetary policies are kept in line with that of the reference country by the central monetary authority, called the currency board. It commits to convert its domestic currency on demand into the foreign anchor currency to an unlimited extent, at the fixed exchange rate. The currency board maintains reserves of the anchor currency up to 100% or more of the domestic currency in circulation. These reserves are generally held in the form of low-risk, interest bearing assets denominated in the anchor currency. An internationally accepted, relatively stable currency is generally selected as the anchor currency.

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The currency board does not have any discretionary powers over the monetary policy. The interest rates are automatically set by the market mechanism. If demand for the anchor currency rises and people start converting more and more of the domestic currency for the anchor currency, the reserves with the currency board get depleted. As the currency in circulation has to be backed by the anchor currency reserves, the depletion of reserves results in a contraction of the domestic currency’s supply. This, in turn, will result in an increase in the domestic interest rates. A high domestic interest rate increases the demand for the domestic currency as more and more people become interested in investing in the economy. This increases the supply of the anchor currency and eliminates the pressure on the domestic currency. The opposite will happen in case of an increase in the supply of the anchor currency. The interest rates, thus, act as the force which brings back the forex markets to equilibrium.

42. MNCs have divisions/subsidiaries in different countries. Each of the subsidiary or division have cash positions, receivables and payables in the same currencies or different currencies. The composition of receivables and payables and cash can be in any combination. In these type of situations MNCs resort to centralized cash management system.

Advantages i. Netting: In large MNC’s, intra-corporate transactions among various subsidiaries of

the parent company or subsidiaries with parent corporate are a common feature. As a consequence there will be receivables and payables among the group subsidiaries resulting in cash inflows and outflows in different currencies. At times the inflows and outflows between two subsidiaries may have matching maturities or may have maturity mismatches. If the receivables and payables are of different currencies, the transaction costs can be higher.

In a centralized cash management system all cash transactions of group companies are settled through a single point. In such circumstances, netting is possible whereby the receivables are netted out against payables and net cash flows are settled among the group subsidiaries. Leading and lagging of receivables/payables is possible to enable matching of maturities. Netting with other corporate entities is also possible.

ii. Management of currency exposure: Another advantage of centralized cash management system is exchange risk management. In a centralized cash management system, the parent can evolve a corporate strategy for exchange risk management keeping overall position of receivables and payables in different currencies of the various subsidiaries in mind. The strategy will reduce the transition cost of the hedging which otherwise would be incurred by each subsidiary individually.

iii. Pooling of cash: Each of the subsidiary will maintain certain amount of liquid position. Some of the subsidiaries may have surplus cash whereas some other may have a deficit. In a centralized cash management system, the center may pool up the cash from surplus subsidiaries for transfer to the deficit units. This will eliminate borrowing cost to the deficit units. The existence of cash pooling center will reduce the burden of cash management at the subsidiary level.

Problems involved in Centralized Cash Management System 1. Cash requirement in domestic currency for a subsidiary is quite unpredictable. A

centralized cash pooling system sometimes may cause hardships to the subsidiary if unforeseen expenditure is to be met by the subsidiary. The parent should evolve a centralized cash pooling system which enables the subsidiary to meet urgent cash requirements.

2. Even the transfer of funds involves cost. Hence centralized cash management system should ensure that fund transfer events are not too many by the pooling center and the system is cost effective in nature.

3. Even in these days of electronic fund transfer systems, delays in fund transfers and making cash available to the subsidiary are possible.

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4. Exchange control regulations of the country where the subsidiary is located will have a serious impact on cash inflows and outflows from subsidiaries to other group corporate or to the parent company.

5. Tax structure in the countries where the subsidiaries are located will be another important factor in centralized cash management system. Cash management system should ensure that the transfer of funds from one subsidiary to another should be cost effective even if the total borrowing cost inclusive of withholding tax at cash surplus center is taken into consideration.

6. A decentralized cash management system can benefit from the proximity of various subsidiaries to major financial centers in the world. A centralized cash management system is generally located at the same place as the parent company, which may not be near any major financial center. This may act as a drawback.

43. The factors affecting the India’s balance of payment account are discussed below:

Exports of Goods and Services

Exports of goods and services are affected by the following factors:

• The prevailing exchange rate of the domestic currency: A lower value of the domestic currency results in the domestic price getting translated into a lower international price. This increases the demand for domestic goods and services and hence their export. This is likely to result in a higher demand for the domestic currency. A higher exchange rate would have an exactly opposite effect.

• Inflation rate: The inflation rate in an economy vis-a-vis other economics affects the international competitiveness of the domestic goods and hence their demand. Higher the inflation lower the competitiveness and lower the demand for domestic goods.

• World prices of a commodity: If the price of a commodity increases in the world market, the value of exports for that particular product shows a corresponding increase. This would result in an increase in the demand for the domestic currency. A fall in the demand for domestic currency would be experienced in case of a reduction in the international price of a commodity.

• Incomes of foreigners: There is a positive correlation between the incomes of the residents of an economy to which the domestic goods are exported, and exports. Hence, other things remaining the same, an increase in the standard of living (and hence, an increase in the incomes of the residents) of such an economy will result in an increase in the exports of the domestic economy. Once again, this would increase the demand for the local currency.

• Trade barriers: Higher the trade barriers erected by other economies against the exports from a country, lower will be the demand for its exports and hence for its currency.

Imports of Goods and Services: Imports of goods and services are affectd by the same factors that affect exports. While some factors have the same effect on imports as on exports, some of them have an exactly opposite effect.

• Value of the domestic currency: An appreciation of the domestic currency results in making imported goods and services cheaper in terms of the domestic currency, hence increasing their demand. The increased demand for imports results in an increased supply of the domestic currency. A depreciation of the domestic currency has an opposite effect.

• Level of domestic income: An increase in the level of domestic income increases the demand for all goods and services, including imports. This again results in an increased supply of the domestic currency.

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• International prices: The international demand and supply positions determine the international price of a commodity. A higher international price would get translated into a higher domestic price. If the demand for imported goods is inelastic, this would result in a higher domestic currency value of imports, increasing the supply of the domestic currency. In case of the demand being elastic, the effect on the supply of the domestic currency would depend on the effect on the domestic currency value of imports.

• Inflation rate: A domestic inflation rate that is higher than the inflation rate of other economies, would result in imported goods and services becoming relatively cheaper than domestically produced goods and services. This would increase the demand for the former, and hence, the supply of the domestic currency.

• Trade barriers: Trade barriers have the same effect on imports as on exports – higher the barriers, lower the imports, and hence, lower the supply of the domestic currency.

Income on Investments: Both payments and receipts on account of interest, dividends, profits etc. depend on the level of past investments and the current rates of return that can be earned in an economy. For payments, it is the level of past foreign investments and the current domestic rates of return; while for the receipts it is the past domestic investments in foreign economies and the current foreign rates of return which are relevant.

Transfer Payments

• Transfer payments are broadly affected by two factors. One is the number of migrants to or from a country, who may receive money from or send money to relatives. The second is the desire of a country to generate goodwill by granting aids to other countries along with the economic capability to do so, or its need to take aids and grants from other countries to tide over difficulties.

Capital Account Transactions: Four major factors affect international capital transactions. The foremost is the rate of return which can be earned on the investments as compared to the returns that can be earned on domestic investments. The higher the differential returns offered by a country, the higher will be the capital inflows. Another factor is the additional risk that accompanies these returns. More the risk, lower the capital inflows. One more factor which has a very significant affect on these transaction is the expected movement in the exchange rates. If the exchange rates are quite stable or the movement is expected to be in the investors favor, the capital inflows will be higher.

High short-term debt may have intimidating effect on a country’s balance of payment. Excessive inflow of short-term debt help the domestic currency to appreciate significantly against the foreign currencies in the short run. But as these debts are short-term in nature, principle with interest have to be repaid in a very short span of time. This will lead to a structural imbalance in the BOP. The country may not have generated enough foreign exchange reserve in this period. As a result of the outflow through repayment of short-term debt the home currency will depreciate. This may lead to the productive capital to leave the country. This will have a multiplier effect on the value of home currency and the country may ultimately fall into the debt trap.

44. a. Transfer Pricing: A number of countries impose restrictions on the profit or the capital that can be repatriated by a company to its foreign parent company. As all the cash flows generated by the foreign subsidiary would not be available to the parent company in the presence of such restrictions, they cannot be considered for evaluating the worth of the project. There are a number of legal ways to circumvent restriction on profit repatriations, one of which is transfer pricing. Transfer pricing refers to the policy of invoicing purchase and sale transactions between a parent company and its foreign subsidiary on terms which are favorable to the parent company, thus, shifting a part of the subsidiary’s rightful profits to the parent. As this method of circumventing repatriation restrictions is very common, authorities are generally very alert as to the price at which transfers are made.

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b. International CAPM: The CAPM states that the investors in a security are compensated only for the systematic risk of the security, and the unsystematic risk can be diversified. The systematic risk of the security is measured by the sensitivity of the security returns to a change in the market returns, given by the beta of the security. International CAPM extends the same logic to the world security markets as a whole. According to this theory, the market portfolio consists of all the securities available in any of the country, and the beta of a security measures the sensitivity of the security returns to a change in the returns on this extended market portfolio. Hence, restricting one’s investments to the domestic market would imply being below the efficiency frontier. According to international CAPM, the return on a security is given by

ri = rf + βw (rw – rf)

where, rf = World risk-free rate of return βw = World beta of the security

= w

w

icov(r , r )Var (r )

rw = Return on the world-market portfolio. However, it is very difficult to apply this model in real life due to the difficulties in

estimating the various variables involved. Yet, the implications of this model are very important for evaluating the usefulness of international investments. If this model would hold good, holding a purely domestic portfolio would involve foregoing some return or taking on additional risk than that which is warranted by the returns, considering that a purely domestic portfolio would be below the efficiency frontier.

c. Exposure and Risk: Foreign exchange exposure is the sensitivity of changes in the real domestic currency value of asses, liabilities, or operating incomes to unanticipated changes in exchange rates. It means that exposure is the amount of assets, liabilities and operating income that is at risk from unexpected changes in exchange rates. Sensitivity can be measured by the slope of the regression equation between two variables. Here, the two variables are the unexpected changes in the exchange rate and the resultant change in the domestic currency value of assets, liabilities and operating income.

The foreign exchange risk is the variance of the domestic-currency value of an asset, liability, or operating income that is attributable to unanticipated changes in exchange rates. According to this definition, foreign-exchange risk results when the domestic-currency value of assets, liabilities or operating incomes, becomes variable in response to unexpected changes in exchange rates. Hence, for exchange rate risk to be present, the presence of two factors are essential. One is the variability of exchanges rates, and the second is the exposure.

Part IV: Case Studies (Problems)

Case Study 1 Read the case carefully and answer the following questions. 1. You are advised to work out the net inflow in Rs. under all the possible eight options. 2. Give your specific views on the impact of each of the events described below (as data on

recent happenings) on interest rates and exchange rates. 3. With the above scenario which option do you think is to be selected i. If the company is willing to take moderate risk ii. If the company is not willing to take any risk. M/s Heavy Machine Ltd. is a company which specializes in manufacturing of Industrial

Boilers. Having established their presence in India, they have decided to explore the possibilities of exports in the light of their receiving an ISO certification. Mr. Sushil Sinha returned from a business trip that he undertook for the above purpose. Mr. Sinha called Mr. Veera Raghavan, the Vice President (Finance) to inform him of a confirmed order that was received by the company. The terms of order among others, contain that

i. Delivery of the boilers should be made within 6-m ii. Payment will be made at the time of delivery iii. The bill can be invoiced in $ at 7,00,000 or DM 9,00,000 iv. There is an import content which requires to be imported from now v. Import is to be invoiced in DM at DM 4,50,000 and to be paid 3m from now or

immediately on import. Mr. Sinha advised Veera Raghavan to work out a plan of action for exchange risk

management. Mr. Veera Raghavan returned to his room and started collecting relevant data. At the end the following data is available with him.

Spot Rate Rs./$ 35.50/85 Rs./DM 25.20/50

3m forward 30/40 20/25

6m forward 40/55 35/40

Interest rates $ DM Rs.

3m 4.50% 5.00% 12.00%

6m 5.00% 5.25% 13.00%

As a part of exchange risk management he is considering the following options. i. Invoicing the export order in $, or DM. ii. Lagging the payable by 3 months or not.

iii. Cover through forward market or leave it uncovered. (The above options are not mutually exclusive.)

He decided that exchange risk has to be covered in the forward as the company is undertaking the export and import for the first time and he does not want to take chances.

He has also collected information on the recent happenings which may have a bearing on the interest rates and forex rates. Following is the information. 1. The formation of coalition government with unconditional support of Congress is

viewed by the markets as a sign of stability in the short-term at least. 2. The reports indicate a possibility of full convertibility on capital account in the

coming budget though some say it is too early. 3. Economic survey report indicated that exports are growing at the rate of 28%,

whereas imports are growing at the rate of 17%. In spite of removal of controls on import of consumer goods the proportion of capital equipment is increasing in the imports.

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4. Bundes Bank is likely to increase the interest rates by 0.25% in the next month and the indications are very strong.

5. US is going through a recessionary period and the currency has depreciated against all the currencies across the Board. The unemployment figures are on the rise.

6. The RBI declared that maintenance of Re. $ parity in the interest of exporters is no more on the top of its agenda.

7. The delay in presentation of the budget resulted in the market not knowing the level of fiscal deficit. In spite of the austerity measures announced by the new government market believes that government borrowing continues to be higher than the previous year.

8. A report by FII on Indian markets opined that interest rates are not likely to come down to the desired levels.

9. The RBI sent a strong signal by reducing the interest rate on government 10-year paper from 14.00% to 13.85%. However, the 91-day and 364-day T-bill rates are marginally moving up.

The actual rates turned out to be as under.

After 3-m Rs./$35.70/36.15 Rs./DM 25.50/90

After 6-m 35.75/36.20 25.65/95

Interest rate after 3-m $ 4.75% DM 5.00% Rs.12.50%

Case Study 2 Read the case carefully and answer the following questions. 1. Is the project acceptable? Base your answer on the adjusted present value technique.

2. Assume that the concessional loan of Rand 200 million is not available and the company is forced to borrow at market rates, with the same terms of repayment.

Is it still advisable for the company to implement the project? Support your answer with workings.

3. What is meant by all-equity discount rate? How is it determined?

4. Translate the projected income statement for the first year given in the case into rupees using

a. Current rate method and

b. Current–Non-current method.

5. Explain the rationale for treatment of inflation in the answer to (1) above.

You may use the following exchange rates (wherever necessary) for answering the above questions:

At the beginning of the first year : Rs.7.35/Rand

Average rate during the year : Rs.7.25/Rand

An Indian automobile company is planning to set up a plant in South Africa to produce cars. The plant will have a capacity of 50,000 cars per annum and each car can be sold at South African Rand 60,000. The plant is expected to have a life of five years, with negligible salvage value. At present the company is exporting 10,000 cars every year to South Africa from its domestic production. The plan of the company is that if cars can be produced in that country without increasing the cost of production, the transportation costs can be saved.

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The initial investment required is Rand 600 million. A part of this can be met from funds blocked in the country, which, if repatriated to India, attract tax at 50%. If the funds are not used for the plant, they would have been repatriated to India. The amount of the blocked funds is Rand 100 million. Of the rest, Rand 200 million will be provided by the Government of South Africa as a soft loan carrying interest at 13%. Had the company borrowed the funds in the market, it would have had to pay interest at 18%. The loan is repayable in equal annual installments starting from the end of the first year of operations over five years. The remaining amount has to be invested by the company as equity. Due to undertaking this project, the borrowing capacity of the company is expected to increase by Rs.100 crore, at an interest of 14%.

The projected income statement for the plant for the first year is projected to be as follows: (million Rand)

Sales 3000

Raw materials 2000

Wages and salaries 250

Selling and administration expenses 100

Depreciation (SLM) 120

Interest 26

Profit before tax 504

Tax (at 40%) 202

Profit after tax 302

The selling price, cost of raw materials, wages and salaries and also the selling and administration expenses are expected to rise at the South African rate of inflation of 8%. Had this plant not been set up, the profit from the cars currently being sold would also have gone up at the same rate of inflation. At present the profit is Rand 6000 per car. But, the number of cars sold would have come down at the rate of 10% every year due to competition from local brands. The initial investment can be amortized under the straight line method over the life of the project.

The following additional information is available:

• The all equity discount rate suitable for the project is 20%.

• The risk-free rate in South Africa is 11% while in India it is 10%.

• Tax rate in South Africa is 40%, while in India it is 35%.

• The inflation rates in India and South Africa will be 5% and 8% through out the life of the project. Purchasing power parity holds good between the two countries.

• The salvage value of the assets at the end of the life of the project is expected to be negligible.

Case Study 3 Read the case carefully and answer the following questions: 1. What is Purchasing Power Parity principle. Explain the underlying law upon which it is

based. Also state the assumptions underlying it. 2. Calculate the net cash flows in sterling for first two quarters for all the four alternatives and

advise Mr. Steve about which alternative to give better result. Show all the necessary calculations.

3. Discuss the various types of internal hedging techniques. 4. What is translation exposure? Explain how translation exposure arises and how it is

measured.

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Blakes Plc., UK

Blakes Plc., a UK company, has recently decided to expand its international trade relationship by exporting to the US. SuperMart Inc., a US retailer has committed itself to annual purchase of 400,000 pieces of ‘Revlus’, Blakes’ primary product, for a price of $50 per piece. The consignment are to be exported in four equal quaterly installments. The first consignment is due on April for other three consignments shipments are to be done in July, October and January next year. The agreement is to last for one year, after which it may be renewed by Blakes and SuperMart.

Blakes also incurs costs of goods sold denominated in Canadian dollar. The primary raw material of Revlus is best quality rubber which is only produced in Canada. The ‘Revlus’ has import content of C$ 35 per piece. Blakes import raw material from Canadian companies spread over quarters in order to avoid excessive raw material inventories.

The following are the expected timing of foreign currency cash flows for the newly acquired order from SuperMart:

Month Receivable * (in $) Payable * (in C$)

April ‘02 – 3,500,000

May ‘02 5,000,000 –

July ‘02 – 3,500,000

August ‘02 5,000,000 –

October ‘02 – 3,500,000

November ‘02 5,000,000 –

January ‘03 – 3,500,000

February ‘03 5,000,000 –

* All the payables and receivables will be accrued at the beginning of the month.

Since Blakes is relatively new to international trade, Steve Douglas, Blakes’ Chief Financial Officer (CFO), is concerned with the potential impact of exchange rate fluctuations on Blakes’ financial performance. Steve is vaguely familiar with various techniques available to hedge transaction exposure, but he is not certain whether one technique is superior to others. Steve would like to know more about the forward, money market and netting possibilities and has asked Rebecca, a financial analyst of Blakes’ to develop hedging strategies based on those above techniques.

Rebecca has gathered the following information from the market:

Spot exchange rates

(on 01.03.2002)

$/£ 1.4240

C$/£ 2.2555

Inflation rates

UK 3%

US 2%

Canada 4%

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Interest rates (p.a.)

Month(s) 1 2 3

Sterling pound 3.25/3.50% 3.50/3.75% 3.75/4.00%

US dollar 2.50/2.75% 2.60/2.95% 2.75/3.0%

Canadian dollar 4.50/4.75% 4.75/5.0% 5.0/5.25%

Rebecca believes that purchasing power parity holds good among three countries and the forward rate will reflect the inflation differential among three countries. Rebecca has decided to take cover for payable and receivable for a single quarter at a time. The following hedging strategies she is considering: i. Cover the payables and receivables through forward market ii. Borrow in dollar, convert the required amount into C$ to settle the payable, rest of dollar

amount converted into £, and repay the dollar borrowings from the receivable proceeds iii. Borrow in C$ to settle the payable and repay the borrowings from dollar receivable iv. Borrow in £ to settle the payable and repay the borrowings from dollar receivable. In order to evaluate the various alternatives, Rebecca has decided to take the future value of net cash flows for each quarter at the end of the quarter i.e., in June, September, December and March next year.

Case Study 4 Read the case carefully and answer the following questions: 1. Explain the factors which would guide Mr. Nick about the choice of currency of the loan. 2. If the interest rates for next four years turns out to be as follows:

1-year LIBOR

Date 15.01.04 15.01.05 15.01.06 15.01.07

Dollar 2.80% 3.00% 2.75% 2.50%

Euro 3.00% 3.15% 3.05% 2.95%

Sterling 4.60% 4.75% 4.55% 4.50%

a. Calculate the expected forward exchange rates of dollar for the next five years. b. Which of the three proposals would you suggest to ASI? Back your answer with detail

calculations. 3. The reason for ASI to acquire the Belgian company is to get foot-hold in the Belgian market.

Discuss the other reasons, which could lead the companies to acquire foreign companies. 4. Discuss the different risk factors associated with foreign direct investments. The latest acquisition of American Snax. Inc. (ASI), a Louisiana based US company in the middle of 2002 has taken place without a hitch, or so thought by Jack Wilmer, Chief Operating Office of ASI. With the acquisition of this company in Belgium, ASI now has a strategic presence covering all the major markets in Europe. The acquired Belgian company manufactured various packaged snack foods that are sold all over Belgium. The Belgian company had been owned and managed by the founder and his family for the last 25 years. However, the younger generation is not interested in continuing the family business, hence, the heirs have agreed to sell the company, on the condition that those family members currently involved in the management of the company would be allowed to retain their responsibilities under the new ownership. Such type of acquisitions of smaller family owned business in comparable terms is not a new approach for ASI, as such businesses may be small by ASI standards but represent significant factor in the local market. Mr. Wilmer has found the conditions and the asking price to be very reasonable, given the brand name the products of the company have. However, this did not stop him from bargaining on the price. The Belgium family conceded a little bit – just enough not to embarrass Mr. Wilmer’s bargaining approach and the deal has been closed promptly.

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The purchase price agreed at $8 million was well within the limits which the Board of Directors of ASI has allowed Mr. Wilmer to acquire the company without further consultations with the Board. So, as soon as the lawyers on both sides prepared the necessary documentation, the ownership of the company is ready to be transferred.

Approximately 15 days before the signing the dotted line, Mr. Nick Young, the treasurer of ASI, first heard the particular details of this acquisition. Mr. Wilmer asked him to make sure that $ 8 million in cash will be available in next 15 days for transferring it to Belgium. Mr. Nick knew an acquisition in Belgium was pending and had prepared for it by keeping ASI’s excess funds invested in securities of short-term maturities and by maintaining ample line of credit with several banks, so the transfer of $ 8 million was done without any trouble. However, the same could not be said for Mr. Wilmer’s second request. Mr. Wilmer asked Mr. Nick to arrange Euro 15 million for the renovation and expansion of the Belgian facility. More specifically, Mr. Wilmer requested that, given the expected cash flows of the Belgian Company, a 5-year loan with approximately equal annual installments is most preferable.

ASI is not quite familiar with the Belgian financial market, so obtaining such a long tenure loan from the Belgian market at a reasonable interest rate will be difficult for the ASI. So he wants to borrow the needed funds in the eurodollar market, as the ASI is quite familiar in that market. Mr. Nick has a soft corner for dollar financing, so he tempted to use this source of funds. But before going to eurodollar market for the fund requirement, he decided to talk with some more banks.

The conversations with the bankers has resulted in the short-listing of following three proposals:

Proposal 1:

5-year $15 million Eurodollar loan from a London based bank. Interest is payable annually at 1-year LIBOR + 175 basis points. The principal is to be repaid in five equal annual installments starting at the end of first year.

Proposal 2:

5-year floating Euro 15 million loan from a Germany based bank. Interest is payable annually at 1-year LIBOR + 100 basis ponts. The principal is repayable in two equal annual installments at the end of 4th and 5th year.

Proposal 3:

5-year fixed £10 million loan form a London based bank. The interest on the loan is 4.75% p.a. The loan is repayable in five equated annual installments.

Any one of the above loans will be availed as on January 15, 2003.

Mr. Nick has decided to cover all the interest and principal repayments in forward market. He is also of the opinion that the one year forward exchange rates for the euro and sterling will follow the interest rate parity condition.

Exchange rate as on January 11, 2003:

$/Euro 1.0325

$/£ 1.5995

Euro/£ 1.5491

Interest rates as on January 11, 2003:

1-year dollar LIBOR 1.75%

1-year euro LIBOR 2.90%

1-year sterling LIBOR 4.10%.

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Case Study 5 Read the case carefully and answer the following questions: 1. There are some added complications which distinguish a foreign project from a domestic

project. Discuss those factors which make international project completely different from a domestic project and how APV technique addresses such complications.

2. Evaluate the investment proposal of Regency InfoTech Ltd. in USA using the Adjusted Present Value (APV) technique based on the estimates and projections of the CFO and advise the CEO of Regency whether the project is worth accepting based on simply quantitative parameters.

3. What discount rates should be used and why for applying APV method for the project in USA for the following? • Cash flows from proposed project • Tax shield on depreciation • Tax shield on interest on incremental borrowing capacity • Repayment of principal and interest on any concessional loan.

4. Countries generally impose restrictions on profit or capital that can be repatriated by a foreign subsidiary to its parent company. Discuss the different ways by which companies can circumvent restrictions on profit repatriations.

Regency InfoTech Ltd. is a fast growing software company based in Bangalore, catering to the US market and a couple of European markets other than the domestic market. It has its distribution and marketing subsidiaries in US as well as some countries in Europe. The CEO of Regency InfoTech is toying with the idea of opening up a unit in either US or Europe, to increase the market presence there. He was keener to open up this unit in a European country but the CFO feels that investing in Europe and not in US is not a better idea due to the low business confidence in the Euro-zone. Euro-zone largely depends on business from US. As US is facing recession, so the economic condition in Euro-zone is also not rosy. So opening a unit in Euro-zone will not create any additional business opportunities for the Regency. The CEO agreed to what the CFO feels and they decide to open a manufacturing unit at Atlanta, US. The CFO, who is an US based NRI has got clout in the US Congress and had got a nod from the Congress for some concessional financing. The following estimates and projections are prepared by the CFO of Regency: The initial investment required for the project is US $ 300 million in plant and machineries and other facilities and $ 35 million in working capital margin. The implementation of project if started now can be operational after one year. When the project will be operational the distribution and marketing subsidiary can be merged into it to look after the distribution and marketing of the products that will be produced in the manufacturing unit at Atlanta. Capacity utilization of the project after being operational is projected as follows:

Year 1 2 3 4 5

Capacity Utilization (%) 70 80 90 100 100

At 100% capacity utilization, the sales revenue at the current prices is estimated at $ 250 million. Regency presently exports software products worth $ 100 million annually to US. If the project is implemented these exports will cease to exist. The net profit margin on these exports is currently 12% in dollar terms, which is expected to grow to keep pace with the inflation rate in US. Regency has an accumulated blocked fund of $ 25 million in US and can be used in this project. The life of the project is 5 years and the salvage value of fixed assets can be taken as 4% of the initial investment in plant and machineries and other facilities. Working capital margin can be realized at the full amount of initial injection. The contribution is expected to be 50% of sales. The fixed cost excluding depreciation for the 5 years of operation is estimated at $ 25 millions at the current prices. Selling expense will constitute 5% of sales. All expenses and revenues will go up as per the inflation rate in US.

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The initial investment in plant and machineries and in other facilities is to be depreciated over the five years on straight-line basis. Due to this project Regency can repatriate profits worth $10 million without paying any taxes at current prices each year, which is also expected to go up as per the inflation rate in US. Due to this project, Regency can increase its borrowing in the Indian market by Rs.6000 million. The US Government has also offered a concessional loan of $ 50 million at 5%, which is available in the US market at 8%. The principal and the interest of this concessional loan would be equally amortized over the period of 5 years. The rest of the amount will be financed through Regency’s own funds in India. Regency faces a borrowing rate of 10% in India. The risk free rate in India and US are 6.0% and 2.0% respectively. The effective corporate income tax rate in US and India are 30% and 35% respectively. There is a double taxation avoidance treaty between India and US under which full credit is given to Indian companies for taxes paid in US, subject to the condition that the rate does not exceed the Indian tax rate. The current exchange rate is Rs.48/$ and following are the expected inflation rates in US and India. It is assumed that PPP between the two countries hold good.

Year Inflation rate in India (%) Inflation rate in US (%)

1 3.80 1.20

2 4.00 1.30

3 3.50 1.50

4 3.90 1.75

5 4.10 2.00

The required rate of return of Indian shareholders of Regency is 16%.

Part IV: Case Studies (Solutions) Case Study 1

1. At the outset there are eight options Export invoiced Import payment Exchange risk $ After 3m Covered DM Rs. After 6m Uncovered

3m Forward rate now Spot rate after 3m 6m Forward rate now Spot rate after 6m

Re./$ 35.80/36.25 35.70/36.15 35.90/36.40 35.75/36.20

Rs./DM 25.40/25.75 25.50/25.90 25.55/25.90 25.65/25.95

DM/$ 1.7830/1.7845 1.7835/1.7850 1.7840/1.7850 1.7830/1.7845

i. Invoice in $/After 3m/covered

Re. inflow after 6m = 7,00,000 x 35.90 = 2,51,30,000 Re. outflow after 3m = 4,50,000 x 25.75 = 1,15,87,500 Interest on 1,15,87,500 for 3m at 12.5% = 3,62,109 1,19,49,609 1,31,80,391

ii. Invoice in $/After 3-m/Uncovered

Re. inflow after 6-m = 7,00,000 x 35.75 = 2,50,25,000

Re. outflow after 3-m = 4,50,000 x 25.90 = 1,16,55,000

Interest on 1,16,55,000 at 12.5% for 3-m = 3,64,219 = 1,20,19,219

1,30,05,781

iii. Invoice $/After 6-m/Covered

Re. inflow after 6-m = 7,00,000 x 35.90 = 2,51,30,000 Re. outflow after 6-m = 4,50,000 x 25.90 = 1,16,55,000

Interest at 5% for 3-m = 1,16,55,000 x 25.95 = 1,45,968.75 1,18,00,968.75

1,33,29,031.25

iv. Invoice $/After 6-m/uncovered

Re. inflow after 6-m = 7,00,000 x 35.75 = 2,50,25,000 Outflow after 6-m = 4,50,000 Interest at 5% for 3-m = 5,625 = 4,55,625 Re. outflow 4,55,625 x 25.95 1,18,23,469

1,32,01,531

v. Invoice in DM/After 3-m/Covered

Re. inflow after 6-m = DM 9,00,000 x 25.55 = 2,29,95,000 Re. outflow after 3-m = 4,50,000 x 25.75 = 1,15,87,500 Interest on 1,15,87,500 at 12.5% = 3,62,109 1,19,49,609

1,10,45,391

vi. Invoice in DM/After 3-m/uncovered

Re. inflow after 6-m = DM 9,00,000 x 25.50 = 2,29,50,000 Re. outflow after 3-m = 4,50,000 x 25.90 = 1,16,55,000 Interest at 12.5% for 3-m 3,64,219 1,20,19,219

1,09,30,781

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vii. Invoice in DM/After 6-m/Covered Re. inflow after 6-m = 9,00,000

Re. outflow after 6-m = DM 4,50,000 x 25.55 = 1,14,97,500 Interest at 5% for 3-m = 5625 at 25.95 = 1,45,968

Net inflow 1,13,51,532 viii. Invoice in DM/After 6-m/Uncovered Re. inflow after 6-m = 9,00,000

Re. outflow after 6-m = 4,50,000 5,625 = 4,55,625

= 4,44,375 x 25.65 = 1,13,98,219 2. i. Market belief that there is no political uncertainty is conducive for greater inflows

which stabilizes the Rs.$ parity on one hand while being conducive for interest rates to decline.

ii. Full convertibility, convergence in the interest rates will be more with the result that interest rate parity will be more relevant.

iii. Increase in exports at a higher pace than imports coupled with imports of capital equipment can lead to higher production and better GDP. This results in the economy becoming stronger. Consequently there is scope of appreciation of Rupee.

iv. Increase of interest rates in Germany can result in DM depreciating against US $. Rupee may also gain against DM even if it does not gain against US $.

v. The recession in US can result in $ depreciating against other currencies and this may overshadow the expected DM depreciation. As a result Re. may gain against DM and US $.

vi. The RBI’s statement makes it clear that it is not going to prop up $ which will add to strengthening of Re.

vii. There is likely to be a higher level of government borrowing which may result in interest rates remaining steady.

viii. The reports add to the earlier indication of interest rates remaining high then reducing the scope for Re. appreciation.

ix. This indicates that a decline in long-term interest rates is expected but the short-term rates will continue to be high and Re. may not appreciate immediately.

3. The net inflow is highest when the export is invoiced in $ and import payment is lagged and exchange risk is covered.

There are strong reasons for Re. to appreciate in the long run. However, in the long run, the company’s receivable is in $ and payable is in DM. Reports indicate a weakening $ and relatively strengthening DM & Rs. It appears that Re. is likely to gain against $ but it is not so certain against DM. It is, therefore, advisable to cover both the receivable and payable in the forward market.

If the company chooses to take moderate risk it may cover the receivable and leave the payable uncovered. It can decide after 3m to postpone payable or to pay after 3m by the then spot rate.

Case Study 2

1. a. Initial investment = Rand 600 million = 600 x 7.35 = Rs.4410 million b. Activated funds = Rand 100 – (100 x 0.50) million = Rand 50 million = 50 x 7.35 = Rs.367.50 million

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c. Cash flows, net of last sales: (Million Rand)

Years

1 2 3 4 5

Sales 3000.00 3240.00 3499.00 3779.00 4081.00

Raw materials 2000.00 2160.00 2333.00 2519.00 2721.00

Wages and Salaries 250.00 270.00 291.60 314.93 340.12

Selling and Administrative expenses 100.00 108.00 116.64 125.97 136.05

Depreciation 120.00 120.00 120.00 120.00 120.00

PBT 530.00 582.00 637.76 699.10 763.83

Tax @ 40% 212.00 232.80 255.10 279.64 305.53

PAT 318.00 349.20 382.66 419.46 458.30

Cash flow = PAT + Depreciation 438.00 469.20 502.66 539.46 578.30

Profit from present sales 60.00 58.32 56.68 55.10 53.56

Tax 24.00 23.33 22.67 22.04 21.42

After tax profit 36.00 34.99 34.01 33.06 32.14

Net cash flow 402.00 434.21 468.65 506.40 546.16

Exchange rate 7.15 6.95 6.75 6.57 6.38

Cash flow in Rs. 2874.30 3017.76 3163.39 3327.05 3484.50

Present value of the cash flows @ 20% = Rs.9,324.63 million

d. Depreciation tax shields:

Years

1 2 3 4 5

Depreciation 120.00 120.00 120.00 120.00 120.00

Depreciation x t 48.00 48.00 48.00 48.00 48.00

Exchange rate 7.15 6.95 6.75 6.57 6.38

Tax shields in Rs. 343.20 333.60 324.00 315.36 306.24

Present value of tax shields @10% = Rs.1,236.67 million,

e. Tax shield from increase in borrowing capacity:

Tax shield = Rs.1,000 million x 0.14 x 0.35 = Rs.49 million.

Present value = 49 x PVIFA(10%,5) = Rs.185.76 million

f. Value of concessional loan:

200 – (40 + 26) x PVIF(18,1) – (40 + 21) x PVIF(18,2)

– (40 + 16) x PVIF(18,3) – (40 + 10) x PVIF(18,4)

– (40 + 5) x PVIF(18,5) = Rand 20.72 million or 20.72 x 7.35 = Rs.152.29 million

Adjusted Present Value = –4,410.00 + 367.50 + 9324.63 + 1,236.67

+ 185.76 + 152.29 = Rs.6,856.85 million

As the Adjusted Present Value is positive, the project is acceptable.

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2. NPV as calculated in (1) = Rs.6,856.85 million Value of the concessional loan = Rs.152.29 million NPV without the benefit from concessional loan = 6,856.85 – 152.29 = Rs.6,704.56 million

Present value of the repayments on the loan made at market rates = Face value, as the cash flows are discounted at the market rate.

Therefore, the NPV after borrowing at market rates = NPV without borrowing – Face value of the borrowing + Face value of the borrowing = NPV without borrowing = Rs.6704.56 million

As the NPV is positive, the project may be implemented. 3. The various adjustments needed to go from the weighted average cost of capital for the firm

to the weighted average cost of capital for the project makes it a somewhat typical technique to use at times. An alternative is the use of an all-equity discount rate, k*, that abstracts from the project’s financial structure and that is based solely on the riskiness of the project’s anticipated cash flows.

To calculate the all-equity rate, we rely on the CAPM: k* = rf + β* (rm – rf) where β* is the all-equity beta – that is, the beta associated with the unleveraged cash

flows. In reality, of course, the firm will not be able to estimate β* with the degree of precision

implied here. Instead, it will have to use assumptions based on theory. If the project is of similar risk to the average project selected by the firm, it is possible to

estimate β* by reference to the firm’s stock price beta, βe. In other words, βe is the beta that appears in the estimate of the firms’s cost of equity capital, ke:

ke = rf + βe [E(rm) – rf] To transform βe into β*, we must separate the effects of debt financing. This is known as

unlevering, or converting a levered equity beta to its unlevered or all-equity value. Unlevering can be accomplished by using the following approximation:

β* = βe/[1 + (1 – t)D/E] where t is the firm’s marginal tax rate, and D/E is its current debt/equity ratio. Thus, for

example, if a firm has a stock price beta of 1,1, a debt/equity ratio of 0.6, and a marginal tax rate of 34%, its all-equity beta equals 0.79 [1.1/(1 + 0.66 x 0.6)].

It turns out that the case of similar risk characteristics is an important one in estimating the foreign project cost of capital.

4. Translation of the income statement: Current rate (at the end of first year) = 7.15

Given

Current rate method*

Current–Non-current method

Rand Rs. Rate Amount Sales 3000 21450 7.25 21750 Raw materials 2000 14300 7.25 14500 Wages and Salaries 250 1788 7.25 1813 Selling and Administration expenses 100 715 7.25 725 Depreciation 120 858 7.35 882 Interest 26 186 7.35 191 Profit before tax 504 3604 7.25 3639 Tax 202 1444 7.25 1465 Profit after tax 302 2160 7.25 2174

* at Rs.7.15/Rand

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5. A question that arises in all capital-budgeting applications, whether the project being evaluated is foreign or domestic, concerns the choice of the ``nominal’’ versus ``real’’ discount rate. The answer is that the choice does not matter provided we are consistent. That is, we reach the same conclusion whether we discount nominal cash flows (those not adjusted for inflation) by the nominal discount rate or discount real (inflation-adjusted) cash flows by the real discount rate. However, if cash flows are easier to forecast in today’s prices so that the forecasts are of real cash flows, as a practical matter it is easier to use these flows and discount at the real rate. (The alternative involves building inflationary expectations into cash flows and then using the nominal discount rate, but this is far more roundabout).

A related question to that of nominal versus real discount rates concerns the currency of expected cash flows. Should we use foreign currency cash flows and discount these at the foreign currency discount rate, or convert foreign currency cash flows into domestic currency, and discount at the domestic currency discount rate? Furthermore, do we use nominal or real discount rates? The answer to these questions is that it does not matter which method we use provided everything is consistent.

That is, if cash flows are in foreign currency we use the foreign currency discount rate, and if cash flows are in domestic currency we use the domestic-currency discount rate. Similarly, if we use real cash flows, in terms of either currency, we should use the real discount rate, in the same currency. When foreign currency cash flows are predetermined, or contractual, we do not have a choice between real and nominal discount rates and between current and future expected exchange rates. Examples of contractual cash flows are revenues from exports sold at fixed prices and depreciation allowances based on historical costs. The contractual amounts are fixed in nominal terms and should therefore be converted into home currency at the expected future exchange rate and discounted at the nominal home country discount rate. Contractual flows do not lend themselves to simplification through the use of today’s cash flows of foreign exchange at today’s exchange rates. It is for this reason that we convert foreign currency cash flows into home currency and discount at the nominal home currency discount rate.

Case Study 3 1. According to the Purchasing-Power Parity Principle (PPP). The price levels (and the

changes in these price levels) in different countries determine the exchange rates of these countries’ currencies. The basic tenet of this principle is that the exchange rates between various currencies reflect the purchasing power of these currencies. This tenet is based on the Law of One Price.

According to the law of one price, in equilibrium conditions, the price of a commodity has to be the same across the world. If it were not true, arbitrageurs would drive the price towards equality by buying in the cheaper market and selling in the dearer one, i.e. by two-way arbitrage. For e.g., if the cost of steel in Germany (in dollar terms) were $300/tonne and in the US it were $350/tonne, arbitrageurs would start buying steel in Germany to sell it in the US. This would increase the steel prices in Germany and reduce the US prices. This process will continue till steel becomes equally priced in both the countries.

The equalization of prices is possible only in perfect-market conditions, where there are no transportation costs and no restrictions on trade in the form of tariffs. In the presence of these two, the price of a commodity can differ in two markets by the quantum of transportation cost between the two countries and/or the amount of tariff imposed on the commodity. Continuing the earlier example, if the cost of transporting a tonne of steel from Germany to the US were $25, the arbitrage would continue to take place only till the difference between the price of steel in the two countries was reduced to $25. However, the process of the genuine buyers of a commodity buying from the cheaper market imposes stricter conditions on the prices in the commodity markets by driving the price to equality in the different markets. Hence, if the cost of transporting steel from the two markets to the buyer country is the same, the price of steel will have to be the same in both the markets. If there is some difference in the transportation costs, then the price may differ to the extent of such difference in the transportation costs. Since this difference in transportation costs is expected to be less than the cost of transporting the commodity from one market to the other (Germany and the US in our example), the genuine buyers’ preference brings the world prices of a commodity closer than is required by arbitrage. Even where arbitrage does not take place, the actions of genuine buyers make the world prices remain close.

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The assumptions of Law of One Price are Movement of Goods: The Law of One Price assumes that there is no restriction on the

movement of goods between countries, i.e. it is possible to buy goods in one market and sell them in another. This implies that there are no restrictions on international trade, either in the form of a ban on exports or imports, or in the form of quotas.

No Transportation Costs: Strictly speaking, the Law of One Price would hold perfectly if there were no transportation costs involved, though there are some transactions (explained later) which bypass this assumption.

No Transaction Costs: This law assumes that there are no transaction costs involved in the buying and selling of goods.

No Tariffs: The existence of tariffs distorts the Law of One Price, which requires their absence to hold perfectly.

2.

March Spot $/£ 1.4240

C$/£ 2.2555

C$/$ 1.5839

Expected forward rates as per PPP:

Month $/£ C$/£ C$/$

April 1.4228 2.2574 1.5865

May 1.4216 2.2593 1.5892

June 1.4205 2.2611 1.5918

July 1.4193 2.2630 1.5945

August 1.4181 2.2649 1.5971

September 1.4169 2.2668 1.5998

Cash flows for the quarter April-June i. Cover through forward market:

Outflow in April = C$3,500,000 × £/2574.2$C

1 = £ 1,550,456

Inflow in May = $5,000,000 × £/4216.1$

1 = £ 3,517,164

Net cash flow in £ taken at the end of June

= – 1,550,456 ⎟⎠⎞

⎜⎝⎛ +

404.01 + 3,517,164 ⎟

⎠⎞

⎜⎝⎛ +

60350.01

= – 1,565,961 + 3,537,681 = £ 1,971,720

ii. Dollar amount to be borrowed at the beginning of April =

120275.01

000,000,5

+ = $4,988,568

Dollar required to settle C$ payable = $/5865.1$C

000,500,3$C = $2,206,114

Net cash flow in April = $4,988,568 – $2,206,114 = $2,782,454

= £4228.1

454,782,2 = £1,955,618

Net cash flow at the end of June = £ 1,955,618 ⎟⎠⎞

⎜⎝⎛ +

40375.01 = £ 1,973,952

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229

iii. C$ to be borrowed in April for 1 month = C$ 3,500,000

C$ to be repaid in May = C$ 3,500,000 ⎟⎠⎞

⎜⎝⎛ +

120475.01 = C$ 3,513,854

$ amount required to repay C$ loan = $5892.1

854,513,3 = $2,211,084

Net cash flow in May = $5,000,000 – $2,211,084 = $2,788,916

= £4216.1

916,788,2 = £ 1,961,815

Net cash flow at the end of June = £ 1,961,815 ⎟⎠⎞

⎜⎝⎛ +

6035.01 = £ 1,973,259

iv. £ to be borrowed in April for 1 month =£/2574.2$C

000,500,3$C = £ 1,550,456

£ to be repaid in May = ⎟⎠⎞

⎜⎝⎛ +

12035.01456,550,1 = £1,554,978

Receivable converted in £ = £/4216.1$

000,000,5$ = £ 3,517,164

Net cash flow in £ = £ 3,517,164 – £ 1,554,978 = £ 1,962,186

Net cash flow at the end of June = £1,962,186 ⎟⎠⎞

⎜⎝⎛ +

6035.01 = £ 1,973,632

Cash flows for the quarter July – September

i. Cover through forward market:

Outflow in July = C$ 3,500,000 × £/2630.2$C

1 = £ 1,546,620

Inflow in August = $ 5,000,000 × £/4181.1$

1 = $ 3,525,844

Net cash flow in £ taken at the end of September

= – 1,546,620 ⎟⎠⎞

⎜⎝⎛ +

404.01 + 3,525,844 × ⎟

⎠⎞

⎜⎝⎛ +

60350.01 = £ 1,984,325

ii. Dollar amount to be borrowed in July =

120275.01

000,000,5

+ = $4,988,568

Dollar required to settle C$ payable = $/5945.1$C

000,500,3$C = $2,195,045

Net cash flow in July = $4,988,568 – $2,195,045 = $2,793,523

= £ 4193.1

523,793,2 = £ 1,968,240

Net cash flow at the end of September = £ 1,968,240 ⎟⎠⎞

⎜⎝⎛ +

4375.01 = £ 1,986,692

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iii. C$ to be borrowed in July for 1 month = C$ 3,500,000

C$ to be repaid in August = C$ 3,500,000 ⎟⎠⎞

⎜⎝⎛ +

120475.01 = C$ 3,513,854

$ amount required to repay C$ loan = $5971.1

854,513,3 = $2,200,147

Net cash flow in August = $5,000,000 – $2,200,147 = $2,799,853

= £ 4181.1

853,799,2 = £ 1,974,369

Net cash flow at the end of September =£ 1,974,369 ⎟⎠⎞

⎜⎝⎛ +

6035.01 = £ 1,985,886

iv. £ to be borrowed in July for 1 month =£/2630,2$C

000,500,3$C = £ 1,546,620

£ to be repaid in August = £ 1,546,620 ⎟⎠⎞

⎜⎝⎛ +

12035.01 = £ 1,551,131

Receivable converted into £ = £/4181.1$

000,000,5$ = £ 3,525,844

Net cash flow in £ = £ 3,525,844 – £ 1,551,131 = £ 1,974,713

Net cash flow at the end of September = £ 1,974,713 ⎟⎠⎞

⎜⎝⎛ +

6035.01 = £ 1,986,232

So, we see that alternative (ii) in both quarters is giving highest net cash flow. Hence, alternative (ii) is preferable.

3. The various internal hedging techniques are • Exposure netting • Leading and lagging • Choosing the currency of invoice • Sourcing

Exposure Netting Exposure netting involves creating exposures in the normal course of business which offset

the existing exposures. The exposures so created may be in the same currency as the existing exposures, or in any other currency, but the effect should be that any movement in exchange rates that results in a loss on the original exposure should result in a gain on the new exposure. This may be achieved by creating an opposite exposure in the same currency or a currency which moves in tandem with the currency of the original exposure. It may also be achieved by creating a similar exposure in a currency which moves in the opposite direction to the currency of the original exposure.

Leading and Lagging Leading and lagging can also be used to hedge exposures. Leading involves advancing a

payment, i.e. making a payment before it is due. Lagging, on the other hand, refers to postponing a payment. A company can lead payments required to be made in a currency that is likely to appreciate, and lag the payments that it needs to make in a currency that is likely to depreciate.

Choosing the Currency of Invoicing One very simple way of eliminating transaction and translation exposure is to invoice all

receivables and payables in the domestic currency. However, only one of the parties involved can hedge itself in this manner. It will still leave the other party exposed as it will be dealing in a foreign currency. Also, as the other party needs to cover its exposure, it is likely to build in the cost of doing so in the price it quotes/it is willing to accept.

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Another way of using the choice of invoicing currency as a hedging tool relates to the outlook of a firm about various currencies. This involves invoicing exports in a hard currency and imports in a soft currency. The currency so chosen may not be the domestic currency for either of the parties involved, and may be selected because of its stability (like the dollar, which serves as an international currency).

Another way the parties involved in international transactions may hedge exposures is by sharing the risk. This may be achieved by denominating the transaction partly in each of the domestic currencies of the parties involved. This way, the exposure for both the parties gets reduced.

Hedging through Sourcing

Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials in the same currency in which it sells its products. This results in netting of the exposure, at least to some extent. This technique has its own disadvantages. A company may have to buy raw material which is costlier or of lower quality than it can otherwise buy, if it restricts the possible sources in this manner. Due to this, this technique is not used very extensively by firms.

4. Translation exposure is the exposure that arises from the need to convert values of assets and liabilities denominated in a foreign currency, into the domestic currency. For example, a company having a foreign currency deposit would need to translate its value into its domestic currency for the purpose of reporting at the time of preparation of its financial statements. Any exposure arising out of exchange rate movement and the resultant change in the domestic-currency value of the deposit would classify as translation exposure. It needs to be noted that this exposure is mostly notional, as there is no real gain or loss due to exchange rate movements since the asset or liability does not stand liquidated at the time of reporting. Hence, it is also referred to as accounting exposure. This fact makes the measurement of translation exposure dependent on the accounting policies followed for the purpose of converting the foreign-currency values of assets and liabilities into the domestic currency.

At the time of the initial transaction, an asset or liability is recorded at a particular rate in accordance with company policy. At a later date, when the need to translate the value of the asset or liability arises, it may be translated either at the historical rate (which was the rate used at the time of the initial transaction) or at some other rate, which would again depend either on company policy, or on accounting standards, or on both. We know that for an asset to be considered as exposed, there needs to be a change in its domestic currency value in response to a change in the exchange rate. Hence, those assets whose values are translated at a historical exchange rate do not result in translation exposure. Only the assets whose values are translated at the current (or post-event) exchange rate contribute to translation exposure. Translation exposure is measured as the difference between exposed assets and exposed liabilities.

Case Study 4 1. The choice between the domestic or foreign currency would depend on a number of criteria,

some of which are listed below:

i. Currency Requirements: A decision has to be taken about the currency needs of the company, keeping in view the future expansion plans, capital imports, export earnings/potential export earnings. A conscious view on the exchange rate also needs to be taken.

ii. Investment: Greater flexibility is available in structuring a debt instrument or a hybrid instrument like Foreign Currency Convertible Bond (FCCB). The company can take a view on instrument depending upon the financials of the company and its future plans.

iii. Depth of the Market: Relatively larger issues can be floated, marketed and absorbed in international markets more easily than in the domestic markets.

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iv. International Positioning: Planning for an international offering has to be a part of the long-term perspective of a company. An international issue positions the issuing company, for a much higher visibility and an international exposure. Besides, it opens up new avenues for further fund-raising activities.

v. Disclosure Requirements: The disclosure requirements for an international issue are more stringent as compared with a domestic issue. The requirements would, however, differ depending upon the market addressed and the place where listing is sought.

vi. Investment Climate: The international offering would be affected by factors like the international liquidity and the country risk, which will not have an effect in a domestic issue. Companies have to depend on the strength of their balance sheets to raise funds at competitive rates in the international markets.

2. a. Expected forward exchange rates as per interest rate parity:

Year $/Euro $/₤

1 1.01751.0325 1.0210

1.0290× =

1.01751.5995 1.5634

1.0410× =

2 1.02801.0210 1.0190

1.030× =

1.02801.5634 1.5365

1.0460× =

3 1.0301.0190× =1.0175

1.0315

1.0301.5365 1.5108

1.0475× =

4 1.02751.0175 1.0145

1.0305× =

1.02751.5108 1.4848

1.0455× =

5 1.0251.0145 1.0101

1.0295× =

1.0251.4848 1.4564

1.045× =

b. Interest and principal repayment schedule for the eurodollar loan:

Year Principal o/s ($ million)

Interest Principal repayment

Total repayment

1 15 0.525 3 3.525

2 12 0.546 3 3.546

3 9 0.4275 3 3.4275

4 6 0.2700 3 3.2700

5 3 0.1275 3 3.1275

Effective cost of the loan is given ‘r’ in the following equation:

15 = 3.525 × PVIF(r, 1) + 3.546 × PVIF(r, 2) + 3.4275 × PVIF(r, 3)

+ 3.2700 × PVIF(r, 4) + 3.1275 × PVIF(r, 5)

For r = 4%, RHS = 15.085

For r = 5%, RHS = 14.677

∴r = 4% + (5 – 4)% × 15.085 15

15.085 14.677

−

− = 4 + 1 ×

0.085

0.408 = 4.21%

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Interest and principal repayment schedule of the euro loan:

Year Principal o/s (Euro Million)

Interest Principal repayment

Total repayment

Exchange rate($/Euro)

Repayment (& million)

1 15 0.585 – 0.585 1.0210 0.5973 2 15 0.600 – 0.600 1.0190 0.6114 3 15 0.6225 – 0.6225 1.0175 0.6334 4 15 0.6075 7.5 8.1075 1.0145 8.2251 5 7.5 0.2963 7.5 7.7963 1.0101 7.8750

Effective interest rate is given by ‘r’ in the following equation:

15.4875 = 0.5973 × PVIF(r,1) + 0.6114 × PVIF(r, 2) + 0.6334 × PVIF(r, 3) + 8.2251 × PVIF(r, 4) + 7.8750 × PVIF(r, 5)

For r = 4%, RHS = 15.209

For r = 3%, RHS = 15.836

r = 3% + (4 – 3)% × 15.836 15.4875

15.836 15.209

−

− = 3 + 1 ×

0.3485

0.627 = 3.56%

For sterling loan annual installment = (4.75%, 5)

£10 million 10

PVIFA 4.360= =₤ 2.2936 million

Repayment Schedule

Year Repayment (£ million) Exchange rate ($/£) Repayment (in $ million)

1 2.2936 1.5634 3.5858

2 2.2936 1.5365 3.5241

3 2.2936 1.5108 3.4652

4 2.2936 1.4848 3.4055

5 2.2936 1.4564 3.3404

The effective interest rate is given by ‘r’ in the following equation:

15.995 = 3.5858 × PVIF(r, 1) + 3.5241 × PVIF(r, 2) + 3.4652 × PVIF(r, 3)

+ 3.4055 × PVIF(r, 4) + 3.3404 × PVIF(r, 5)

For r = 4%, RHS = 15.447

For r = 2%, RHS = 16.338

r = 2% + (4 – 2)% × 16.338 15.995

16.338 15.447

−

− = 2 + 2 ×

0.343

0.891= 2.77%

So, sterling loan is the most cheapest one.

3. Companies invest in foreign physical assets for a number of reasons. The important ones are:

Economies of scale As the domestic market saturates for a company’s products, it starts viewing overseas

markets as a potential source of growth. Continuous growth is essential for achieving further economies of scale, which is necessary for any business enterprise to survive in a competitive market.

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Need to Get around Trade Barriers Despite the growing importance of international trade, trade barriers continue to be in most

of the countries due to various economic, political and social reasons. The need to get around these trade barriers prompts corporates to make FDI in order to expand the market for its products.

Comparative Advantage The locational advantages offered by a country by way of lower costs serve as an important

incentive for a corporate to start production facilities abroad.

Vertical Diversification Companies going for vertical diversification may sometimes need to expand overseas due

to non-availability of opportunities in the domestic market.

General Diversification A corporate may like to invest overseas for the benefits of diversification across various

markets. As in the case of portfolio investments, investment in physical assets when spread over various countries, is expected to give a steadier or a higher stream of income.

Attacking Foreign Competition Companies being challenged by foreign competitors in their home country may have an

incentive in establishing production bases in the competitors countries. The incentive may be tow-fold. On one hand, it may provide them with the same cost advantages as their competitors. At the same time, the competitors’ attention may get diverted as they start concentrating on protecting their market shares in the home market.

Extension of Existing International Operations For a corporate involved in exporting goods to other countries, establishing a foreign

subsidiary may appear a natural extension. Starting with a sales subsidiary, the corporate may graduate to having licensing agreements, and finally overseas production capacities.

Product Life Cycle As a product moves to the maturity stage its production process becomes more standardized

and producers from developing countries become interested in producing it. As the developing country producers enjoy a cost advantage at this stage (mainly due to cheap labor), the producers of the country where the innovation took place need to shift their production facilities to the developing countries in order to be able to compete. This requires foreign direct investment.

Non-transferable Knowledge Certain types of knowledge e.g., the experience in manufacturing and marketing a

particular product) cannot be transferred to foreign producers for a price and hence the need to set up overseas operations to fulfill the desire to exploit a company’s existing knowledge in foreign markets.

Brand Equity Some brands enjoy international reputation. The popularity of these brands act as an

incentive for their producers to expand overseas. E.g. Levi’s set up operations in India to exploit its international reputation as a producer of good quality denim clothes.

4. Investments in foreign countries carry some additional risks when compared to domestic investments. These risks stem from the uncertainties related to the conversion of the cashflows into the domestic currency, which can be broadly classified as country risk (also known as political risk) and currency (or exchange) risk.

Country risk is the uncertainty as to whether the investor would be able to convert the realizations into the domestic currency. This risk arises due to the possibility of the foreign government preventing the conversion of its currency for various reasons. The government may even expropriate the asset, which would result in a complete loss to the investor.

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Currency risk is the uncertainty as to the rate at which the realizations would be converted into the domestic currency. As this rate would not be know in advance, there would be the risk of a loss due to an unfavorable movement of the exchange rate. This risk can be hedged to a certain extent by covering it in the forward, futures or option markets. Yet, the costs of the hedging have to be considered while taking such a step. Another way to reduce these risks is to invest across many countries, so that a loss suffered due to the weakening of one currency would get at least partially offset by the gains on the stronger currencies. Sometimes there may not be a currency risk at all as investors may be buyers of other goods (other than securities) in those very markets in which they invest thus eliminating the need to convert the currencies.

While it is not possible to measure the political risk, currency risk can be measured and factored into the risk of foreign investment.

Variance of domestic currency returns on foreign investment

= Var (rf) + Var (S~) + 2Cov(rf, S~)

The above equation shows that the risk on foreign investment consists of three elements - the variability of the returns on the foreign security, the variability of exchange rate, and the covariance between the exchange rate and the returns on the foreign security. Thus exchange rates increase the riskiness of a foreign investment by being volatile, and more so if they are positively correlated with the foreign security returns.

Case Study 5 1. The main complications which distinguish a foreign project from a domestic project can be

summarized as follows:

Exchange Risk and Capital Market Segmentation

Cash flows from a foreign project are in a foreign currency and therefore subject to exchange risk from the parent company’s point of view. How to incorporate this risk in project evaluation? Also, what is the appropriate cost of capital when the host and home country capital markets are not integrated?

Country Risk

Assets located abroad are subject to risks of appropriation or nationalization (without adequate compensation) by the host country government. Also, there may be changes in applicable withholding taxes, restrictions on remittances by the subsidiary to the parent, etc. It is difficult to incorporate these risks in evaluating the project.

International Taxation

In addition to the taxes the subsidiary pays to the host government, there will generally be withholding taxes on dividends and other income remitted to the parent. In addition, the home country government may tax this income in the hands of the parent. If double taxation avoidance treaty is in place, the parent may obtain some credit for the taxes paid abroad. The specific provisions of the tax code in the host and home countries will affect the kinds of financial arrangements between the parent and the subsidiary. There is also the related issue of transfer pricing which may enable the parent to further reduce the overall tax burden.

Blocked Funds

Sometimes, a foreign project can become an attractive proposal because the parent has some funds accumulated in a foreign country which cannot be taken out (or can be taken out only with heavy penalties in the form of taxes). Investing these funds locally in a subsidiary or a joint venture may then represent a better use of such blocked funds.

In addition, like in domestic projects, we must be careful to take account of any interactions between the new project and some existing activities of the firm–e.g. local production resulting in loss of export sales.

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As in the case of domestic projects, we will adopt a step-wise approach to the evaluation of foreign projects. However, now we will include an additional step:

1. First treat the project as a branch operation of the parent company. All the cash flows generated by the project belong to the parent since the project has no distinct identity. This allows us to focus on the pure economics of the project.

2. Next, consider the project as a fully equity financed, wholly owned subsidiary of the parent, incorporated under the host country laws, having a distinct legal identity. Now we focus on the various financial arrangements between the parent and the subsidiary and consider what means are available to the parent to increase the cash flow transfers between the subsidiary and the parent and minimize the overall tax burden.

3. Finally, as in the case of a domestic project, incorporate the effects of external financing such as the interest tax shield.

The reasons we consider intra-corporate financing separately from external financing are first, their effects can be estimated more precisely than those of external financing, second the nature of internal financing arrangements is sensitive to the particular features of the tax law in the host and home countries and third, it always forces us to keep in mind that any change in the nature of intra-corporate financial relationships impinges only on the allocation of profits between the parent and the subsidiary and not a net gain or loss (except when it saves on overall tax burden).

2. The expected exchange rate for five years using PPP as follows:

Year Rs / $

0 48

1 1.03848 49.231.012

× =

2 1.0449.23 50.541.013

× =

3 1.03550.54 51.541.015

× =

4 1.03951.54 52.621.0175

× =

5 1.04152.62 53.701.02

× =

Initial out flow = 48 × (300 + 35 – 25) = Rs. 14,880 million

Loss of profit from exports

Year 1 2 3 4 5

Sales ($) 101.20 102.52 104.05 105.87 107.99

Profit ($) 12.14 12.30 12.49 12.70 12.96

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237

Cash Flows from Operations (Net of lost sales)

Year 1 2 3 4 5

Sales ($ million) 177.1 205.03 234.12 264.69 269.98

Contribution 88.55 102.52 117.06 132.35 134.99

Fixed cost 25.30 25.63 26.01 26.47 27.00

Selling expenses 8.86 10.25 11.71 13.23 13.50

PBT 54.39 66.64 79.34 92.65 94.49

Tax @ 35% 19.04 23.32 27.77 32.43 33.07

PAT ($ million) 35.35 43.32 51.57 60.22 61.42

Less: loss of profit from export sales 12.14 12.30 12.49 12.70 12.96

Net Cf from operations 23.21 31.02 39.08 47.52 48.46

Terminal Cf* 47.00

Total Cf 23.21 31.02 39.08 47.52 95.46

Exchange rate (Rs 1$) 49.23 50.54 51.54 52.62 53.70

Cf in Rs. million 1142.63 1567.75 2014.18 2500.50 5126.20

PV @ 16% 984.95 1164.84 1291.09 1380.28 2440.65

Total present value of cash flows = Rs 7261.81 million *Terminal Cf:

Salvage value of fixed asset = 300 × 0.04 = $12 million

Recovery of working capital margin = $35 million

Total = $47 million

Depreciation each year = 3005

= $ 60 million

Present value of depreciation tax-shield = 60 × 0.35 × 49.23 × PVIF(6%, 1) + 60 × 0.35 × 50.54 × PVIF(6%, 2) + 60 × 0.35 × 51.54 × PVIF(6%, 3) + 60 × 0.35 × 52.62 × PVIF(6%, 4) + 60 × 0.35 × 53.70 × PVIF(6%, 5) = 1033.83 × 0.943 + 1061.34 × 0.890 + 1082.34 × 0.840 + 1105.02 × 0.792 + 1127.70 × 0.747 = Rs. 4546.23 million. Tax-shield due to incremental borrowing capacity = 0.10 × 6000 × 0.35 × PVIFA(6%, 5) = Rs. 884.52 million

[Note: Above two cases, the discount rate is taken as domestic risk-free rate assuming the probability that the project will give profit is high.] Concessional loan repayment

Annual installment = (5%, 5)

50PVIFA

= 504.329

= $11.55 million

Benefit due to concessionary loan = 48 (8%, 5)50 11.55 PVIFA⎡ ⎤− ×⎣ ⎦ = 48 [ ]50 46.12−

= Rs. 186.24 million

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Value of illegally repatriated profit

Year 1 2 3 4 5

Cf 10.12 10.25 10.41 10.59 10.80

Exchange rate 49.23 50.54 51.54 52.62 53.70

Cf in Rs. 498.21 518.04 536.53 557.25 579.96

PV @16% 429.46 384.90 343.92 307.60 276.06

Total present value = Rs. 1741.94 million

APV = –14,880 + 7261.81 + 4546.23 + 884.52 + 186.24 + 1741.94 = –14,880 + 14,620.74

= –Rs.259.26 million

As the APV is negative, the company should not invest in the project.

3. a. This rate should be the nominal discount rate for contractual cash flows. As the cash flows have been converted to the domestic currency, it should be the domestic nominal discount rate. For non-contractual cash flows, if expressed in nominal terms, this should be the nominal rate.

b. 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, then the risk-premium may be negligible, and the domestic nominal risk-free rate may be used.

c. Since the borrowing capacity would be measured in nominal terms, this should be the nominal rate. Again, if the probability of positive cash flows is strong, the domestic nominal risk-free rate may be used.

d. As the nominal foreign-currency interest rate would have had to be paid in the absence of the concessionary loan, that rate should be used as the discount rate for calculating the present value of the repayments of the concessionary loan.

4. There are a number of legal ways to circumvent restrictions on profit repatriations. These should also be accounted for, especially as some of them involve the way the project is to be financed. Some of these ways are discussed below:

• Transfer pricing

• Royalties

• Leading and lagging

• Financing structure

• Inter-company loans

• Currency of invoicing

• Reinvoicing centers

• Countertrade

• Transfer Pricing

Transfer Pricing

Transfer pricing refers to the policy of invoicing purchase and sale transactions between a parent company and its foreign subsidiary on terms which are favorable to the parent company, thus shifting a part of the subsidiary’s rightful profits to the parent. As this method of circumventing repatriation restrictions is very common, authorities are generally very alert as to the price at which transfers are made.

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Royalties The foreign subsidiary may use the parent company’s trademarks and copyrights and pay

royalties as compensation. As this is not a transfer of profit, the normal restrictions on profit repatriation do not cover these payments. Leading and Lagging

Leading and lagging payments between the parent company and the subsidiary, based on expected movements in exchange rates can help in transferring profits from the latter to the former. Suppose the subsidiary has to pay its parent company a sum which is denominated in a currency that is expected to harden. The subsidiary lags (delays) the payment so that a part of the subsidiary’s profits get transferred to the parent company. In the event of such a payment being denominated in a currency that is expected to depreciate, the subsidiary leads (advances) the payment, again with the same effect.

Financing Structure

An overseas project can be funded solely through equity investments, or through a mixture of equity and debt. In cases where there are restrictions on repatriation of profits and repayment of capital, part of the project can be funded through loans from the parent company to the foreign subsidiary. Generally, there are fewer restrictions on payment of interest and repayment of loans than on profit repatriation. Also, interest payments are tax deductible for the subsidiary whereas dividend payments are not (for the parent company both are taxable). There is another tax incentive involved as repayment of loans is non-taxable in the hands of the parent company, whereas funds transferred as dividends are. This way, repatriation restrictions can be maneuvered around, along with getting additional tax advantages, by extension of loans to the subsidiary by the parent company, instead of making direct equity investments.

Inter-company Loans

The methods mentioned above are fairly common ways of getting around regulations in a legal manner. Over a period of time, authorities have become aware of them and frown upon payments to a foreign parent company, under whatever disguise. Hence the danger of the subsidiaries being disallowed from making such payments always looms large. To get around these problems, companies can resort to inter-company loans. The simplest way is that two companies make parallel loans to each others’ subsidiaries, with the amounts and timing of the loans and the interest payment as also the loan repayment matching. This can be refined if each of the subsidiary companies is based in the same country as the other’s parent company. In that case, the loans come totally out of the ambit of exchange control regulations as both the loans are made within the countries involved.

Another way of extending such loans without the parent getting directly involved is a back-to-back loan involving a major multinational bank or a financial institution. Under this method, the parent corporation makes a loan to the bank/FI, with the bank/FI extending an equivalent loan to the foreign subsidiary. For the bank, the loan is risk-free as it is backed by the parent company’s loan.

Currency of Invoicing

Choice of currency in which intra-group trade is invoiced is an important tool for transferring profits within different companies of the same group. Exchange controls are generally imposed to prevent the local currency from depreciating. If the currency is expected to depreciate despite the controls, the exports from the subsidiary based in that country to other group companies can be invoiced in that country’s currency. Also, the imports of that subsidiary from other group companies can be invoiced in some hard currency (one that is expected to appreciate). As the country’s currency depreciates, the

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subsidiary’s profits will fall from what they would have been otherwise, and the profits of other group companies will increase.

Reinvoicing Centers

Trades between companies in the same group can be routed through a reinvoicing center. Reinvoicing centers act as an intermediary by buying from one company and selling them on to the other. The margin between the buying and the selling rates is the amount of profit transferred from the subsidiary to the reinvoicing center. Such centers are mainly used for the management of exposures, but can also be used for converting non-repatriable cash flows into repatriable cash flows, when set up in countries with lesser capital controls. In addition to such conversion, setting up of such reinvoicing centers in tax havens can reduce the overall taxes, and hence increase the after-tax cash flows.

Countertrade

Countertrade involves the parent company and the subsidiary buying from and selling to each other. The most common form taken is barter trade. While the goods transferred from the subsidiary (the value of which may be very high compared to the value of goods received by it) may not be useful for the parent company directly, it can sell them to some third party, with the proceeds serving as an indirect transfer of the subsidiary’s profits.

Part V: Caselets (Questions) Caselet 1

Read the caselets carefully and answer the questions preceding each caselet. 1. Foreign capital plays a very crucial role in the capital scarce developing countries. But the

recent experience of some of the South-East Asian and Latin American countries shows that foreign capital can cause more harm than good, if there is capital flight. Keeping capital within the country for a reasonable period of time is a concern for these countries and these countries initiated various measures to achieve this objective. Explain how a graduated capital gains tax based upon the length of time the investment was held would deter new investors from investing in Malaysia. How would it provide an incentive for foreign investors to keep their capital in Malaysia?

2. How would the inflow of foreign capital in the form of foreign investment aid the economic development of Malaysia? What would happen to the Malaysian economy if there were a sudden, significant outflow of capital?

3. The article mentions that the Malaysia’s currency has been pegged to the dollar. How is this fixed exchange rate maintained in the face of changes in the demand and supply for foreign exchange?

When the Asian financial crisis hit Malaysia, Prime Minister Mahathir Mohammad responded by banning the removal of foreign money and making Malaysia’s currency, the ringgit, non-convertible outside of the country. The Prime Minister blamed his country’s financial problems on foreign currency traders. In February, Malaysia replaced the ban on the removal of foreign capital with an exit tax that provided investors with a steep penalty for the withdrawal of funds held for less than one year. Malaysia just announced that it has removed the exit tax on foreign investment. The government does not believe that the removal of the tax will result in a mass exodus of capital from the country. Malaysia still imposes a capital gains tax on profitable investments. The capital gains tax, like the exit tax, is graduated to encourage investors to leave their capital within the country. The capital gains tax raises the cost of investment in Malaysia and could still be a deterrent to investment. Possibly as a result of Malaysia’s position on capital controls, it has attracted less foreign investment than other Asian countries, like South Korea or Thailand, whose economies have also rebounded. Malaysia’s economic recovery has been aided by setting the ringgit to the dollar at a low rate. Exports became very competitive as a result and economic growth was 4.1 percent in the second quarter. Whether Malaysia’s economy will continue this growth depends very much on the reaction of investors to the relaxation of controls. A significant capital outflow could damage the recovery. Dr. Mahathir believes that the outflow of capital will not be significant. Malaysia has accumulated $32 billion in reserves and has a current account surplus; it could withstand the expected level of outflow.

Caselet 2 4. Every country would like to see that its currency is stable in the short run and is not

misaligned in the long run. In the short run, a volatile currency deters foreign investors and increases the cost of trading. In the long run, exchange rate of the currency should reflect the fundamentals of the economy. Bretton Woods System is a compromise model expected to derive the virtues of fixed exchange rate in the short run and of floating exchange rate in the long run. Briefly discuss the essential features of the Bretton Woods System.

5. The Bretton Woods System implemented in 1946 served the world for about 25 years. In late 1960s, growing strains in the system surfaced and finally the system was officially declared dead in 1971. What do you think are some of the factors that have caused the demise of the Bretton Woods System?

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6. IMF is a vocal advocate of free capital flows. One of the policy prescriptions of IMF for the troubled countries is to float the domestic currency and allow free flow of capital. But some experts say capital control is the best way to fight global financial crises. Do you agree? Justify.

Calls for a new global financial system echo from many corners. It is claimed that the global financial crises of recent years are signals that the Bretton Woods System that has ruled the world economy for 50 years is broken. Over the last few months there have been studies, commissions, forums, and analyses that have developed proposals for a new system. Perhaps the only thing all of these reports have in common is the belief that the old system is in need of fixing. One proposal being pushed by many European countries calls for an early warning system for financial crises. The idea is that the International Monetary Fund (IMF) would broadcast its reviews of member countries to the world in enough time for them to react. The problem with this proposal is that the IMF sometimes forecasts a crisis that does not emerge or reports that an economy is healthy when it is not. Some experts, who view the cause of the global crises as the rapid withdrawal of capital, call for capital controls – either limits, or taxes, on investment funds in small nations. The problem with this approach is that when countries impose controls, owners of capital seek other places for their investments. The IMF has suggested that countries become prequalified for aid – sort of like having a credit line at your bank. Then, should a crisis arise, the IMF can provide funding very quickly. It is thought that having this additional security might avoid a financial crisis. The one time that this was tried in Brazil, it did not work. Other proposals include `target zones’ for currency fluctuations, forcing banks to provide additional financial support to countries where they have placed loans, and having the IMF play the role of international policeman – making sure that countries are in compliance with international rules and regulations. There is one other alternative – to stick with the present system. There are those who argue that crises are healthy in that each crisis maker markets function more efficiently.

Caselet 3 7. Since World War II, trade liberalization is on the rise. One form of trade liberalization is

regional trading arrangement. There are various types of regional trading arrangements ranging from free-trade area to economic and monetary union. European Economic Union is an example for economic union. Describe what is an economic union. What are the objectives of the European Union?

8. How does euro’s decline lead to an increase in inflation? Why are European leaders concerned about inflation and higher interest rates?

The euro, the currency of the European Economic Union, was introduced in January 1999 with hopes that it would become a powerful rival to the dollar. On Wednesday, May 3, 2000, the euro sunk to a new low against the dollar – a decline of 24 percent since its introduction. The reasons for the euro’s decline are unclear. European leaders now worry that inflation may increase and, consequently, interest rates may need to be increased. The causes of the euro decline are puzzling. The economies of the European nations comprising the EEU are improving. Economic growth and consumer confidence is stronger than it has been in years. High unemployment, a problem that has plagued Europe for many years, is declining for the first time. Exports are booming and inflation is lower than in the US and is expected to fall with the decline in oil prices. Some analysts feel that the euro’s problems are in part the result of political factors. Greece, a country that the EEU rejected for membership 2 years ago has now been recommended for admission by the European Commission and the European Central Bank. Many feel that the admission of Greece will weaken the EEU.

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Caselet 4 9. Governments across the globe try to achieve various economic objectives through fiscal

and monetary policies. Fiscal policy refers to the revenue and expenditure policies pursued by the government and monetary policy refers to money supply and interest rate policies pursued by the monetary authority of a country, usually central bank of the country. Why does Ecuador’s central bank lose control of its monetary policy functions when it replaces the Sucre with the US dollar?

10. The government claims that the switch to the dollar would help control inflation and promote foreign investment. How does having the US dollar as Ecuador’s currency help control inflation? How does it promote foreign investment?

The President of Ecuador, Jamil Mahuad, wants to replace the sucre, Ecuador’s current national currency with the US dollar. His plan won approval from Ecuador’s central bank after three current board members resigned to protest this policy. President Mahuad decided to replace the sucre in an attempt to rescue Ecuador from its worst economic crisis in 70 years. Almost every major Latin American country has seen its currency weaken in the past few years. Some of these countries, like Brazil, responded by devaluing their currency. Argentina has linked its currency to the dollar. The value of the sucre currently floats in relation to the dollar and the sucre has lost 67 percent of its value in 1999, as well as a few percentage points in the first few days of 2000. Ecuador had proposed buying sucres now in circulation and replacing them with US dollars. Sucres will then disappear except in the form of coins. At the official exchange rate of 25,000 sucres to the dollar, Ecuadorian officials estimate that $450 million will be needed to accomplish the switch. Since the country’s foreign reserves are in excess of $1.2 billion, there should not be any difficulty in accomplishing this. The estimate of $450 million does not consider savings or checking accounts. The government’s plan is to restrict or delay redemption of these accounts by issuing dollar-denominated bonds as compensation for accounts in excess of $4,000. The impact of the switch will be felt throughout the economy. Ecuador’s central bank will lose control of monetary policy and its functions will be restricted to currency exchange. The International Monetary Fund wants to restart negotiations that have been underway for nearly a year to provide a $250 million loan for Ecuador. The decision to replace the sucre has met some opposition. In addition to the resignations from the central banks, there are street protests and a call for a general strike to protest the government’s policy.

Caselet 5 11. Argentina has a currency board system. Under currency board system, Argentina pegged

the exchange rate between peso and US dollar in an effort to control inflation and promote economic growth. Identify what are the major benefits of a currency board system.

12. What would happen to Argentina’s exports if Argentina were able to devalue its currency? What would happen to GDP?

Argentina decided to peg the value of its currency, the peso, to the dollar, in an effort to control inflation and promote growth. This policy was very effective – moderate price increases provided the stability that produced average annual growth rate of 5.8 percent between 1991 and 1998. Argentina is now in a recession. The stability that resulted from the dollar-peso peg now prevents Argentina from stimulating its economy by weakening its currency. Argentine exporters are burdened by high labor taxes, high interest rates – about 17 percent in inflation-adjusted terms, and high costs for business services. Without the ability to devalue its currency, business firms must seek alternative means to lower their costs. However, this being an election year, Argentina’s government has not adopted cost-cutting policies for business. Tax cutting policies, like those adopted in the early 1990s, would increase competitiveness, but in this election year, proposed tax changes appear to hurt competitiveness. With an inflexible exchange rate and no policies to assist exporters, gross domestic product is predicted to fall 3 percent this year and exports to decline 12 percent.

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Argentina’s lack of competitiveness means that its exports either command lower prices, or that there are fewer buyers of its products. The consequent slowdown in economic activity is contributing to a rise in Argentina’s debt at a time when servicing this debt is climbing. Argentina’s reaction to its mounting debt is to refinance it. It recently swapped $3.91 billion of short-term notes for new two- and five-year notes. Almost every major Latin American country has seen its currency weaken in the past few years. Some of these countries, like Brazil, responded by devaluing its currency. Argentina has stubbornly stuck to its dollar link. It therefore must seek other means to stimulate its economy.

Caselet 6 13. American automobile companies view Japanese imports as their major competitor. What

type of foreign exchange exposure do American automobile companies face? Why are they now much happier? Many American companies have operations in Germany and Japan. How should they feel about the dollar’s new position in those countries?

14. The article tries to show that exporters and importers have opposite feelings about the strength of domestic currency. Should the domestic currency be strong or should it be weak? What do you base your conclusion on?

Since the beginning of July, the dollar has fallen about 20.7 percent against the yen and 12.7 percent against the German mark. Although American consumers love a strong dollar as it means that the imported goods they buy are lower in price and vacations in other countries are cheaper. American businesses prefer a weaker dollar. When the dollar is weak, exports rise and the threat from foreign competition is lowered. This recent fall of the dollar should be welcome news for American companies, but there is no cheering yet. While the dollar has depreciated against the yen and mark, it has remained relatively strong against the Canadian dollar and the Mexican peso, the US’s major trading partners. Accordingly, the trade-weighted exchange rate, a measure of each currency’s impact on US trade, has only declined 4.8 percent. This is not enough of a change to make a big difference, because currency fluctuations affect earnings almost immediately, but take a longer time to have a broader economic impact. As a result of the dollar’s slide, importers will be paying more. Whether this will have an appreciable effect on inflation is uncertain because the increased cost of imported goods may be offset by reduced profit margins if there is slack demand.

Caselet 7 15. Briefly discuss how pegging of Thai baht at an unrealistic exchange rate led to an economic

crisis. 16. Why the Thai government wanted to resist depreciation of baht? What measures Thai

government took to stabilize the baht? Although it may seem unlikely, stock markets in the US and throughout the world were battered this week, possibly as the result of currency problems in the small South-East Asian country of Thailand. Many countries in South-East Asia peg their currencies loosely to the dollar. That means that the baht was allowed to fluctuate in a narrow range to the dollar. With economic growth, Thailand found that its currency was overvalued with the result that imports had increased dramatically and exports had slowed to low amounts. Business had borrowed dollars rather than bahts to finance their investments because of the dollars’ lower interest rate. As the balance of trade worsened, talk of devaluation arose. Individuals borrowed bahts and used them to buy dollars. Businesses bought dollars to protect themselves from devaluation. The increased demand for dollars coupled with the belief of international speculators that a devaluation of the baht was imminent resulted in the devaluation of the baht. Uncertainty in the currency markets in South-East Asia put pressure on the currencies of Malaysia, Indonesia, the Philippines and then spread to Hong Kong even though the Hong Kong dollar is fixed to the American dollar. To keep the currency stable interest rates rose and Hong Kong’s stock market plunged. The turmoil in Hong Kong’s stock market was quickly followed by turmoil all over the world.

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Caselet 8 17. What are the determinants of supply of and demand for foreign exchange? 18. How does fiscal reforms and structural reforms of financial institutions expected to

strengthen the Yen? What determines the value of a currency? In the world’s financial markets currencies are just like any other commodity – their price determined by supply and demand. Some demand arises because buyers actually need the currency they are purchasing in order to purchase goods and services or to be a tourist in that country. Others have purely speculative motives, that is, they hope to profit from changes in the value of a currency. The addition of the speculative motive is often the cause of dramatic swings in the price of a currency. For example, in 1995, the US economy was relatively weak, and Japanese investors were wary of continuing to put money into US investments. The economic situation in Japan also contributed to the decline in the demand for dollars. Japanese firms had sustained large losses on a number of their investments in Japan. In order to cover those losses, dollar investments were exchanged for yen. The combination of the weakness in the US economy and the need to repatriate yen resulted in a strong flow of money out of dollars and into yen, pushing the exchange rate of yen for dollars to a record high. In 1998, the strength of the US economy, record levels of the US stock market and high yields in the US bond market, coupled with a weakness in Japan’s economy, has reversed capital flows. Japan’s economy is in a recession. Real estate values have been falling for a number of years, the banking system is struggling with bad debts, and interest rates are at record low levels. With all these problems, Japan does not appear to be a promising place for investment and the yen has fallen accordingly. The US and Japanese governments could intervene in the currency market to halt the yen’s slide. But interventions without change in the underlying policy or economy is unlikely to permanently halt or reverse a currency’s slide. A shift in relative interest rates between Japan and the US could improve the exchange rate; however, Japan cannot raise interest rates because of its recession and the US cannot lower its because of inflationary fears. Japan can stimulate its economy through tax cuts and US officials are apparently urging Japan to do so. What is the future course of the yen? According to Mickey Levy, chief financial economist at NationsBank in New York, “Until Japanese policy makers take credible steps toward not just fiscal reform but massive structural reform of their financial institutions, the yen will likely test its recent lows and go through them.”

Caselet 9 19. In choosing an exchange rate system, a country must decide whether to allow value of its

currency to be determined by free-market forces or to be fixed against some standard value. Characteristics of the economy play a significant role in determining the exchange rate system suitable for the country. Briefly discuss the influence of the following factors in deciding about the exchange rate system suitable for a country.

a. Size and openness of the economy b. Inflation rate c. Degree of financial development d. Credibility of policy makers and e. Capital mobility. 20. One argument often heard in support of the fixed exchange rate system is that it reduces the

cost of international trade and capital flows since resources are spent on managing exchange rate risk are released. In the long run is this a valid argument? Justify.

Especially in emerging markets, exchange rate regimes are the hemlines of macroeconomics – ideas about what looks best change all the time, at the whim of fashion. In recent decades, the shifts have followed a pattern, veering between floating currencies on the one hand, and fixed exchange rates on the other, taking in a slew of pegs, bands and crawls in between. In the financial crises of 1997-98, the middle ground was weakened: pegged exchange rates crashed from Bangkok to Brasilia. Since, the extremes have been in vogue.

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In Latin America, dollarization has hogged the headlines. Argentina, which already has a currency board flirted with the idea of adopting the dollar last year. Central America’s small states are studying the option (already adopted by Panama). In a recent, desperate, decision, Ecuador also decides to abandon its currency, the sucre, in favor of the dollar. But the hullabaloo about dollarization has distracted attention from a quieter trend in the opposite direction. Over the past year, Brazil, Chile and Colombia have all abandoned their exchange rate targets and bands, and moved to fully floating currencies. Mexico’s peso has floated since 1995. And each of these countries – along with other emerging economies including Poland, South Africa and the Czech Republic – sets monetary policy through a more-or-less formal process of inflation targeting. The goal is to keep the flexibility of a floating currency, allied to a rigorous monetary framework to conquer inflation.

Caselet 10 21. One often raised criticism against the policy measures advocated by IMF for the troubled

countries is that these policies are not sensitive about local concerns and are anti-poor. Do you agree? Why or why not?

22. What is the impact of South-East Asian Crisis on foreign direct and portfolio investments in the region?

IMF is under attack. Its critics opine that its policies do not generate prosperity or alleviate poverty and it tinkers too much with the domestic policies of the borrowing nations. IMF’s remedy of floating exchange rate has also been under fire. With the exception of Hongkong, all the countries of the crisis ravaged South-East Asia have allowed to float their currencies, as one of the many remedies (but very important one) to come out of the crisis. Unfortunately this floating has only resulted in downward journeys for the currencies. Hongkong, South Korea, Thailand, Malaysia and Indonesia suffered large devaluations during the period end 1996 through December, 1999. Hongkong managed with lesser devaluation against the US dollar with only 0.5 percent fall and 5.6 percent fall in GDP per capita. Indonesia is the worst hit with the corresponding figures of 66.4 percent and 35.5 percent. Thailand has figures of 31.6 percent and 30.8 percent whereas Malaysia has figures of 33.5 percent and 25.6 percent. South Korea with an exchange rate fall of 26 percent and GDP per capita fall of 5.6 percent came next to Hongkong. Hongkong, therefore, provides an interesting contrast. It had a currency board, which firmly fixed the local currency to the US dollar. As the storm raged, its link to the greenback held tight and GDP per capita fell by much less than it did in neighboring countries. The chief spokesman of IMF, in defense of the Funds’ Asian policies argued that South Korea has managed a growth of 10 percent in 1999 and Thailand 4 percent. But those were only partial recoveries from the sickening falls these countries suffered. The critics of IMF maintain that the institution’s wrong headed policies decimated Asian living standards and the poor were hit much hard. Yet another criticism is that the policies of IMF are, in many cases, destructive and politically driven. In February, 1998, President Suharto, the Indonesian leader, acting under experts’ advice, proposed adoption of currency board (like Hongkong) to stop the future fall of the Rupaiah. The market loved the proposal. On the day this proposal hit the press, the Rupaiah strengthened by 28 percent against the dollar. It is pertinent to note that Suharto was not a popular man either with IMF or the Clinton administration. A stabilized Rupaiah (had the currency board idea been implemented) would have strengthened the position of Suharto. The critics of IMF maintain that both IMF and administration of Clinton mounted a massive counter attack, pressurizing the Indonesian government to back up the board idea. The board idea was, however, inadvertently vindicated by Michael Camdessus, the departing IMF managing director. On his retirement, Camdessus boasted that “it created the conditions that obliged President Suharto to leave his job”. IMF, therefore, caused considerable human suffering in the excuse of trying to accomplish a political goal, as alleged by the critics of IMF.

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Caselet 11 23. In the recent past dollarization is the hottest policy issue being discussed in many of the

Latin American countries. This essentially involves replacing their home currencies with US dollar. This is considered to be panacea for many economic ills like inflation, economic instability, and foreign investor confidence. Ecuador is one of the Latin American countries actively considering dollarization. Discuss what are the benefits Ecuador can expect by adopting dollar as its currency.

24. Many are skeptical about the benefits of dollarization. Apart from nationalistic sentiments, dollarization is opposed on economic grounds also. Discuss what are the disadvantages of dollarization.

Ecuador’s decision to dollarize had rekindled a debate over dollarization in Latin America. Many countries, including Mexico, Argentina, Venezuela and Peru, in South America have toyed with this idea in the immediate past. The advocates of dollarization argue that the greenback not only brings down inflation and interest rates in unstable economies but also eliminates currency risk and devaluation while promoting investment. But on the other hand this entails surrendering the monetary policy to the US Federal Reserve. The lack of sync with the US economy can lead to cumbersome situations such as the decision of the Federal Reserve to hike interest rates to cool growth in the US may prove disastrous to a foreign economy which needs to grow. Though Panama, which adopted the dollar a century ago, has put up an impressive performance many others are wary of the partial abdication of sovereignty accompanying such conversion. Mexico has been engaged in this discussion since 1998 in the wake of its economy getting increasingly intertwined with that of the US. Further, the leading business houses as a result of big companies having huge dollar reserves gained from exports and $ denominated debt have been continually urging the Government to reconsider, despite the latter considering the free floating exchange rate to be the reason for Mexico’s capability to ward off the financial upheavals emanating from around the globe. Argentina has all the more reasons to switch due to the peso being pegged to the dollar on one-to-one rate and the free circulation of dollars. But the idea has lost vigor with changes in the political arena. Experts opine that Argentina has no advantage of having its own money. The confidence is shaken every time an emerging economy lands itself in a crisis. Most of the debts are dollar denominated and devaluation can spell ruin. Venezuela and Peru can also benefit from the conversion though serious discussion is yet to be taken up in political circles. Brazil and Chile are comparatively well off with their move to the floating exchange system and skillful management of monetary policies. Ecuador has recently witnessed a political coup and in the recent past the local currency has lost considerable value causing inflation to cross 60 percent. The turbulent and unpredictable state of affairs has forced people to think that even if dollarization works it might only be a veiled coincidence. Further, dollarization may prove to be a disservice in countries with profligate public sector enterprises accompanied with lack of fiscal discipline. Though dollarization simplifies trade by eliminating forex transaction costs, it also eliminates the interest income earned from holding currency reserves and fails to tackle the problem of overspending. Nevertheless, the call for adoption could escalate in future with the multiplication of trade between Latin America and the United States.

Caselet 12 25. In 1990s Japanese leaders have realized the importance of liberalizing the markets and

encouraging competition and foreign participation in the economy. Many sectors of the economy are now opened for foreign investments and DBJ is going all out to provide assistance to the foreign investors. Why do you think Japan has become aggressive in attracting FDI?

26. FDI in Japan has been growing at a healthy pace in the recent past. It grew from Yen 3.7 trillion in 1995 to Yen 13.4 trillion in 1998. What factors, do you think, make Japan attractive for foreign investors? What factors hinder foreign investment in Japan?

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Japan initiated regulatory reforms in 1993, in an attempt to reinvigorate an economy flattened by the collapse of the asset bubble in the beginning of the 1990s, and weighted down by the resulting mass of bad debts for the rest of the decade. But these reform efforts have been largely ineffective, mainly due to excessive state intervention. Regulatory reforms have been too slow and too episodic to deliver sustainable economic growth. There was much excitement worldwide in early 1999 when Japanese growth resumed. Japanese stock market boomed last year, responding to signs of more modern management thinking, better financial discipline and corporate restructuring. But growth has remained weak due to high rate of savings, even with low interest rates. Low growth, high savings, high employment costs besides onerous and arbitrary regulations, is not an ideal situation for foreign companies to set up operations. Still FDI is growing at a healthy rate in recent years: From $33 bn in 1995 to $69 bn in 1996 and $119 bn in 1998. The Development Bank of Japan (DBJ) was launched in 1999, with the aim of promoting sustainable development of Japanese economy. DBJ lends at subsidized rates to capital investment in Japan; its loans are structured with lengthy grace periods and low and fixed interest rates, to support foreign investment projects, that private sector lenders might be reluctant to fund because of perceived high risk of long time lags between initial investment and eventual profit. Its loans and guarantees rarely exceed more than 50 percent of project cost, but its support often encourages private sector lenders to provide funding. Encouraging foreign direct investment has become a growing priority as Japan has grasped its potential role in stemming unemployment as established corporations begin to restructure, and as a means of learning new management styles. Japan offers investors, the world’s second largest market, excelling in new product development and production technology. However, insufficient English language ability, expensive land and high personnel costs are the deterrants for the FDI flow. However, excessive regulation is diminishing. FDI investment in Japan is now shifting to service industries, notably financial services, besides retailing sector. Foreign investments in Cinema complexes are also doing well, signifying a shift in consumer mood. DBJ focuses on mid size and smaller companies. For example, DBJ recently provided support to JPK Technology, a new Japanese subsidiary of Malaysian company JPKM, in setting up a research and development and technical support center in Tokyo. The fast growing Malaysian company carries out precision injection and moulding assembly for the audio and video equipment industry. Even in Japan’s agricultural sector, that is notorious for protectionism, foreign firm’s entry is now selectively encouraged. DBJ, therefore, is playing a very crucial role in reviving the economy of Japan by its novel financial schemes, and in the process is “trying to close the information gap between foreign and Japanese firms”.

Caselet 13 27. In the long run what should be the policy objectives of a Central Bank? Justify. 28. Explain how can misalignments in exchange rate lead to misallocation of resources? The principal task of a Central Bank is to keep inflation under check. Should it also adjust interest rates in response to excessive movements in asset prices? Foreign exchange intervention is unlikely to work unless it is allowed to feed into interest rates. Many Central Bankers in the past did not favor raising of interest rates to prick a stock market bubble. They argued that monetary policy should focus solely on inflation. In a recent meeting of Central Bankers, it was concluded that Central Bankers should indeed change interest rates in direct response to movements in equity prices or exchange rates. By doing so, it observed, they would reduce the variability of both inflation and output over time. The analysis of the meet also has the virtue of encompassing exchange rate misalignments and equity bubbles within the same framework. Markets in both shares and currencies tend to overshoot at times, leading to the formation of bubbles that can have similar consequences such as misallocation of resources.

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Most Central Banks already take some account of asset prices in making inflation forecasts. Thus they will raise interest rates if the `wealth effect’ caused by higher equity prices threatens to increase consumer spending and hence future inflation. Similarly, they may raise rates if a weak exchange rate threatens to push up import prices. However, the Committee report argues that Central Bankers should respond to asset price movements for other reasons than merely their direct impact on inflation. For instance, a stock market bubble typically encourages a build up of debt. When share prices collapse, the financial system and economy as a whole is at risk. Likewise, large exchange rate misalignments rarely correct themselves without some pain. By paying more attention to asset prices, Central Bankers can actually improve their long-term inflation record. Consider a share price bubble: raising interest rates may initially put inflation below target. But by letting some air out of the bubble sooner, the impact on inflation and output, when it bursts is more modest. By undershooting inflation a little now, it reduces the risk of undershooting to a great extent at some time in future. Similarly, if a currency seems significantly undervalued, a Central Bank should raise interest rates by more than necessary to keep a lid on future inflation. If a currency seems ludicrously overvalued, interest rates should be cut even if that means inflation moves slightly above target in the short-term. However, share price bubbles or exchange rate misalignments are difficult to identify. Monetary policy is always dealing with uncertainty; this is no reason to ignore asset prices. On the basis of the report, interest rates would probably need to be a bit higher than at present in the Euro area. Central Banks would have to explain carefully why they are temporarily missing their inflation targets. There is a risk that this could damage a Central bank’s credibility. For instance, if a Central Bank allowed inflation to overshoot its target in order to push down its currency, markets might conclude that it had gone soft on inflation. Likewise using interest rates to resist surging equity prices would be hard to sell to the public. The truth is that single-minded inflation target may be flawed.

Caselet 14 29. “The World Trade Organization (WTO) is the only global international organization

dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to help producers of goods and services, exporters, and importers conduct their business” says the WTO. Briefly discuss what are the functions of WTO.

30. A lot of heat has been generated on the issue of China joining the WTO. Why is the USA interested in seeing China as a member of WTO? What do China gain by joining WTO? It is expected that India can increase its bargaining power in the WTO if China becomes a member. How can it be so?

China is expected to enter WTO (World Trade Organization) later this year and start to lower its formidable barriers to imported goods. Experts, however, feel that it would be difficult to get china comply with WTO provisions, as its recent record of compliance is not good. Foreigners seeking patent, trade mark and copyright protection get second class treatment from Chinese bureaucrats. Piracy and counterfeiting of foreign goods are rampant, despite years of promises to reform. Some market opening concessions in the deal reached last November with China by US are just a replay of forgotten promises stretched back to 1979. The result: US shipments to China make up just 2 percent of American exports, and the figure has not changed for 10 years. But such gloomy thoughts were lost in the Clinton administration’s euphoria over its come from behind victory on May 24, as the house of representatives voted to give China permanent normal trade relations. White house acknowledges that foot dragging by China on opening its markets could make things difficult. So the administration is planning a wide ranging effort to force compliance. Once China becomes a WTO member, the US and 135 other members can haul it before WTO’s dispute settlement panels. But that process can take years and governments can ignore adverse rulings. Europe, for example, continues to block US exports of beef and bananas in defiance of the WTO. To avoid similar impasses in China, the US is recruiting a small army of US bureaucrats and handholders to look after the interests of American exporters and investors there. The white house is planning to hire trade experts who will monitor compliance with the agreement,

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provide China with technical assistance in rewriting its laws and civil procedures, and help steer US businesses through the thicket of Chinese regulations, many of which are not even written down. China has long demanded certain promises from foreign companies that bid on projects there like, commitments to buy Chinese parts and services, transfer technology and conduct a portion of their research and development in China. China has now agreed to stop insisting on such promises. But that concession may prove unenforceable. Contracts may go to the foreign companies that offer such inducements and Chinese may say that none was required to give them. Perhaps the biggest challenge for US exporters and investors will lie in reviving the Chinese legal system. Today private business contracts are often enforced by bureaucrats relying on government directives rather than on a history of written case law and regulations. E-commerce sales and contracts are not legally binding and regulatory standards are unpublished. The rule of law in China is rudimentary at best. The lack of legal infrastructure is one reason Chinese counterfeiters can knock off US manufactured goods with impunity. China, however, appears to be eager to give its creaky economy, some free market, free trade shock therapy, through tariff reductions on farm imports, notwithstanding domestic resistance. The question is, will Chinese workers go without social services to pursue capitalism’s promised rewards. If the deal between the US and China is to have any meaning, the toughest work is yet to be done.

Caselet 15 31. In which way the proposed AMF differ from the IMF? 32. What are the pros and cons of swapping agreements? The International Monetary Fund (IMF) is so unpopular in East Asia that it now has an entire economic crisis named after it. And although their economies are now recovering, many of the region’s governments are determined to shake off their nemesis for good. They are still a long way from establishing an Asian Monetary Fund, as some politicians would like. But at an Asian Development Bank meeting in Thailand this week, finance ministers from 13 countries agreed to push ahead with a plan to help each other in the event of a currency run. The basic idea is not new. A weak collection of bilateral agreements was arranged after Mexico’s peso collapsed in the mid-1990s. But it was not enough to prevent runs on several currencies – starting with the Thai baht – in 1997 and 1998. To beef up the region’s defenses, the new initiative aims to make much greater use of Japan’s and China’s substantial foreign exchange reserves – and of both countries’ desire for more clout in the region. The existing arrangement proved inadequate. It was based on “repurchase” agreements between participating central banks, which agreed to provide each other with cash against the security of, for example, Treasury bonds. So it provided liquidity rather than credit. And when countries were known to be using it, as Thailand did in mid-1997, it was taken in the market as a sign of weakness, and so served only to intensify pressure on the baht. Similar problems would dog any scheme based around the ten countries of the Association of South-East Asian Nations (ASEAN) – which includes crisis-hit countries such as Indonesia, Malaysia and Thailand. Most ASEAN countries would themselves be at risk were there another wave of currency panic. And none of them really trusts each other in a pinch. These are serious shortcomings, and the new initiative offers a big improvement, by bringing in Japan and China. So far, hardly any details have been fleshed out. But Japan hopes to model it on two bilateral deals it struck with neighboring countries last year. Its agreement with South Korea allows each central bank to swap its local currency for up to $5 billion in cash from its counterpart; a similar arrangement with Malaysia provides reserves of up to $2.5 billion. Because Japan’s economy is so large, its reserves so massive ($304 billion), and because it is so keen to curry favor in the region, its bilateral pledges are more credible than are those among ASEAN members. If it were to extend similar pledges to the rest of ASEAN, and if China were to offer bilateral swaps from its own $159 billion stockpile, East Asia’s governments might feel more confident the next time their currencies came under attack.

Part V: Caselets (Answers) Caselet 1

1. It is true that sudden flight of capital leads to serious economic problems for the host country. To discourage inflow of short-term capital and encourage retention of capital within the country, countries take various measures. Graduated capital gains tax is one such measure. Capital gain is the surplus realized when an asset is sold at a higher price than the price at which it was bought. Depending on the holding period of the asset, capital gains can be classified as short-term or long-term. Short-term capital gains are usually taxed at higher rate than long-term capital gains. That is, tax rate applicable decreases as the holding period increases. This is called graduated capital gains tax.

Graduated tax rate deters fresh investments in the country because higher tax rates reduce the realized return. Also, any sort of control sends negative signals to the prospective investors and investments decrease. Graduated capital gains tax decreases the realized rate of return at the shorter end of the maturity period, if short-term capital gains are repatriated. By keeping their capital investments for some more time the investors can increase their realized returns substantially since tax rates are lower for higher holding periods.

Therefore, graduated capital gains tax deter new investments and provide an incentive for the existing investors to keep their capital in the host country.

2. One of the key factors influencing economic development of a country is investment. Larger the investment, higher can be the rate of economic growth. Most of the developing countries, including Malaysia, have investment requirements greater than the domestic savings. This gap can be filled by foreign capital inflow. Therefore, foreign capital can increase the investment capability of a country. Apart from this foreign capital can help a country tide over the current account deficit in the short run.

Foreign capital helps the economy by bringing in better management techniques, latest technology and improved R&D facilities in the host country. In some cases export oriented foreign investments can improve the balance of payments position also. Foreign investments also improve the competitive environment in the country.

If there is a sudden and significant outflow of capital from Malaysia, domestic investment would fall drastically. This leads to large-scale unemployment and fall in the GDP. Large-scale capital outflow results in increased supply of domestic currency and increased demand for foreign currency. This will result in substantial depreciation of the domestic currency. If the country depends on imports for essential consumption then depreciation of domestic currency results in inflation.

3. Left to market forces, exchange rate of a currency depends on the supply and demand forces for the currency. Malaysian ringgit is no exception. When ringgit is pegged to the dollar, exchange rate between ringgit and dollar remains fixed irrespective of the market supply and demand. This can be ensured by intervention in the foreign exchange market. When ringgit depreciates against dollar, there is more demand for dollars and more supply of ringgit. Now, Malaysian central bank can intervene in the market by selling dollars for ringgit. This creates additional supply of dollars and additional demand for ringgit, thereby propping up the ringgit. In the same way intervention by the Malaysian central bank can prevent ringgit from appreciating by selling ringgit for dollars. Sustainability of the pegged rate depends on the foreign exchange reserves position of Malaysia.

Caselet 2 4. The essential features of the Bretton Woods System are: A system was established under which the exchange rates were fixed (adjustable peg

system), with the provision of changing them if the necessity arose. All the members of IMF were to fix the par value of their currencies either in terms of gold,

or in terms of the US dollar. The par value of US dollar was fixed at $35 per ounce. The US stood ready to exchange US$ for gold at the value. All other countries were obliged to exchange their currencies for dollars at the parity rate. All these values were fixed with the approval of IMF.

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Member countries maintain their exchange rate within a band of 1% on either side of the fixed par value.

Currencies were required to be convertible for trade related and other current account transactions, though governments were given the power to regulate capital flows. For the purpose of such conversion, gold reserves are needed to be maintained by the US & dollar reserves by other countries. The monetary authorities were to stand ready to buy or sell dollars in exchange for their currencies.

5. Under the Bretton Woods System, the member countries had the option of pegging their currency to either gold or to the dollar. The only reserve asset was gold. As the gold stocks did not increase substantially in the years following the agreement, this provision acted as an impediment to the growth of international trade.

Since other governments were ready to hold dollar reserves, and not convert them into gold, the US started following a system of fractional reserves. The total number of dollars issued by the Federal Reserve was far in excess of the value of the gold held by it. As it would not have been possible for the federal reserve to convert all the dollars into gold, the system ran on the confidence of other countries on its ability to do so, and their non-insistence for an immediate conversion. This created a paradox in the system known as the Triffin’s paradox.

The system had become too rigid, despite the aim of the members being otherwise. As the system provided for realignment of exchange rates in case of a fundamental disequilibrium, predicting exchange rate movements became very easy thus putting currencies at the mercy of speculators.

With the above inherent weaknesses in the Bretton Woods System, the US came under strain in maintaining the par value of gold at US $35/ounce when iflation increased in the US economy and conversion of US $ into gold increased. This raised doubts about the ability of Fed to maintain the par value of US $ and many countries started converting their $ reserves into gold, resulting in a loss of confidence. This forced the US to announce suspension of gold-exchange standard since its gold reserves were not sufficient to meet the demand for gold.

6. It is true that capital control is the best way to fight global financial crisis. Specially in the case of small and open economies.

There must be norms to control the outflow of capital from a country. Although such norms may act as a barrier for prospective investors, in the long run they only save a country from a crisis, as was evident in the recent South-East Asian crisis, where the countries had allowed the capital to move freely.

As we have seen many of the financial crises were triggered by the flow of short-term capital. If there are no controls on the flow of short-term capital, some adverse news can lead to a large outflow of capital in a short period of time. This can put a tremendous pressure on the currency and can aggravate the problems.

Therefore, capital flight is not desirable for a country. Only a strong and a sustainable economy must introduce capital account convertibility.

Caselet 3 7. Economic union is the extreme form of economic integration among countries. Economic

integration is a process of eliminating restrictions on international trade, payments and factor mobility. Economic integration thus results in uniting two or more national economies. Under an Economic and Monetary Union, the process of integration is complete. There are no factors hindering flow of goods and factors of production and all macroeconomic policies are completely harmonized and a common currency introduced for all the countries.

The European Union’s mission is to organize relations between the Member States and between their people in a coherent manner and on the basis of solidarity.

The main objectives are • To promote economic and social progress (the single market was established in

1993; the single currency was launched in 1999); • To assert the identity of the European Union on the international scene (through

European humanitarian aid to non-EU countries, common foreign and security policy, action in international crises; common positions within international organizations);

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• To introduce European citizenship (which does not replace national citizenship but complements it and confers a number of civil and political rights on European citizens);

• To develop an area of freedom, security and justice (linked to the operation of the internal market and more particularly the freedom of movement of persons);

• To maintain and build an established EU law (all the legislation adopted by the European institutions, together with the founding treaties).

8. For European countries foreign trade to national income ratio is relatively high. When euro depreciates imports become costlier. This can lead to higher inflation. Apart from this, depreciation of euro makes exports more profitable than producing for domestic consumption thereby increasing the price level in the European countries. Therefore, euro’s decline can lead to higher inflation. If inflation increases, interest rates also increase so as to fight the inflation and to maintain the current real rate of interest.

Higher inflation and higher interest rates are bad for any economy. Economies of European nations are showing signs of revival. Unemployment rates have started downward trend, inflation is lower and exports are booming. If inflation and interest rates increase at this juncture, economies can be pushed back into recession and high unemployment rates.

Caselet 4 9. Replacement of Ecuador’s currency Sucre with US dollar is called dollarization of Ecuador.

With dollarization, dollar will be the legal tender in Ecuador and there will not be a central bank in Ecuador. The important functions of a central bank are to manage the money supply in the economy and conduct monetary policy functions to achieve the stated macroeconomic objectives. Monetary policy is conducted through effective control over money supply in the economy.

When Ecuador dollarizes its economy, money supply and rate of interest will not be under the control of central bank of Ecuador. Ecuador effectively surrenders these tools to the Fed bank of US. Now money supply and rate of interest are governed by the Fed banks actions than the measures by Ecuador’s central bank.

Therefore, dollarization results in lose of control over monetary policy functions for the central bank of Ecuador.

10. In the long run the source of inflation is excess money supply in the economy. With dollarization, money supply in Ecuador will not be under the control of the central bank. This effectively curbs the excess supply of money in the economy. Now inflation in Ecuador will be closely linked to the inflation in the US. If inflation in Ecuador differs greatly from that of US, commodity arbitrage will take place thereby equalizing prices in both the countries. Hence, dollarization will help control inflation in Ecuador.

Foreign investments are attracted by high returns offered by many developing countries. But a major source of the risk associated with these investments is wide fluctuations in the currency. If this risk can be reduced, investments in these countries become very attractive.

By dollarizing Ecuador can almost eliminate foreign exchange risk associated with these investments. Most of the capital flows are denominated in dollar. If dollar becomes Ecuador’s currency, risk on account of foreign exchange rate volatility is eliminated. Even for capital flows denominated in other currencies like DM or Yen, the risk will be much less and cost of hedging will be low. Therefore, dollarization will promote foreign investment in Ecuador.

Caselet 5 11. Currency board is a monetary authority that issues notes and coins convertible into a

foreign anchor currency at a fixed exchange rate. The main benefits of currency board system are • Currency board system makes a nation’s currency and exchange rate regimes more

rule-bound and predictable since the exchange rate is fixed.

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• There will be effective control over money supply in the economy. Money supply will be determined by the reserve position of the anchor currency.

• Inflationary tendencies in the economy will be automatically corrected. • Effective control over budget deficit since government borrowing will be restricted

to what foreign and domestic lenders are willing to lend to the government at the going rate of interest.

• Investor confidence in the currency increases and there will be more inflow of capital.

• By increasing confidence promoting trade and investment, economic growth of the country will improve.

12. If Argentina devaluates its currency, it can expect to increase exports. One of the determinants of demand for a product is its own price. And one of the important determinants of supply is profitability of the product. If Argentina devalues its currency, peso, exports become more profitable for the exporters. For a given foreign currency realization the exporter would get more pesos now. Therefore, exporters would strive to export more and exports from Argentina would increase.

Exporters can also reduce the foreign currency price of exports without affecting their profitability. Since they get more pesos for a unit of foreign currency, they can reduce the foreign currency price of the product keeping peso profits constant. This will increase the demand for Argentina’s exports. Therefore, devaluation would increase exports from Argentina.

Increase in exports would in turn increase the GDP. Increased exports create additional demand for the products produced in Argentina. When aggregate demand increases, aggregate output for the economy also increases. Therefore, increased exports would increase the GDP.

Caselet 6 13. American automobile companies face operating exposure. This is because the exchange

rate affects the operating cash flows of these companies. When dollar appreciates against yen, automobile imports by Americans from Japan will increase thereby reducing the demand for American automobiles thus affecting the operating cash flows of American automobile companies.

American automobile companies are much happier because main competition for these firms is from Japan and Germany. With the depreciation of dollar against yen and DM dollar price of imported cars increases and demand for cars produced by American firms will increase making American firms more competitive in the domestic market as well as in the international market.

Weak dollar positively affects the repatriated profits of the American firms operating in Germany and Japan. For the same yen and DM profits they earn they will get more dollars now.

14. The exchange rate of a currency should reflect the fundamentals of the economy. There is no such thing as strong or weak currency. If a currency is artificially maintained at a strong or weak position, misallocation of resources would result in the long run.

Let us see what happens if a currency is at a strong position. A strong currency makes exports uncompetitive and imports cheaper. Exports might be internationally competitive but for the strong domestic currency. On the other hand, imports become cheaper and domestic industry producing these products will suffer. Again, domestic producers may be competitive but for the strong domestic currency. Sometimes the economy can be pushed into a recession with a steep fall in the aggregate demand for domestic production.

If a currency is artificially maintained at a weak position, exports become attractive and imports unattractive. This may be despite the uncompetitive firms operating in exports and import substitute goods.

This way a strong or weak currency can lead to misallocation of resources in the long run. If the exchange rate reflects the true competitiveness of the domestic economy, there will be optimum utilization of resources and stable economic growth in the long run.

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Caselet 7 15. In 1997, several of South-East Asia’s most important currencies abandoned their links to

the US dollar. This episode reopened one of the oldest debates in economics: whether a currency should have a fixed or floating exchange rate.

After more than a decade of maintaining the Thai baht’s peg to the US dollar Thai authorities abandoned the peg in July 1997. By October, market forces had led the baht to depreciate by 60 percent against the dollar. The depreciation triggered a wave of speculation against other South-East Asian currencies. Over the same period, the Indonesian rupiah, Malaysia ringgit, Philippine peso, and South Korean won abandoned links to the dollar and depreciated 47, 35, 34 and 16 percent, respectively.

Although Thailand was widely regarded as one of South-East Asia’s outstanding performers throughout the 1980s and 1990s, it relied heavily on inflows of short-term foreign capital, attracted both by the stable baht and by Thai interest rates, which were much higher than comparable interest rates elsewhere. The capital inflow supported a broad-based economic boom that was especially visible in the real estate market.

The downside to Thailand’s economic boom became apparent by 1996, when economic activity slowed, led by a sharp reduction in Thai export growth. Export growth fell in part because of a steep appreciation in the baht, which was linked to a sharply appreciating US dollar. The economic slowdown was accompanied by a sharp interruption in Thailand’s real estate boom and the failure of several large banks. As a result, both local and foreign investors got nervous and began withdrawing funds, which put downward pressure on the baht.

16. Thai government sought to resist these depreciation pressures for several reasons. First, the stable baht had encouraged many Thai firms to borrow in dollars without hedging their foreign-currency exposure, so a depreciation of the baht would increase their debt burden. Second, a sharp depreciation could increase the cost of foreign borrowing, as investors would demand to be compensated for the increased baht volatility. Finally, a weaker baht would tend to increase inflation and reduce the purchasing power of domestic residents. It became clear that Thailand wanted to have its cake and eat it too – pegging its currency to the US dollar while welcoming the inflow of foreign capital.

To resist depreciation pressures, the Thai central bank purchased baht with dollars in the foreign exchange market and also raised interest rates, which increased the attractiveness of the baht. However, the purchases of the baht greatly depleted Thailand’s reserves of hard currency. Moreover, raising interest rates adversely affected an already weak financial sector by dampening economic activity. These factors ultimately contributed to the abandonment of the baht’s link to the dollar.

Caselet 8 17. The factors influencing the demand for and supply of foreign exchange can be identified by

looking at the balance of payments statement of a country. Traditionally the focus has been on the use of foreign exchange in settling international transactions in goods and services. When a country imports goods and services from a foreign country, the payment should be made in the home currency of the exporting country. This particular transaction creates demand for foreign currency and supply of home currency. In the same way, exports create demand for home currency and supply of foreign currency. Apart from export of goods and services, there are flows of payments on account of the previous investments across borders. This repatriation of investment income also creates demand for and supply of foreign exchange. These transactions are captured in the current account of a balance of payments statement.

Capital flows have assumed greater significance in the recent past. Capital flows across countries in search of better risk-adjusted returns. When foreign capital flows into the domestic country, there is a supply of foreign currency and demand for domestic currency. In the same way when capital flows out of the country, there is demand for foreign currency and supply of domestic currency.

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Therefore, demand for and supply of foreign currency is determined by the flows of goods and services and capital across countries.

18. Strength of a currency is determined by the strength of the economy. When the economy is growing, unemployment is low and prices are stable the currency will also be strong. Now the Japanese economy is mired in problems: recession, high unemployment and collapse of the banking system. If the government can take credible measures to stem the rot, outlook for the Japanese economy is expected to improve helping the recovery of yen.

Expectations play a major role in determining exchange rates. Expectations are based on the macroeconomic policy measures initiated by the government. If the Japanese government initiates policy measures to revive the economy and improve the health of the financial sector, expectations turn positive and yen can be expected to strengthen.

Caselet 9 19.

Characteristics of Economy

Implication for the Desired Degree of Exchange Rate Flexibility

Size and openness of the economy

If trade is a large share of national output, then the costs of currency fluctuations can be high. This suggests that small, open economies may best be served by fixed exchange rates.

Inflation rate If a country has much higher inflation than its trading partners, its exchange rate needs to be flexible to prevent its goods from becoming uncompetitive in world markets. If inflation differentials are more modest, a fixed rate is less troublesome.

Degree of financial development

In developing countries with immature financial markets, a freely floating exchange rate may not be sensible, because a small number of foreign-exchange trades can cause big swings in currencies.

Credibility of policy makers

The weaker the reputation of the central bank, the stronger the case of pegging the exchange rate to build confidence that inflation will be controlled.

Capital mobility The more open an economy to international capital, the harder it is to sustain a fixed rate.

20. To shield themselves against the risks of loss caused by exchange rate volatility that can arise with floating exchange rates, individuals and corporates must allocate significant amount of resources in hedging activities. By reducing the variability of exchange rates, a system of fixed exchange rates largely eliminates the incentive to engage in such hedging activities thereby yielding a potential resource savings. Nevertheless, adopting fixed exchange rate system exposes individuals and businesses to the possibility of incurring sizable unhedged losses as a result of unexpected devaluation. Unexpected devaluations can result if there is a persistent fundamental disequilibrium or macroeconomic policies of this country are not in tune with the rest of the world. Therefore, we should consider both aspects of the fixed exchange rate system while evaluating long-term affects.

Caselet 10 21. Yes. I do agree that IMF policy prescriptions for the troubled countries are not sensitive to

the ground realities and are anti-poor. Policy prescriptions usually advocated by IMF for the troubled countries are

• Devaluation and floating the currency • Reduction of fiscal deficit • Reduce the role of government and public sector in the economy • Liberalize foreign and domestic trade.

This is the standard set of policy prescription.

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The criticism against this policy set is that IMF does not consider the ground realities prevailing in the troubled countries and prescribes the same policy set for all the countries.

Let us consider the effect of devaluation. Devaluation is advocated to reduce the trade deficit. If imports and exports are price elastic for the country concerned, trade deficit will worsen and results in higher level of inflation. Therefore, before deciding on devaluation, we should be sure about the demand elasticities and effect on inflation.

In many of the developing countries fiscal policies are pro-poor. If fiscal deficit is reduced drastically, the axe is expected to fall first on the poor. Liberalization and reduction of government’s role has to be proceeded cautiously. Otherwise, domestic industry can be decimated and poor will be left to fend themselves.

As we have seen in South-East Asia, IMF advocated policy set could lead to more troubles if the policies are not applied selectively.

22. The objectives of foreign direct investment and portfolio investments are different. FDI aims to produce goods and services in the host country and hence investments are in physical assets. Portfolio investments aim at greater returns in the form of capital gains, dividends and interest and hence investments are in financial assets. FDIs are long-term in nature and portfolio investments are short- to medium-term in nature. Portfolio investments can be liquidated at a very short notice and FDI cannot be liquidated at a short notice.

The consequences of South-East Asian crisis are sharp depreciation of domestic currencies, fall in GDP and asset prices. These made FDI attractive and portfolio investments unattractive. Many companies in the region were bankrupt because of the currency crisis and became attractive targets for foreign investors. Sharp depreciation of domestic currencies made acquiring these companies very cheap. Since the long-term outlook for these economies was good, it makes sense for foreigners to acquire companies and physical assets. Therefore, the crisis can increase the FDIs in the region.

The crises lead to flight of portfolio investments. In the short run, there was a lot of political and economic uncertainty. Currencies were also not stable and losing value at a fast pace. Therefore, the risk premium increased sharply but expected returns were very low because of depreciating currency and falling asset prices.

Caselet 11 23. Dollarization is a controversial issue that can get nationalist politicians as well as

economists excited. Advocates of dollarization put forward the following arguments: • Economic stabilization • Higher inflow of foreign capital • Increase in foreign trade.

In the long run the most important source of inflation is excess supply of money. Monetary authority may have to increase the money supply in excess of the prudential limits in pursuing other macroeconomic goals. This can lead to inflation. When rate of inflation creeps up, rate of interest in the economy will also go up. Higher inflation and interest rates leads to economic instability in the country. Dollarization can effectively control inflation and interest rates in the domestic economy thereby promoting economic stability. With dollarization, inflation and interest rate in the domestic economy will be equal to those in the US.

Dollarization can eliminate the risk of devaluation for most of the investors. When risk of devaluation is eliminated, investor confidence increases and there will be more capital inflows into the country.

Dollarization simplifies trade with other countries by eliminating exchange rate transaction costs. If most of the foreign trade is invoiced in dollars, dollarization can do away with hedging and transacting in foreign currencies thereby reducing the costs associated with foreign trade.

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24. Many experts are skeptical about the success of dollarization in stemming the economic crises. Opposition to dollarization is mainly on account of • Control over monetary policy • Income earned on currency holdings • Root causes for economic crises.

Two important macroeconomic policy options available for any government are fiscal and monetary policies. These policies are used to achieve various macroeconomic objectives like economic growth, eradication of unemployment, etc. With dollarization the government effectively loses control over monetary policy. This is an undesirable consequence of dollarization. Dollarization in effect surrenders the control over monetary policy to US Federal Reserve. This can result in a conflict of domestic macroeconomic objectives and objectives of US monetary policy.

Domestic government loses the income earned from holding currency reserves. Foreign currency reserves of a country are usually in the form of gold, balances with other central banks and investments in foreign securities. With dollarization, the country need not hold any foreign exchange reserves and the income earned otherwise on the foreign currency reserves is lost.

The root causes of many an economic crisis across the world are inefficiency in public sector and overspending. Dollarization cannot address these root causes of the economic crises.

Caselet 12 25. In the 1990s, Japanese economy was flattened. In the early 1990s, the asset bubble

collapsed. Later economy was weighed down by the resulting mass of bad debts. Japanese corporates were slow in restructuring their companies and adopting new management techniques and inculcating financial discipline. Very high costs of production in Japan led to a massive shifting of production facilities to overseas by the Japanese companies. All these contributed to high unemployment rates, low economic growth and consumer pessimism. Therefore, the pressing needs of the hour for Japanese government were economic growth and lower unemployment.

Foreign direct investment is expected to mitigate some of these problems. It can revive the demand in the economy, bring in new management techniques and help consolidate the weak financial sector. This can improve the economic growth and provide more employment. In the long run, Japanese corporates will be exposed to more competition and new management techniques, which will make them more dynamic.

Therefore, encouraging foreign direct investment has become a growing priority as Japan grasped its potential role in stemming unemployment as established corporations begin to restructure, and as means of learning new management styles.

26. Only in 1990s, Japan has started liberalizing entry for foreign investors. Japan offers the second largest market in the world. By investing in Japan, producers can get closer to the customers. Apart from getting closer to the customers, foreign firms expect to excel in product development, production technology and other aspects of industrial technology by establishing a foothold in Japan.

The initiatives taken by DBJ make investment in Japan attractive. DBJ lends at concessional rates of interest. The maturity period is usually 10 to 25 years with a grace period of 5 years and the repayment structure is convenient for the borrower. Participation by DBJ also encourages private participation. Therefore, easy availability of credit also makes the FDI attractive for the investors.

Factors hindering foreign investment in Japan are • High cost of production • Insufficient English-language abilities • Opaque and arbitrarily enforced regulatory procedures.

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Caselet 13 27. In the long run, the objective of a central bank should be inflation control. This is because

of the strong correlation between the money supply and inflation in the long run. In the long run the main source of sustainable inflation is money supply. If inflation is under control, the economy can achieve a much better growth rate and can ensure stability in the foreign exchange market in the long run.

But in the short run, the central bank may have to deviate from the targeted inflation and pursue other objectives like exchange rate management. This does not mean there is a conflict between the short-term objective of exchange rate management and the long-term objective of inflation control. A more or less stable exchange rate can reduce the variability of inflation in the long run. A fast depreciating currency may require intervention from the monetary authority in the form of increased interest rates. In fact this will help moderate the inflation since depreciation of the currency can increase the prices of imports and inflation in the economy.

Therefore, in the long run, the primary objective of a monetary authority should be inflation control.

28. Misalignment of a currency can be either undervaluation or overvaluation of the currency. When the currency is undervalued, more units of the currency are required to obtain a unit of foreign currency. This can lead to reduction in imports and increase in exports, which results in reallocation of resources in the economy. Increased prices of imports necessitate domestic production of these goods, which is not on account of any advantage in the production of these goods. Therefore, resources are allocated to produce these goods because undervalued domestic currency made this proposition attractive. In the same way more goods will be produced for exports since undervalued domestic currency make exports more profitable.

An overvalued currency will lead to an increase in imports and decrease in exports. When a currency is overvalued, a fewer units of the home currency are required to obtain a unit of foreign currency. This makes the import of goods more attractive in relation to domestic production, which diverts the resources earlier used in domestic production of these goods. This diversion of resources is not on account of any competitive disadvantage but for misalignment of exchange rate. In the same way overvalued currency results in a decreased demand for exports and reallocation of resources.

Caselet 14 29. Functions of WTO are

• Administering WTO trade agreements • Forum for trade negotiations • Handling trade disputes • Monitoring national trade policies

Technical assistance and training for developing countries. Administering WTO trade agreements: WTO is responsible to administer the agreements

negotiated and signed by member countries and ratified by their parliaments. The WTO agreements cover goods, services and intellectual property. They spell out the principles of liberalization, and the permitted exceptions. They include individual countries’ commitments to lower customs tariffs and other trade barriers, and to open and keep open services markets. They set procedures for settling disputes. They prescribe special treatment for developing countries. They require governments to make their trade policies transparent.

Forum for trade negotiations: WTO is a forum where important issues related to international trade are discussed by member nations.

Handling trade disputes: Any disputes related to international trade, interpretation and implementation of the WTO agreements are resolved by the WTO. Without enforcement, the rules-based system would be worthless. The WTO’S procedure underscores the rule of law, and it makes the trading system more secure and predictable. It is clearly structured, with flexible timetables set for completing a case. First rulings are made by a panel.

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Appeals based on points of law are possible. All final rulings or decisions are made by the WTO’s full membership. No single country can block these.

Monitoring national trade policies: Compliance with the provisions of the agreements by member nations is monitored by WTO.

The WTO organizes around 100 technical cooperation missions to developing countries annually. It holds on average three trade policy courses each year in Geneva for government officials. Regional seminars are held regularly in all regions of the world with a special emphasis on African countries. Training courses are also organized in Geneva for officials from countries in transition from central planning to market economies.

30. Chinese markets are protected with various tariff and non-tariff barriers. If these barriers can be removed, American exporters can gain immediate access to the huge Chinese market. It is expected that USA can increase its exports to the extent of $3 billion if China becomes a member of WTO. Therefore, interest of America lies in the potential market China offers to its products.

By joining WTO, China can get the Most Favored Nation (MFN) status. This allows China to get the best terms negotiated with any member country applicable for all other member trading nations.

Though China is the world’s third largest economy, it is a poor country. With China on its side, developing countries can increase their bargaining power at WTO negotiations. China is also a country with abundant labor resources as India is and comparative advantages of both the countries are more or less similar. Therefore, our interests are likely to be very similar at trade negotiations and China’s entry increases our bargaining power.

Caselet 15 31. IMF was the result of the Great Depression and the exchange rate volatility and competitive

devaluations during that period. Primary objective of IMF was to maintain stable exchange rates and a multilateral credit system. The proposed Asian Monetary Fund is also in response to a crisis: South-East Asian crisis. But the objective of this arrangement is to extend mutual help in case of a currency crisis. These two differ in their coverage and terms of assistance. IMF covers the countries of the world, but AMF may cover only South-East Asian region only. Assistance from IMF comes with stringent conditions in terms of macroeconomic policies to be pursued by the country in trouble. AMF may not be concerned about the structural reforms the country should undertake and limit itself to providing assistance.

Another difference is that the IMF was concerned about the exchange rate system and international liquidity. IMF was responsible for administering the Gold-exchange standard and issued Special Drawing Rights (SDRs) to increase international liquidity. AMF, if established, may not be bothered about exchange rate system and international liquidity.

32. The swapping arrangement works on the following lines: when a currency, say Thai baht, faces a run, neighboring countries like Malaysia or Japan can swap their currencies for Thai baht. The immediate result of this is to increase the supply of foreign currency and create demand for Thai baht. This helps Thai baht halt the run.

Advantages of this arrangement are easy and faster access to foreign currency. When there is run on a currency, it becomes extremely difficult for the country to borrow in the international markets. The cost of borrowing will be prohibitive. Finance from international agencies like IMF cannot be timely and come with a lot of policy prescriptions. These macroeconomic policy prescriptions can aggravate the problem rather than helping the country as happened with the South-East Asian countries. The swapping arrangement can provide immediate help without any conditions attached to it. And there are no interest costs associated with the swap. Therefore, swap arrangement provides easy and faster access to foreign currency.

The probable strains in the arrangement can be limited availability of foreign exchange reserves with the member countries or the run is on the currencies of all the members of such an arrangement. With limited availability of foreign exchange reserves, members may not be able to go for a swap. If the run is on all the countries, there will be no one to swap the foreign currency. Another disadvantage with this arrangement can be the perceived weakness on the part of the country looking for the swap.

Part I: Questions on Basic Concepts SECTION II: INTERNATIONAL TRADE Trade Blocks 1. The World Trade Organization (WTO) began its operations in

a. 1994

b. 1995

c. 1196

d. 1997

e. 1998

2. Which of the following statements is not true?

a. The WTO is a chartered trade organization.

b. The WTO has a legal status and enjoys privileges/immunities on the same footing as the IMF and the World Bank.

c. India is not one of the founder members of the WTO.

d. The WTO is a successor of GATT.

e. GATT was a forum where member countries met from time to time to discuss and solve world trade problems.

3. The WTO is based in

a. Geneva, Switzerland

b. New York, USA

c. London, UK

d. Paris, France

e. Berlin, Germany.

4. TRIPs stands for

a. Trade Related Aspects of Intellectual Property Rights

b. Trade Review of Intellectual Property Rights

c. Trade Review of Intelligent Property Rights

d. Trade Related Aspects of Intellectual Policy

e. None of the above.

5. Which of the following is true regarding TRIMs (Trade related aspects of investment measures)?

a. TRIMs calls for the removal of all trade related investment measures within a period of five years.

b. TRIMs requires foreign investment companies to be treated at par with national companies.

c. Agreement on TRIMs requires mandatory notification of all non-confirming TRIMs and their removal within two years for developed countries, five years for developing countries and seven years for least developed countries.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

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6. Which of the following is the first multilateral agreement to provide legally enforceable rights to trade in all services? a. TRIPs b. TRIMs c. GATs d. PTA e. None of the above.

7. Which of the following is not a basic principle of GATs? a. GATs covers all services, including those provided in the exercise of government

authority. b. As per GATs, national providers should be favored. c. GATs advocates no discrimination between other members of the agreement. d. Both (a) and (b) above. e. Both (a) and (c) above.

8. As per TRIPs, copyrights are protected for a minimum period of ______ years after the death of the author. a. 10 years b. 20 years c. 30 years d. 40 years e. 50 years.

9. Which of the following conditions are necessary for the success of a cartel? a. The elasticity of demand for total consumption by the rest of the world must be

high. b. The cartel must control a very large share of the world market for the cartelized

commodity. c. The elasticity of supply of the cartelized commodity by the rest of world must be

low. d. Both (a) and (b) above. e. Both (b) and (c) above.

10. Which of the following countries are not members of OPEC? a. Ecuador. b. Algeria. c. United Arab Emirates. d. Nigeria. e. Venezuela.

11. The headquarters of OPEC is situated at a. Geneva, Switzerland b. Vienna, Austria c. Washington D.C, USA d. Paris, France e. Cairo, Egypt.

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12. Which of the following are the objectives of OPEC?

a. To coordinate and unify petroleum policies among member countries in order to secure fair and stable prices for petroleum producers.

b. To provide efficient, economic and regular supply of petroleum to consuming nations.

c. To provide a fair return of capital to those investing in the industry.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

13. GATT came into force in the year

a. 1947

b. 1948

c. 1950

d. 1970

e. 1990.

14. The European Common Market was founded in the year

a. 1950

b. 1952

c. 1957

d. 1960

e. 1965.

15. Which of the following is an objective of the European Common Market (ECM)? a. Creation of a customs union.

b. Elimination of custom duties and quantitative restrictions in exports and imports, as well as other measures having equivalent effect.

c. Establishment of common customs tariff and common commercial policy.

d. Both (b) and (c) above.

e. All of (a), (b) and (c) above.

16. As per the EMU, the currency of each member country could fluctuate between the wide _____ band to the narrow ______ up to August 1993.

a. 4%, 2%

b. 4.5%, 2.5%

c. 6%, 2.25%

d. 6.5%, 2.5%

e. 6.25%, 2.25%.

17. Which of the following statements is true about the European Community?

a. EC has not been successful in achieving a complete economic and political union.

b. One of the objectives of EC is the abolition of obstacles to freedom of movement for persons, services and capital.

c. The EC has entered into a commercial agreement with India for the import of textiles under the Multi Fibre Agreement (MFA).

d. Both (b) and (c) above.

e. All of (a), (b) and (c) above.

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18. NAFTA stands for

a. North Atlantic Free Trade Agreement

b. North American Free Trade Agreement

c. North African Free Trade Agreement

d. North African Free Trade Association

e. North American Free Trade Association.

19. NAFTA consists of which of the following countries?

a. USA, Canada and Mexico.

b. USA and Mexico.

c. South Africa, Nigeria and Sudan

d. South Africa and Nigeria

e. USA and Canada.

20. Which of the following are objectives of NAFTA?

a. Protection for investment in the sense that no investment can be expropriated without full compensation.

b. Lowering barriers for easier movement of goods across borders.

c. Substantial tariff reductions over a specified time-frame.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

21. The primary objective of UNCTAD is to formulate policies relating to developmental aspects including a. Trade

b. Aid

c. Transport

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

22. The UNCTAD meets once in every _______ years.

a. 2

b. 3

c. 4

d. 5

e. 6.

23. Which of the following is a function of UNCTAD?

a. To promote international trade between countries, especially for accelerating the economic development of LDCs.

b. To formulate principles and policies of international trade.

c. To facilitate the coordination of activities of other international agencies within the UN system in the field of international trade and related problems of economic development.

d. Both (b) and (c) above.

e. All of (a), (b) and (c) above.

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24. The bilateral treaty between USA and Russia provides which of the following basic guarantees? a. Companies from each country will be treated as favorably as their competitors. b. Clear limits are established on the expropriation of investments and ensure that

investors will be fairly compensated. c. US and Russian investors have the right to transfer funds into and out of the

countries in which the investment is located without delay using a market rate of exchange.

d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

25. Which of the following is not true regarding the Generalized System of Preferences (GSP)? a. GSP was set up to allow developed countries certain benefits from trade preference,

enabling them to attain economic self-sufficiency by means of trade liberalization. b. All industrial products subjected to tariffs are included in GSP. c. As per GSP, not all developing countries receive preferential treatment. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

26. Which of the following is an international cartel? a. OPEC b. UNCTAD c. NAFTA d. ECM e. None of the above.

Export–Import Policy 27. Which of the following is not a prerequisite for effecting exports from India?

a. Obtaining Importer-Exporter Code from DGFT. b. Registration with an export promotion council. c. Registration with the Reserve Bank of India. d. Both (b) and (c) above. e. None of the above.

28. The validity of the EPCG license is a. 6 months b. 12 months c. 15 months d. 18 months e. 24 months.

29. Which of the following statements is not true? a. Export Promotion Councils assist member exporters in their export marketing

activities. b. Export Promotion Councils receive their financial assistance from the Government

of India. c. The Registration Cum Membership (RCMC) is necessary for an exporter to avail

exim benefits. d. The RCMC is valid for a period of 3 licensing years. e. Each export promotion council is responsible for the promotion of a particular group

of products, projects and services.

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30. Identify the incorrect statement.

a. Export contracts are required to be denominated in freely convertible currency.

b. Export proceeds are to be realized within 6 months of date of shipment or the due date of payment whichever is later.

c. Exports from India may be made without any restriction.

d. Both (a) and (c) above.

e. Both (b) and (c) above.

31. Which of the following statements is true?

a. Goods included in the ITC(HS) classification may be exported freely without any restriction.

b. Goods which fall under the restricted list cannot be exported or imported.

c. Goods which fall under the canalized list can be exported or imported only through specified agencies.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

32. Which of the following is not true regarding import licenses?

a. Import licenses are valid only for the validity period specified on the license.

b. The value indicated on import license is always for FOB value of goods authorized to be imported.

c. Goods which require an import license can be imported only by the actual user, unless otherwise specified.

d. Advance license is issued for duty free import of inputs subject to value addition and export obligation.

e. Advance license is issued under the duty exemption scheme.

33. Canalized goods in relation to imports refers to those goods which

a. Can be imported freely

b. Can be imported only by certain agencies

c. Cannot be imported

d. Fall under the restricted category of imports

e. Can be imported using a special import license. 34. Which of the following fall under the category of ‘deemed exports’?

a. Supply of goods to projects funded by UN agencies. b. Supply of goods to export oriented units. c. Undertaking turnkey contracts abroad. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

35. Which of the following is included in the prohibited list of exports? a. Cattle. b. All forms of wild life. c. Petroleum Products. d. Onions. e. Mineral Ores.

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36. The acronym ‘LERMS’ stands for a. Liberalized exchange rate management system b. Liberalized exchange rate management scheme c. Liberalized exchange rate management scrip d. Liberalized exchange rate mechanism e. Liberalized exchange regulation and mechanism.

37. As per LERMS _____ % of current account receipts were required to be surrendered to the Reserve Bank of India at official rate. a. 15 b. 20 c. 30 d. 40 e. 60.

38. The export-import policy is announced for a period of a. 1 year b. 2 years c. 3 years d. 4 years e. 5 years.

39. Exports and Imports come under the purview of a. Ministry of Finance b. Ministry of Commerce c. Ministry of External affairs d. Ministry of Home e. Ministry of Small Scale Industries.

40. Which of the following are the objectives of the current EXIM policy? a. Accelerating the country’s transition to a globally oriented vibrant economy. b. Encouraging attainment of internationally accepted standards of quality. c. Enhancing technological strength and efficiency of Indian agriculture, industry and

services. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

41. ITC(HS) refers to a. Import Trade Control (Harmonized System) b. International Trade Control (Harmonized System) c. International Trade Control (Harmonic System) d. Indian Trade Classification (Harmonized System) e. Indian Trade Classification (Harmonic System).

42. Which of the following are not exempted from export declaration forms? a. Trade samples supplied free of payment. b. Personal effects of travelers, whether accompanied or unaccompanied. c. Goods imported free of cost on re-export basis. d. Export of goods on lease basis. e. Both (a) and (c) above.

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43. The Registration Cum Membership Certificate is issued by a. Export Promotion Councils b. Reserve Bank of India c. Director General of Foreign Trade d. Ministry of Commerce e. Ministry of External Affairs.

44. Which of the following is true as per EPCG scheme? a. New capital goods, including computer software systems, are allowed to be

imported. b. Import of capital goods is not subject to actual user condition. c. Import of capital goods up to 15% of the CIF value of the capital goods is allowed at

5% customs duty subject to an export obligation equivalent to 5 times CIF value of capital goods on FOB basis.

d. Both (a) and (b) above. e. Both (a) and (c) above.

45. Which of the following is not true regarding export obligation under the export promotion capital goods scheme? a. Export obligation should be fulfilled by export of goods manufactured by the use of

capital goods imported under the scheme. b. If the exporter processes and adds value to the goods manufactured by the use of

imported capital goods, export obligation will stand enhanced by 50%. c. Export obligation should be fulfilled by the EPCG license holder and cannot be done

through a third party. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

46. Which of the following is true as per the Export Promotion Capital Goods Scheme? a. Realization of export proceeds in respect of exports made under the EPCG Scheme

shall be in freely convertible currency. b. Exports under the EPCG scheme will be only physical exports and not deemed

exports. c. Export obligation under this scheme will have to be fulfilled over a period of 8 years

reckoned from the date of issuance of license. d. Both (a) and (b) above. e. Both (a) and (c) above.

47. An advance license can be issued for which of the following? a. Physical exports. b. Intermediate supplies. c. Deemed exports. d. Both (a) and (c) above. e. All of (a), (b) and (c) above.

48. The GR/PP procedure has been waived subject to which of the following conditions? a. Export of goods is made by post parcel or air freight. b. The export transaction does not involve any foreign exchange outflow. c. Value of the shipment does not exceed Rs.25,000. d. Both (b) and (c) above. e. All of (a), (b) and (c) above.

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49. Exporters of Gem and Jewelry are eligible to import their inputs by obtaining

a. Special Import Licenses

b. Advance Licenses

c. Replenishment Licenses

d. Diamond Imprest Licenses

e. Both (c) and (d) above.

50. Firms dealing with sale and purchase of rough diamond can operate diamond dollar accounts provided

a. They have a track record of at least 1 year in that business and also have an average annual turnover of Rs.2 crore or above during the preceding three licensing years

b. They have a track record of at least 2 years in that business and also have an average annual turnover of Rs.2 crore or above during the preceding three licensing years

c. They have a track record of at least 3 years in that business and also have an average annual turnover of Rs.5 crore or above during the preceding three licensing years

d. They have a track record of at least 4 years in that business and also have an average annual turnover of Rs.7 crore or above during the preceding three licensing years

e. They have a track record of at least 5 years in that business and also have an average annual turnover of Rs.7 crore or above during the preceding three licensing years.

51. Which of the following is not true regarding ‘deemed exports’?

a. Goods under ‘deemed exports’ do not leave the shore of the country.

b. The central idea of deemed exports is that supply of goods has indeed facilitated inflow/retention of forex into/within the country.

c. Supply of goods to projects funded by UN agencies does not fall under the category of ‘deemed exports’.

d. Advance licenses can be used for deemed exports.

e. Both (c) and (d) above.

52. Which of the following is true as per the EXIM policy 2001-2002?

a. Quantitative restrictions are totally dismantled.

b. Export growth rate is targeted at 18% for the year 2001-2002.

c. Second-hand capital goods up to 10 years old are allowed to be freely imported.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

Documentary Credits 53. Which of the following statements is true?

a. When an ex-works price is quoted, the risk and cost to bring the goods from the exporter’s place to the desired location will be to the exporter’s account.

b. FOB price is inclusive of ex-works price, transportation charges up to the place of shipment but exclusive of all other costs involved.

c. C&F price covers FOB value of goods plus freight charges of transporting goods to the port of destination.

d. When a CIP price is quoted, the responsibility of arranging and paying for insurance lies with the buyer of goods.

e. Both (b) and (d) above.

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54. Identify the incorrect statement. a. Documentary credits are governed by UCPDC 400. b. In documentary credit operations, all parties deal with documents. c. In documentary credit operations, parties do not deal with goods, services or

performances to which the goods relate to. d. A letter of credit may be defined as an arrangement where payment is made against

documents. e. The UCPDC guidelines are issued by the International Chamber of Commerce

(ICC). 55. The bank which opens the LC in favor of the beneficiary is the

a. Issuing Bank b. Advising Bank c. Confirming Bank d. Nominated Bank e. Reimbursing Bank.

56. A letter of credit is opened in favor of the a. Applicant of LC b. The importer of goods c. The exporter of goods d. The exporter’s bank e. The advising bank.

57. Which of the following is not true? a. The term ‘negotiation’ means giving of value. b. Where a credit is freely negotiable, any bank may be a nominated bank. c. A credit which is restricted for negotiation will have a specific bank as a nominated

bank. d. The advising bank is usually situated in the country of the buyer of goods. e. None of the above.

58. Which of the following statements is not true? a. In a letter of credit transaction, the negotiating bank becomes the holder in due

course. b. The bank which has opened the letter of credit, has the right to refuse documents

submitted to it in case they contain discrepancies. c. The letter of credit is not independent from the sale contract or any other contract on

which it is based. d. Both (a) and (c) above. e. None of the above.

59. Identify the incorrect statement. a. A revocable LC may be canceled by the opening bank only by giving prior notice to

the exporter. b. An LC which does not indicate whether it is revocable or irrevocable will be treated

as revocable LC. c. A nominated bank that has effected payment to the exporter, prior to receiving

notice of cancelation under an revocable LC, is entitled to claim payment from the opening bank.

d. A revocable LC is disadvantageous from the point of view of the exporter. e. Both (a) and (b) above.

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60. An irrevocable letter of credit a. Can be amended without the consent of the applicant b. Can be amended without the consent of the opening bank c. Is favorable from the point of view of the exporter d. Both (a) and (b) above e. All of (a), (b) and (c) above.

61. Which of the following statements is not true? a. Under a deferred payment credit, the exporter may or may not be called to draw

drafts. b. A deferred payment credit carries an undertaking of the opening bank to make

payment(s) on the date(s) determinable in accordance with the stipulations of the credit.

c. In case of an acceptance credit, the exporter may or may not draw a draft on the drawee/specified bank.

d. Both (a) and (b) above. e. Both (b) and (c) above.

62. Identify the incorrect statement. a. A confirmed letter of credit has the guarantee of not only the opening bank but also

the confirming bank. b. Only irrevocable letters of credit can be confirmed. c. The confirming bank will add its confirmation only if requested by the opening

bank. d. A confirmed letter of credit is slightly costlier than other forms of LCs. e. Confirming banks are usually located in the country of the buyer.

63. In case of an acceptance credit a. The exporter is required to draw a bill of exchange b. The buyer need not pay immediately c. The seller cannot discount the bill of exchange with his bank d. Both (a) and (b) above e. All of (a), (b) and (c) above.

64. Which of the following statements is not true? a. A credit cannot have more than one amendment. b. Any amendment made to the letter of credit will be communicated to the exporter

through the same bank that advised the credit. c. The exporter need not give notification of acceptance or rejection of any amendment

made to the letter of credit. d. Both (a) and (b) above. e. Both (a) and (c) above.

65. Which of the following is the best form of credit available to the exporter? a. An acceptance credit. b. A negotiation credit. c. A confirmed irrevocable credit. d. A revocable credit. e. A payment credit.

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66. Confirmation of the credit will be made by the advising bank only on the request of the a. Importer b. Exporter c. Exporter’s bank d. Opening bank e. Nominated bank.

67. A revolving letter of credit a. Is one in which the limit under the credit is renewed as and when bills drawn under

it are paid, to the extent of such bills b. Is one in which the limit is reduced permanently to the extent of the bills drawn

under the credit c. Is useful where continuous transactions between the exporter and the importer are

expected d. Both (a) and (c) above e. Both (b) and (c) above.

68. Which of the following statements is not true regarding transferable credit? a. A transferable credit can be transferred only once. b. A transferable credit is one under which the exporter has the right to make the credit

available to third parties. c. Transferable credit is also known as back-to-back credit. d. Both (a) and (c) above. e. Both (b) and (c) above.

69. A transferable credit a. Can be transferred only if it is expressly designated as ‘transferable’, ‘divisible’,

‘fractionable’, ‘assignable’ or ‘transmissible’ b. May be transferred in fractions up to the full limit of the credit provided partial

shipments are not prohibited c. Will be transferred by the transferring bank only to the extent and in the manner

consented to by such bank d. Both (b) and (c) above e. All of (a), (b) and (c) above.

70. A back-to-back credit a. Is considered safe from the banker’s point of view b. Is one that is opened against the security of another credit called the main credit c. May be opened when the beneficiary does not want to reveal the source of supply to

the buyer d. Both (a) and (b) above e. Both (b) and (c) above.

71. Which of the following statements is true? a. The terms and conditions of the back-to-back credit should be exactly as that of the

original letter of credit. b. A back-to-back credit is only an extension of the original credit. c. While opening a back-to-back credit, the bank should take care to ensure that the

original credit is an irrevocable credit. d. Both (a) and (b) above. e. Both (a) and (c) above.

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72. Anticipatory credit

a. Is a credit where advance payment is made at the pre-shipment stage

b. May be a red clause letter of credit or a green clause letter of credit

c. Is widely used in international trade

d. Both (a) and (b) above

e. All of (a), (b) and (c) above.

73. Standby credit

a. Is widely used in the USA

b. Is a substitute for bank guarantee

c. Is a credit that is payable upon adducing evidence of a party’s non-performance of the agreement

d. Both (b) and (c) above

e. All of (a), (b) and (c) above.

74. Which of the following is not true?

a. A confirming bank will not be bound by any amendment not routed through it.

b. If an amendment to a credit is advised to the confirming bank, it is up to the bank to accept or reject it.

c. Partial acceptance of amendments that are contained in one and the same advice of amendment by the beneficiary, is a valid acceptance as per UCP 500.

d. A bank which is not prepared to confirm the credit should inform the same to the opening bank.

e. Both (b) and (d) above.

75. Which of the following is the most riskiest form of payment from the point of view of the exporter?

a. Advance Remittance.

b. Open Account.

c. Consignment Sale.

d. Documentary Collections.

e. Letter of Credit.

76. Which of the following statements is not true?

a. As per exchange control guidelines, banks will open letters of credit only for their own customers participating in the trade.

b. While submitting an application for opening a letter of credit, limited companies are required to submit to the bank a copy of the board resolution authorizing the company to establish the letter of credit.

c. In case of imports on cash basis, remittance should be completed within 3 months from the date of shipment.

d. The rate of interest if any for the usance period of the bill of exchange drawn under a LC should not exceed the prime rate of interest in the country of the currency in which goods are invoiced.

e. Both (c) and (d) above.

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77. Opening an import letter of credit involves certain safeguards from the banker’s point of view. Which of the following are not true? a. While opening an import letter of credit, the banker should check if the importer

possesses an importer-exporter code number issued by the DGFT. b. Exchange control copy of the import license should be submitted to the authorized

dealer at the time of opening an import letter of credit. c. The import license should always be endorsed in the relevant column for the FOB

value of the import. d. At the time of opening an import letter of credit, the import license should still be

valid. e. Commodity mentioned in the import license should be the same as mentioned in the

application made for opening an import letter of credit. 78. Which of the following is not a valid condition with regard to opening of an import letter of

credit? a. In case of goods falling in the negative list, the importer is required to submit the

exchange control copy of the import license to the authorized dealer. b. The import license should be valid for shipment at least up to the last shipment date

requested for in the letter of credit application. c. Payment in respect of goods imported from Nepal or Bhutan should be made in

rupees, and such an LC should be treated as a domestic LC. d. Remittance in case of imports on cash basis should be made within a period of six

months from the date of shipment. e. If the beneficiary is from an ACU country, the LC should necessarily be

denominated in US dollars. 79. Which of the following is false regarding a bill of exchange?

a. The bill of exchange should be drawn by the beneficiary or any authorized person and should be signed by the drawer.

b. The bill of exchange should be drawn conditionally on the applicant or any other specified drawee.

c. The bill should be drawn payable at a tenor specified in the credit. d. The bill of exchange should unless otherwise specified be drawn in the same

currency of the invoice/LC. e. The bill of exchange should be dated.

80. Which of the following conditions is incorrect regarding a commercial invoice? a. The commercial invoice should be in the name of the bank opening the letter of

credit. b. The invoice should not include any other charges which are not specified in the

letter of credit. c. The invoice should show deductions towards advance payment made, agency

commission payable, etc. as applicable. d. Final amount of invoice or the percentage of drawing as permitted in the LC should

correspond with the draft amount. e. The gross value of the invoice should not exceed the credit amount.

81. A bill of lading a. Serves as a receipt by the shipping company acknowledging that the goods have

been received for transportation b. Is a negotiable instrument c. Possessor can claim a right to the goods covered by it d. Both (a) and (c) above e. All of (a), (b) and (c) above.

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82. Identify the correct statement. a. A bill of lading cannot be transferred by endorsement and delivery. b. A bill of lading should show the name of the carrier and must be issued by a named

carrier or his agent. c. A bill of lading need not indicate the name of the consignor, but should indicate the

name of the consignee. d. A bill of lading when drawn, is presented only in a single copy. e. The description of goods in a bill of lading should always be a complete description

of goods. 83. When the goods are delivered to the shipping company for transportation, at first a

temporary receipt is issued by the shipping company. This receipt is known as a. Bill of lading b. Mate’s receipt c. Seaway bill d. Freight receipt e. Liner way bill.

84. Which of the following statements is not true? a. A bill of lading is a document of title to the goods. b. A mate’s receipt is a substitute for a bill of lading. c. The transfer of a mate’s receipt passes title in the goods to the transferee. d. A mate’s receipt is prima facie evidence of the quantity and condition of the goods

received by the shipping company. e. Both (b) and (c) above.

85. Which of the following conditions needs to be satisfied by the exporter while submitting insurance documents? a. The insurance document must be expressed in the same currency as the letter of

credit. b. The insurance document must give the name of the assured and also give brief

details of the goods insured. c. Unless otherwise specified, the insurance document should be issued for an amount

of 100% of CIF/CIP value of goods. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

86. A documentary letter of credit a. Offers advantages only to the exporter of goods b. Offers advantages both to the exporter and the importer c. Absolves the exporter from knowing in detail the exchange control regulations of

the importer’s country d. Both (a) and (c) above e. Both (b) and (c) above.

87. Which of the following credit is payable upon certification of the party’s non-performance of the agreement? a. Payment credit. b. Standby credit. c. Revolving credit. d. Deferred credit. e. Anticipatory credit.

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88. In a transit credit a. The advising bank will be situated in the beneficiary’s country b. The advising bank will be situated in the importer’s country

c. The advising bank will be situated in a country other than the beneficiary’s d. No advising bank will be used for advising the credit e. None of the above.

89. A credit that is denominated in the currency of a third country is a. Transit credit b. A reimbursement credit c. A transferable credit d. An anticipatory credit e. Deferred credit.

90. Documentary credits are regulated by a. UCP 500

b. UCP 400 c. UCP 300 d. URC 522 e. URC 524.

91. The opening bank is given _________ working days to scrutinize export documents received from the negotiating bank. a. 5 b. 7 c. 9 d. 10 e. 15.

92. Which of the following is prima facie evidence of purchase and sale? a. Commercial Invoice. b. Shipping Bill. c. Mate’s Receipt. d. Import Manifest. e. Bill of Entry.

93. Which of the following documents is a document of title to goods? a. Shipping bill. b. Bill of lading. c. Mate’s receipt. d. Commercial invoice. e. Bill of exchange.

94. Which of the following is not true regarding an insurance document to be submitted by the exporter? a. Insurance documents should be issued and signed only by insurance companies. b. Cover notes issued by brokers are valid documents and are acceptable by bankers. c. The insurance document should indicate the mode of conveyance of goods. d. The insurance document need not indicate the nature of risks covered. e. Both (b) and (d) above.

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95. Unless specified, the insurance document should be issued for an amount of ________ of ________ value of goods. a. 110%, CIF b. 100%, CIP c. 110%, FOB d. 100%, CIF e. 120%, CIF.

96. Which of the following statements is not true? a. Where an insurance document is issued in more than one copy, all the copies must

be submitted to the banker. b. The insurance document should not contain any clause affecting the interest of the

assured. c. Insurance documents cannot be signed by underwriters or agents of insurance

companies. d. The insurance document should be in a negotiable form. e. Both (a) and (c) above.

97. Which of the following describes the incoterm ‘FOB’? a. The seller delivers when the goods are placed alongside the vessel at the named port

of shipment. b. The seller is said to have delivered once the goods cross the ship’s rail at the named

port of shipment. c. It means that the seller pays the freight for the carriage of the goods to the named

destination. d. The seller fulfills his obligation to deliver when the goods have been made available

at the named place in the country of importation. e. The seller is said to have delivered when he hands over the goods to the carrier.

98. Under which of the following incoterms is the exporter required to arrange for marine insurance against buyer’s risk of loss or damage to the goods during carriage. a. FOB b. Ex-works c. CIF d. CFR e. CPT.

99. The UCP first appeared in the year _____. a. 1920 b. 1933 c. 1940 d. 1945 e. 1953.

100. Which of the following statements is not true? a. An advising bank will advise an LC only after verifying its authenticity. b. An advising bank cannot assume the role of a confirming bank. c. A bank which is asked to confirm the credit may confirm it or refuse to do so. d. A confirming bank assumes primary responsibility of effecting payment to the

beneficiary under the LC. e. In a credit that is freely negotiable, any bank can negotiate documents submitted by

the exporter.

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101. Which of the following statements is true?

a. The issuing bank shall be irrevocably bound by an amendment(s) issued by it from the time of the issuance of such amendment(s).

b. An advising bank which chooses not to confirm a credit should inform the same to the opening bank and the beneficiary without delay.

c. The terms of the original credit (for a credit incorporating previously accepted amendment(s)) will remain in force for the beneficiary until the beneficiary communicates his acceptance of the amendment to the bank that advised such amendment.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

102. Which of the following statements is true as per UCPDC?

a. A beneficiary is permitted to partially accept amendments contained in one and the same advice of amendment.

b. All credits must clearly indicate whether they are available by sight payment, by deferred payment, by acceptance or by negotiation.

c. Mere examination of documents without giving value does not constitute a negotiation.

d. Both (b) and (c) above.

e. All of (a), (b) and (c) above.

103. Which of the following is valid as per UCPDC?

a. If a bank uses the services of an advising bank to have the credit advised to the beneficiary, it must also use the services of the same bank for advising an amendment(s).

b. When an issuing bank instructs an Advising Bank by an authenticated teletransmission to advise a credit, the teletransmission will be deemed to be the operative credit instrument. However, a mail confirmation should also be sent.

c. If incomplete or unclear instructions are received to advise, confirm or amend a credit, the bank requested to act on such instructions may give preliminary notification to the beneficiary for information only and without responsibility.

d. Both (a) and (c) above.

e. All of (a), (b) and (c) above.

104. Identify the correct statement as per UCPDC.

a. Documents which appear inconsistent with each other will be rejected by the bank.

b. If the exporter submits documents which are not specified in the credit, bank will examine even such documents.

c. All the banks concerned in a credit transaction are given a reasonable time not exceeding seven days totally after receipt of documents to examine the same.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

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105. Identify the incorrect statement as per UCPDC.

a. If a credit contains conditions without stating the documents to be presented in compliance therewith, banks will deem such conditions as not stated and will disregard them.

b. All the banks concerned with an LC transaction have to determine on the basis of documents alone, whether they are in compliance with the terms and conditions of the LC.

c. Notice of refusal to take up the documents by the issuing bank/confirming bank/negotiating bank should be given to the beneficiary even where documents are not directly received from him.

d. Banks assume no liability or responsibility for errors in translation and/or interpretation of technical terms and reserve the right to transmit credit terms without translating them.

e. Both (a) and (c) above. 106. Which of the following is true as per UCPDC?

a. A claiming bank is not required to furnish a certificate of compliance of the terms of the credit to the reimbursing bank, while claiming payment.

b. When reimbursement is not received by the claiming bank, the issuing bank will be held responsible for making such payment.

c. Any loss of interest due to failure to make reimbursement to the claiming bank on first demand will be the issuing bank’s responsibility.

d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

107. Which of the following will not be treated as a valid document as per UCPDC? a. Documents signed by facsimile signature. b. Documents signed by perforate signature. c. Document on which an electronic method of authentication is used. d. Document that is signed by stamp. e. None of the above.

108. Which of the following is true as per UCPDC? a. Documents bearing a date of issuance prior to the date of credit and submitted

within the time limits set out in the credit will not be accepted by banks. b. Where as per the credit, multiple documents are to be submitted, this condition will

be satisfied by the presentation of one original and the remaining number in copies except where the document itself indicates otherwise.

c. Unless otherwise indicated in the credit, copies of documents need not be signed. d. Both (a) and (b) above. e. Both (b) and (c) above.

109. As per UCPDC, which of the following conditions are not true? a. Banks will accept transport documents issued by a freight forwarder provided the

name and signature of the freight forwarder as carrier is indicated on it. b. A clean transport document is one which bears no clause or notation which

expressly declares a defective condition of the goods. c. Banks will not accept transport documents stating that freight or transportation have

still to be paid, even if the credit permits. d. Both (a) and (c) above. e. None of the above.

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110. As per UCPDC, commercial invoice a. Should be made out by the beneficiary b. Should be issued in the name of the opening bank c. Must be compulsorily signed d. May be refused if they are issued for amounts in excess of the amount permitted by

the credit e. Both (a) and (d) above.

111. Which of the following is true as per UCPDC? a. Banks utilizing the services of another bank or other banks for the purpose of giving

effect to the instructions of the Applicant do so for the account and at the risk of such applicant.

b. The banks concerned will be held responsible should the instructions they transmit not be carried out, as they themselves have taken the initiative in the choice of such other bank(s).

c. The applicant of a letter of credit shall be bound by and liable to indemnify the banks against all obligations and responsibilities imposed by foreign laws and usages.

d. Both (a) and (c) above. e. All of (a), (b) and (c) above.

112. Which of the following statements is not true as per UCPDC? a. Credits should stipulate the type of insurance required and, if any, the additional

risks which are to be covered. b. Failing specific stipulations in the credit, banks will accept insurance documents as

presented, without responsibility for any risks not being covered. c. Unless otherwise stipulated in the cedit, banks will accept an insurance document

which indicates that the cover is subject to a franchise. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

113. Which of the following is not valid as per UCPDC? a. Description of goods in the commercial invoice must correspond to the description

given in the credit. b. In all documents (other than commercial invoice), the goods may be described in

general terms not inconsistent with the description of the goods in the credit. c. Where the word "approximately" is used in connection with the amount of the credit

, it is to be construed as allowing a difference not to exceed 15% more or 15% less than the amount to which they refer.

d. Both (b) and (c) above. e. None of the above.

114. Identify the correct statement keeping in view the UCPDC guidelines applicable to documentary credits. a. Unless the credit stipulates otherwise, partial shipments/drawings are permitted as

per UCPDC. b. Transport documents which appear on their face to indicate that shipment has been

made on the same means of conveyance and for the same journey, provided they indicate the same destination, will not be regarded as covering partial shipments.

c. Shipments made by post will not be treated as partial shipments if the post receipts or certificates of posting appear to have been stamped or signed in the place from which the credit stipulates the goods are to be dispatched, and on the same date.

d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

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115. As per UCPDC, unless otherwise stipulated in the credit, if drawings and/or shipments by installments within given periods are stipulated in the credit and any installment is not drawn and/or shipped within the period allowed for that installment, the credit ceases to be available a. For only that installment b. For that and any subsequent installments c. For the next two installments d. For the next three installments e. For the next four installments.

116. Which of the following conditions is not valid as per UCPDC? a. The letter of credit should specify the date within which documents are to be

presented to the bank. b. Banks will refuse to accept documents presented after 30 days of shipment, in case

the credit does not indicate a date for presentation of documents. c. If the last day for presentation of documents falls on a day on which the bank is

closed for reasons other than those mentioned in Article 17 of the UCPDC, then the date for presentation of documents will be shifted to the preceding day on which the bank is open.

d. Both (b) and (c) above. e. All of (a), (b) and (c) above.

117. As per UCPDC, the term ‘first half `of a month will be construed as a. 1st to 14th both dates inclusive b. 1st to 15th both dates inclusive c. 1st to 14th both dates exclusive d. 1st to 15th both dates exclusive e. 1st to 16th both dates inclusive.

118. Which of the following is a financial document as per URC 522? a. Transport Documents. b. Promissory Notes. c. Commercial Invoice. d. Bills of Exchange. e. Both (b) and (d) above.

119. As per URC 522, the ‘principal’ is a. The party who entrusting the handling of a collection to a bank b. The bank which has been entrusted the handling of a collection c. Any bank, other than the remitting bank, involved in processing the collection d. The collecting bank making presentation to the drawee e. None of the above.

120. Details of which of the following should be included in a collection instruction? a. Details of the bank from which the collection was received. b. Details of the principal. c. Details of the drawee. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

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121. Which of the following is not true as per URC 522?

a. As per URC 522, presentation is the procedure whereby the presenting bank makes the documents available to the drawee as instructed.

b. The collection instruction should state the exact period of time within which any action is to be taken by the drawee.

c. Expressions like ‘prompt’, ‘immediate’ should not be used in the collection instruction while referring to presentation.

d. Where no bank is nominated as the collecting bank, the remitting bank will utilize the services of any bank in the country of payment.

e. None of the above.

122. As per URC 522

a. Collections should not contain bills of exchange payable at a future date with instructions that commercial documents are to be delivered against payment

b. If a collection contains a bill of exchange payable at a future date and the collection instruction indicates that commercial documents are to be released against payment, then documents will be released only against such payment

c. If a collection contains a bill of exchange payable at a future date and the collection instruction does not indicate anything, then commercial documents will be released only against acceptance

d. Both (a) and (b) above

e. Both (b) and (c) above.

123. Which of the following is true as per URC 522?

a. Goods can be directly dispatched to the address of a bank.

b. Goods should not be directly dispatched to the address of a bank.

c. Goods that are directly dispatched to the address of a bank, will continue to be at the risk and responsibility of the person dispatching the goods.

d. Both (b) and (c) above.

e. Both (a) and (c) above.

124. Which of the following is true regarding multimodal transport?

a. Multimodal transportation means carriage of goods by two or more modes of transport.

b. A multimodal transport document can only be in a non-negotiable form.

c. A non-negotiable multimodal transport document means a multimodal transport document which indicates only one named consignee.

d. Both (b) and (c) above.

e. Both (a) and (c) above.

125. An airway bill is made out in

a. A single original

b. Two originals

c. Three originals

d. Four originals

e. Five originals.

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126. Which of the following is not true regarding an airway bill?

a. An airway bill is prima facie evidence of receipt of cargo.

b. An airway bill is a document of title to the goods.

c. Where a credit calls for an actual date of dispatch, the airway bill should indicate a specific notation of such date.

d. The date of dispatch indicated on the airway bill will be deemed to be the date of shipment.

e. The airway bill serves as an instruction sheet giving all the instructions needed for moving the goods.

127. Which of the following is not true as per UCPDC?

a. The bank effecting the transfer shall be under no obligation to effect such transfer except to the extent and in the manner expressly consented to by such bank.

b. If a credit is transferred to more than one Second Beneficiary(ies), refusal of an amendment by one or more Second Beneficiary(ies) invalidates the acceptance(s) by the other Second Beneficiary(ies) with respect to whom the credit will be amended accordingly.

c. Transferring bank charges in respect of transfers including commissions, fees, costs or expenses are payable by the First Beneficiary unless otherwise agreed.

d. Both (b) and (c) above.

e. None of the above.

128. The UCPDC 500 is not applicable to which of the following credits?

a. Standby letters of credit.

b. Confirmed letters of credit.

c. Unconfirmed letters of credit.

d. Revocable letters of credit.

e. None of the above.

129. Which of the following is not true?

a. All confirmed credits are also irrevocable letters of credit.

b. When the advising bank does not add its confirmation, but merely forwards the credit to the beneficiary, the credit remains unconfirmed.

c. A bank advising the credit to the beneficiary is also required to confirm it.

d. The confirming bank will not be bound by any amendment not routed through it.

e. Both (b) and (c) above.

Export Finance and Exchange Control Regulations Governing Exports 130. Export declaration form required to be submitted by an exporter in case of export of

computer software in non-physical form is

a. GR form

b. VP form

c. PP form

d. SOFTEX form

e. Form A1.

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131. Which of the following forms is to be submitted by an exporter for declaring exports in the case of specified customs offices and specified categories of shipping bills under the EDI systems? a. GR form. b. Form SDF. c. PP form. d. VP form. e. SOFTEX form.

132. Identify the incorrect statement. a. Export proceeds are to be received through the medium of an authorized dealer. b. VP forms are required to be submitted in a set of two copies. c. The duplicate copy of the GR form and relevant documents have to be submitted to

the authorized dealer within 21 days from shipment of goods. d. Both (b) and (c) above. e. None of the above.

133. Which of the following are true regarding participation of exporters in trade fairs abroad? a. Export promotion councils are not permitted to participate in trade fairs abroad. b. Exporters participating in trade fairs abroad are permitted to open foreign currency

accounts for depositing foreign exchange obtained by sale of goods sent for display. c. Repatriation of proceeds earned by sale of goods in trade fairs is not mandatory. d. Documentary evidence as to reimport of goods unsold should be furnished within 10

days from the close of the trade fair. e. Both (a) and (d) above.

134. Which of the following statements is not true? a. Counter trade proposals involving adjustment of value of exports and imports can be

made by opening an escrow account in any freely convertible currency. b. Surplus funds in the escrow account may be held in a short-term deposit. c. No overdraft will be permitted against the funds held in the escrow account. d. Application for opening an escrow account should be made to the Reserve Bank of

India. e. Both (b) and (c) above.

135. Which of the following are not true? a. GR forms are to be made in a set of two copies. b. VP forms are to be submitted in a single copy. c. When GR forms are submitted to the customs by the exporter, the customs allot an

8-digit code number to the GR form. d. Both (b) and (c) above. e. None of the above.

136. Export proceeds of goods (other than deferred payment terms for project and service exports) are normally required to be realized a. On the due date for payment b. Within six months from the date of shipment of goods c. Within 15 months from the date of shipment of goods d. On the due date for payment or within 6 months from the date of shipment of goods

whichever is earlier e. On the due date for payment or within 15 months from the date of shipment

whichever is later.

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137. In the case of 100% EOUs, _______ % of export proceeds can be retained in foreign currency in the EEFC account.

a. 15

b. 20

c. 35

d. 50

e. 70.

138. Exports wherein goods are sent to the exporter’s agent abroad and sold by him there are referred to as _____________.

a. Cash Exports

b. Deemed Exports

c. Consignment Exports

d. Project Exports

e. Exports on open account.

139. Which of the following are true as per FEMA?

a. Only authorized dealers are permitted to deal in foreign exchange.

b. Foreign exchange purchased by a person can be used for any valid purpose other than what was intended.

c. Unutilized foreign exchange need not be returned.

d. Utilization of foreign exchange for a purpose other than what was intended is an offense under FEMA.

e. Both (a) and (d) above.

140. Usance bill is

a. A bill that is payable immediately

b. Also called a sight bill

c. A bill that is drawn at a place outside India, but made payable in India

d. A bill that is payable after a specified period of time

e. Both (a) and (b) above.

141. In case of exports to Indian owned warehouses abroad, established with the permission of the RBI, a maximum period of ________ months is allowed for realization of exports proceeds.

a. 12

b. 15

c. 18

d. 24

e. 36.

142. Andhra Bank maintains an account in pound sterling with Grindlays Bank, London. While corresponding with Grindlays Bank, Andhra Bank would refer to this account as

a. Nostro Account

b. Vostro Account

c. Loro Account

d. NRE Account e. FCNR Account.

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143. Exporters who wish to open foreign currency accounts abroad for crediting export proceeds have to make an application to the exchange control department in a. Form A3 b. Form EFC c. Form ENC d. Form ECB e. Form ECT.

144. Which of the following conditions should be satisfied in case exporters receive advance payments against exports? a. Goods to be exported should be shipped within one year from receipt of advance

payment. b. Rate of interest payable on the advance should not exceed LIBOR + 100 basis

points. c. Shipments are to be monitored by the authorized dealer through whom the advance

payment is received. d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

145. Reduction in value of the bill, after the bill has been sent for negotiation/collection will be permitted if a. Reduction does not exceed 15% of invoice value b. The exported goods are articles made out of cut and polished diamonds c. The exporter is not on the caution list of RBI d. Both (a) and (c) above e. Both (b) and (c) above.

146. Authorized dealers will write off unrealized export bills provided a. The amount has been outstanding for 270 days or more b. The exporter has made all efforts to recover the amount and documentary evidence

to this effect has been submitted c. The aggregate amount of write off during the calendar year will not exceed 10% of

total export proceeds realized by the exporter during the previous calendar year d. Both (a) and (b) above e. Both (b) and (c) above.

147. Which of the following statements is true? a. SOFTEX form is used for declaration of export of computer software in physical

form. b. SOFTEX form is used for declaration of export of computer software in non-

physical form. c. SOFTEX form should be submitted in a set of 2 copies. d. Both (a) and (b) above f. All of (a), (b) and (c) above.

148. Which of the following conditions have to be fulfilled regarding agency commission on exports? a. Rate of commission should not exceed 12.5% of invoice value. b. Amount of commission should be declared on the export declaration form and

should be accepted by customs authorities. c. Commission may be paid even before the shipment of goods. d. Both (a) and (b) above. e. Both (b) and (c) above.

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149. Which of the following is not true regarding R-returns? a. Purchases and sale of foreign exchange by authorized dealers are reported to the

Reserve Bank of India in R-returns. b. R-returns are to be submitted twice a month. c. R-returns are to be submitted by offices falling under Category A or B or C. d. For each currency there are 2 R-returns. e. It is compulsory to submit the exchange control copies of import licenses fully

utilized/expired along with R-returns. 150. Banks have to extend a minimum of _____ % of net bank credit to the export sector.

a. 5 b. 7 c. 10 d. 12 e. 15.

151. Pre-shipment finance a. Is basically a long-term finance b. Can be availed only if the exporter possesses an importer-exporter code number

from the RBI c. Can be availed if the exporter is not on the caution list of the RBI d. Is meant for financing export sales receivables of the exporter e. Both (c) and (d) above.

152. Packing Credit a. Is extended to exporters who have the letter of credit in their name b. Can also be extended, where the sales contract is concluded by exchange of

messages between the two parties c. Will be extended to supporting manufacturers who have orders in their name, but do

not have letters of credit in their own name d. Both (a) and (b) above e. All of (a), (b) and (c) above.

153. Identify the incorrect statement. a. Disbursement of funds under packing credit takes place in phases depending on the

length of the operating cycle. b. Margin that is brought in by the exporter at the time of availing packing credit, takes

care of erosion in the value of the goods charged to the banker. c. Packing credit can be extended at a concessional rate of interest for a maximum

period of 180 days or for the operating cycle of the particular activity whichever is higher.

d. Both (a) and (c) above. e. None of the above.

154. In case of packing credit, concessional rates of interest will be applicable only if export of goods takes place within a. 180 days from date of availing finance b. 180 days from the date of shipment of goods c. 270 days from the date of availing finance d. 270 days from the date of shipment e. 360 days from the date of availing finance.

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155. Pre-shipment finance under the running account facility will be granted

a. Only in case of a genuine need

b. Only if the exporter’s track record is good

c. Provided the Letter of Credit is submitted within a reasonable period of time

d. Both (b) and (c) above

e. All of (a), (b) and (c) above.

156. Which of the following statements is false?

a. Overdue packing credit will not be eligible for concessional rate of interest.

b. Packing credit advances may be liquidated from proceeds of payments receivable from the Government of India.

c. Packing credit not liquidated by export proceeds will also be eligible for concessional rate of interest.

d. Exporters availing running account facility in respect of commodities falling under selective credit control should submit letters of credit within one month from the date of sanction of packing credit.

e. Both (c) and (d) above.

157. Pre-shipment Credit in Foreign Currency (PCFC)

a. Is made available to cover only imported inputs of the exported goods

b. Is available only for exports on deferred payment basis

c. Can be extended in one convertible currency in respect of an export order invoiced in another convertible currency

d. Is made available to the exporter with an intention of providing finance at internationally competitive rates

e. Both (c) and (d) above.

158. Which of the following is not a source of fund for banks under Preshipment Credit in Foreign Currency (PCFC) scheme?

a. Exchange Earners Foreign Currency Accounts (EEFC).

b. Non Resident External (NRE) Accounts.

c. Resident Foreign Currency (RFC) Accounts.

d. Foreign Currency (Non Resident) Accounts (Banks), FCNR(B).

e. Escrow Accounts.

159. Which of the following is not true?

a. Pre-shipment finance cannot be extended against duty drawback entitlements provisionally certified by the customs authorities.

b. An exporter who has availed PCFC will have to compulsorily avail of post-shipment finance in foreign currency only.

c. Where lines of credit from abroad are arranged by banks, prior approval of the RBI is not required as long as the rate of interest does not exceed 1% over 6 months LIBOR.

d. Both (a) and (b) above.

e. Both (b) and (c) above.

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160. Which of the following statements are true?

a. If banks avail of lines of credit under PCFC, liabilities arising out of such utilization will be exempted from maintenance of reserve ratio requirements.

b. PCFC is self liquidating in nature.

c. Quantum of pre-shipment finance will not normally exceed FOB value of goods or domestic value of goods, whichever is lower.

d. Both (a) and (b) above.

e. All of (a), (b) and (c) above.

161. Which of the following is not true regarding post-shipment finance?

a. Post-shipment finance is extended to the actual exporter or to an exporter in whose name the export documents are transferred.

b. Post-shipment finance will not be made available to deemed exporters.

c. Post-shipment finance can be extended up to 100% of the invoice value of the goods.

d. Post-shipment finance may be offered on short-term basis or on long-term basis depending upon the payment terms offered by the exporter to the overseas buyer.

e. Interest on post-shipment finance will depend on the nature of the bills i.e. whether it is a demand bill or a usance bill.

162. Post-shipment finance

a. Is given by banks after shipment of goods

b. Is basically meant for financing export sale receivables of the exporter

c. May be in the form of advances against bills sent on collection basis

d. Will be from the date of negotiation of export documents till due date maintained on the relative export bill

e. All of the above.

163. Which of the following statements is not true?

a. In order to avail post-shipment finance, the exporter is required to submit the shipping documents to the bank within 21 days from the date of shipment of goods.

b. Post-shipment finance can be extended up to 100% of the invoice value of the goods.

c. Post-shipment finance may be availed of either in Indian rupees or by using the rediscounting of export bills abroad scheme.

d. Sight bills are charged a higher rate of interest when compared to usance bills.

e. Sight bill that is not paid on or before the normal transit period is an overdue bill.

164. Which of the following statements is true?

a. Normal transit period fixed by FEDAI in respect of export bills is dependent on the geographical location of the country to which the bill relates to.

b. In case of usance bills, concessional rate of interest is applicable up to the normal transit period.

c. An export bill which has a usance of more than 180 days will be eligible for concessional rate of interest.

d. Post-shipment finance will not be available to an exporter in whose names the export documents are transferred.

e. None of the above.

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165. Exchange control regulations in India are governed by a. The external affairs ministry b. The Reserve Bank of India c. The Ministry of Commerce d. The Director General of Foreign Trade e. FEDAI.

166. R-returns are required to be submitted to the Reserve Bank of India every a. Week b. Fortnight c. Month d. Quarter e. Half-year.

167. Which of the following conditions should be fulfilled for an exporter to avail packing credit? a. Goods to be exported should not be banned for export. b. The country to which exports are to be made is not under political or economic

stress. c. The exporter’s name is not in the exporter’s caution list of Reserve Bank of India. d. Both (a) and (c) above. e. All of (a), (b) and (c) above.

168. If no export takes place within 360 days of availing finance under PCFC scheme, PCFC will be adjusted at the a. TT selling rate for the currency concerned b. TT buying rate for the currency concerned c. Bill selling rate for the currency concerned d. Bill buying rate for the currency concerned e. Spot selling rate for the currency concerned.

169. An export bill which has a usance period of more than ________ days will not be eligible for concessional rates of interest. a. 45 b. 90 c. 180 d. 270 e. 360.

170. Which of the following is not true regarding ‘Rediscounting of export bills abroad’ scheme? a. Rediscounting of export bills abroad scheme serves as an additional window for

early realization of export proceeds. b. Under this scheme, only authorized dealers can have an access to the overseas

market for rediscounting of export bills. c. Exporters can discount their export bills directly with the overseas bank provided

discounting is done through the branch of an authorized dealer designated for the purpose.

d. Both (b) and (c) above. e. None of the above.

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171. Proposals for export on elongated credit terms should be submitted in ____________ to the regional office of the Reserve Bank of India. a. Form A2 b. Form ECB1 c. Form ENC d. Form ECT e. Form XOS.

172. Part drawings by exporters will be accepted by authorized dealers provided the undrawn balance is subject to a maximum of ________ of export value. a. 5% b. 10% c. 12% d. 15% e. 20%.

173. Which of the following conditions have to be satisfied in order that a request for write off of unrealized export bills is accepted by the authorized dealer? a. The amount should be outstanding for 270 days or more. b. The aggregate amount of write off during a calendar year should not exceed 10% of

the total export proceeds realized during the previous calendar year. c. The overseas buyer is declared insolvent and a certificate to that effect has been

obtained. d. Both (a) and (c) above. e. Both (b) and (c) above.

174. An exporter who expects to realize the export proceeds beyond the time stipulated by the exchange control regulations should make an application for the said purpose to RBI in __________ . a. Form ECB1 b. Form ETX c. Form GR d. Form A1 e. Form ENC.

175. The rate of agency commission on exports should not exceed a. 5% of invoice value b. 7% of invoice value c. 7.5% of invoice value d. 10% of invoice value e. 12.5% of invoice value.

176. The main document required by the customs authorities for permitting export of goods (by ship) outside India is a. Shipping bill b. Inspection certificate c. The RCMC d. 3 copies of packing list e. 2 copies of commercial invoice.

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177. An export bill (sight) denominated in foreign currency will be crystallized if it is not paid a. Within 15 days after normal transit period b. Within 20 days after normal transit period c. Within 25 days after normal transit period d. Within 30 days after normal transit period e. Within 35 days after normal transit period.

178. Which of the following bills is eligible for rediscounting of export bills abroad scheme? a. Export bills with a usance period of 180 days from the date of shipment including

normal transit period and grace period. b. Export bills with usance period of 90 days. c. Export bills with a usance period of 270 days from the date of shipment. d. Export bills with a usance period of 180 days from the date of shipment, excluding

normal transit period. e. Export bills with a usance period of 180 days from the date of shipment, excluding

normal transit period and grace period. 179. Which of the following statements is true? a. Trade discount given by the exporter is not required to be declared on the GR form.

b. In case of consignment exports, freight and marine insurance should be arranged in India.

c. Where after the goods have been shipped, there is a change in the buyer to whom goods are transferred, prior approval of the RBI is not required, if the reduction in value of the bills does not exceed 15% of the invoice value.

d. Both (b) and (c) above. e. All of (a), (b) and (c) above.

180. Packing credit is available to a. Manufacturer-exporters b. Merchant-exporters c. Export Houses d. Both (a) and (b) above e. All of (a), (b) and (c) above.

181. Which of the following is not true regarding packing credit? a. Packing credit cannot be a clean advance. b. Packing credit advances are normally granted on secured basis. c. The period of packing credit depends upon the circumstances of each individual

case. d. Both (b) and (c) above. e. All of (a), (b) and (c) above.

182. ECGC stands for a. Export Credit Guarantee Corporation b. Export Crisis Government Corporation c. Export Credit Guarantee Company d. Exporters Credit Guarantee Company e. External Credit Guarantee Corporation.

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183. Exporters are permitted to retain ______ of export proceeds in foreign currency in the EEFC accounts. a. 20% b. 25% c. 35% d. 50% e. 70%.

184. Which of the following is not true regarding EEFC accounts? a. EEFC accounts can be maintained in any convertible foreign currency. b. EEFC accounts cannot be maintained in the form of a savings account. c. EEFC account will be credited only after the foreign exchange is realized. d. No credit facility, whether fund based or non-fund based can be permitted in India

or abroad, against the funds held in EEFC account. e. Both (a) and (d) above.

185. Which of the following statements is false? a. For the purpose of submission of R-returns, authorized dealers who maintain

independent foreign currency accounts in their own names fall under category B. b. R-returns are submitted once a month. c. All foreign exchange transactions made by an authorized dealer are reported to the

Reserve Bank of India in R-returns. d. Both (a) and (b) above. e. None of the above.

Import Finance and Exchange Regulations Relating to Import Finance 186. Which of the following is not valid in respect of advance remittance in case of imports into

India? a. Advance remittance made in respect of imports should be repatriated back to the

country, in case goods are eventually not imported into India. b. Where the advance remittance exceeds US dollars 25,000 guarantee from an

international bank of repute situated outside India should be obtained. c. Where the imported goods fall under the negative list, the importer should hold the

exchange control copy of a valid import license. d. Import of goods should be made within 6 months from the date of remittance. e. Both (b) and (d) above.

187. Applications connected to advance remittance in respect of imports into India should be made in a. Form ECB b. Form A1 c. Form A4 d. Form ECB1 e. Form ECB2.

188. Which of the following forms should be used in respect of import payments connected with merchanting trade transactions? a. Form A1 b. Form A2 c. Form A3 d. Form A4 e. Form ECB3.

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189. Details about drawal and utilization of loan amount in respect of import under foreign loans/credits should be furnished to the RBI in a. GR form b. Form A1 c. Form A2 d. Form ECB2 e. Form ECB3.

190. Forward Contracts for imports a. Can be booked only in case of genuine transactions and where there is exposure to

exchange risk b. May be booked for both Indian residents as well as non-residents c. Will be allowed only for contracts denominated in US dollars d. Cannot be rolled over e. When canceled have to be compulsorily reported to the RBI.

191. If the supplier of goods is from an ACU country, LC will be denominated in a. Indian rupees b. US dollars c. ACU dollars d. Pound Sterling e. Deutsche Mark (DM).

192. In case of imports into India (for home consumption), the goods will be assessed to duty based on a. The rate prevailing on the date the ship touches Indian waters b. The rate prevailing on the date of presentation of bill of entry to the customs

department c. The rate prevailing on the date of presentation of import manifest to the customs

department d. The rate prevailing on the date of unloading the goods imported into India e. The rate prevailing on the date of payment of duty.

193. Which of the following statements is false? a. In case advance remittance in respect of import of goods into India exceeds US

dollars 15,000, guarantee from an international bank of repute situated outside India should be obtained.

b. Where capital goods are imported, a certified copy of the contract or any other evidence regarding terms of payment is required.

c. In case goods are eventually not imported into India, it is the duty of the authorized dealer to ensure repatriation of advance remittance paid into India.

d. Where books are to be imported into India, a list of books to be imported should be obtained by the authorized dealer.

e. Both (b) and (d) above. 194. Which of the following statements is true?

a. Sale of foreign exchange for import payment can be made by authorized dealers only to persons resident in India.

b. Foreign exchange for import payment can be sold by authorized dealers to residents of Nepal.

c. Foreign exchange for import payment can be sold by authorized dealers to residents of Bhutan.

d. Both (a) and (b) above. e. All of (a), (b) and (c) above.

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195. While making import payments, importers are permitted to withhold a certain portion of the cost of goods, towards guarantee of performance. This should not exceed ____ % of the cost of goods.

a. 5

b. 7

c. 10

d. 12

e. 15.

196. Which of the following is true in respect of the amount withheld by the importer towards guarantee of performance?

a. Interest at the rate of 5% is payable on such amount.

b. Interest payable on the withheld amount should not exceed the prime rate of the country of the importer.

c. No interest is payable on such amounts withheld.

d. Interest at the rate of 7% is payable on such amount.

e. Interest at the rate of 12% is payable on such amount.

197. In case of imports under foreign loans/credits, details about drawal and utilization of the loan amount will have to be furnished to the Reserve Bank of India in

a. Form A1

b. Form ECT

c. XOS statement

d. Form ECB2

e. Form ECB1.

198. Which of the following is not true regarding advance remittances towards imports made by merchant exporters to overseas suppliers?

a. Advance remittances will be permitted only if confirmed orders have been received by merchant exporters.

b. Advance remittances will be permitted if the transaction results in adequate profit to the merchant exporter.

c. In case the amount of advance remittance exceeds $5000, guarantee from an international bank of repute should be obtained.

d. Advance remittance will be permitted only if the authorized dealer is convinced about the capabilities of the merchant exporter in meeting his obligations under the order received by him.

e. Both (a) and (d) above.

199. Which of the following statements is not true?

a. No import license is required in case of imports into bond for the purpose of re-export.

b. Where goods are imported under penalty, remittance will up to the FOB value of goods mentioned in the exchange control copy of the customs bill of entry.

c. In case shipment of replacement goods is to be made after the expiry of import license, the importer will have to apply to the import trade control authorities for revalidation of license.

d. Both (a) and (b) above.

e. None of the above.

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200. Which of the following is not true about booking of forward contracts in case of imports?

a. Forward contracts in case of merchanting trade transactions will have to be necessarily booked for both legs of the transaction i.e. import and export.

b. Information about cancelation of forward contracts will have to be furnished to the Reserve Bank of India on a regular basis.

c. Delivery period of forward contract should be linked to the shipment/payment schedule under the contract even though contracts may be booked for shorter maturities.

d. A1 forms are to be used to indicate that remittances have been made under a forward contract.

e. Forward contracts can be booked only in respect of persons resident in India.

Part I: Answers to Questions on Basic Concepts

Trade Blocks 1. (b) The World Trade Organization is the successor of GATT and commenced its operations

in 1995. 2. (c) India is one of the founder members of the World Trade Organization. 3. (a) The WTO is based in Geneva, Switzerland. 4. (a) The acronym TRIPS stands for Trade Related Aspects of Intellectual Property Rights. 5. (e) All the alternatives given are true. 6. (c) The General Agreement on Trade in Services (GATS) is the first multilateral agreement

to provide legally enforceable rights to trade in all services. 7. (d) GATS has three basic principles: First it covers all services except those provided in the

exercise of governmental authority; Second, there should be no discrimination in favor of national providers and Third, there should be no discrimination between other members of the agreement.

8. (e) As per TRIPS, the rights of authors of literary and artistic works are protected by copyright, for a minimum period of 50 years after the death of the author.

9. (e) For a cartel to be successful, the elasticity of demand for total consumption by the rest of the world must be low. The cartel must control a very large share of the world market for the cartelized commodity. The elasticity of supply of the cartelized commodity by the rest of the world must be low.

10. (a) Ecuador is currently not a member of OPEC. 11. (b) The headquarters of OPEC is situated at Vienna, Austria. 12. (e) All the alternatives given are objectives of OPEC. 13. (b) GATT was a multilateral treaty that came into force in January, 1948. 14. (c) The European Common Market (ECM) was founded in the year 1957. 15. (e) All the alternatives given are objectives of the European Common Market. 16. (c) As per the exchange rate mechanism established by the European Council, the currency

of each country could fluctuate between the wide 6% band to the narrow 2.25% up to August, 1993.

17. (e) All the statements are true. 18. (b) NAFTA stands for North American Free Trade Agreement. 19. (a) USA, Canada and Mexico are members of NAFTA. 20. (e) All the alternatives given are objectives of NAFTA. 21. (e) The primary objective of UNCTAD is to formulate policies relating to developmental

aspects including trade, aid, transport, finance and technology. 22. (c) The UNCTAD meets once in every 4 years. 23. (e) All the alternatives given are functions of UNCTAD. 24. (e) The bilateral treaty between USA and Russia provides that:

• Companies from each country will be treated as favourably as their competitors. • Clear limits are established on the expropriation of investments and ensure that

investors will be fairly compensated. • US and Russian investors have the right to transfer funds into and out of the

countries in which the investment is located without delay using a market rate of exchange.

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25. (d) The GSP was set up to allow developing countries certain benefits from trade preference, enabling them to attain economic self sufficiency by means of trade liberalization. Not all industrial products subjected to tariffs are included in the GSP.

26. (a) OPEC is an international cartel.

Export-Import Policy 27. (c) Registration with Reserve Bank of India is not required for effecting exports from India. 28. (e) The export promotion capital goods license (EPCG) is valid for a period of 24 months. 29. (d) The Registration Cum Membership Certificate (RCMC) issued by the Export Promotion

Council is valid for a period of 5 licensing years. 30. (e) Export proceeds should be realized within 6 months from the date of shipment or the

due date for payment whichever is earlier. Exports from India are categorized into the Open General License (OGL) category and the negative list. Export of goods under the OGL category may be made freely. However, goods falling in the negative list can be Exported if an export license is procured.

31. (c) Canalized goods can be exported or imported only through specified agencies. 32. (b) Value indicated on import licenses is always for CIF (Cost, Insurance and Freight)

value of goods authorized to be imported. 33. (b) Canalized goods are those goods which can be imported only by certain agencies. 34. (d) Goods that do not leave the shore of the country are considered as deemed exports.

Supply of goods to projects funded by UN agencies and supply of goods to export oriented units are regarded as deemed exports.

35. (b) Export or import of all forms of wild life are prohibited. 36. (a) LERMS stands for Liberalized Exchange Rate Management System. 37. (d) As per LERMS, 40% of current account receipts were required to be surrendered to the

RBI at official rate. 38. (e) The export-import policy is announced for a period of 5 years. 39. (b) Exports and Imports come under the purview of the Ministry of Commerce. 40. (e) All the alternatives given are the objectives of the Exim Policy 1997-2002. 41. (d) ITC(HS) refers to Indian Trade Classification (Harmonized System). 42. (d) Export of goods on lease basis is not exempted from export declaration form. 43. (a) When an exporter registers with the Export Promotion Council, a Registration Cum

Membership certificate is issued. 44. (a) As per the EPCG scheme, new capital goods, including software systems are allowed to

be imported. 45. (c) The exports shall be direct exports in the name of the EPCG license holder. However,

the export through third party(ies) is also allowed provided the name of the EPCG license holder is also indicated on the shipping bill.

46. (e) Under the EPCG scheme realization of export proceeds shall be in freely convertible currency except in case of deemed exports. Export obligation has to be fulfilled over a period of 8 years reckoned from the date of issuance of license.

47. (e) Advance license is issued under the Duty Exemption Scheme. It can be issued for Physical exports, Intermediate supplies as well as Deemed exports.

48. (e) Alternatives (a) and (b) will have to go together, i.e Export of goods is by post-parcel or air freight and does not involve any foreign exchange outflow. Also, exemption is permitted in case the goods or software are accompanied by a statement by the exporter that the value of the shipment does not exceed Rs.25,000.

49. (e) Exporters of Gem and Jewelry are eligible to import their inputs by obtaining Replenishment Licenses and Diamond Imprest Licenses.

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50. (c) Firms dealing with sale and purchase of rough diamonds can operate diamond dollar accounts provided they have a track record of at least 3 years in that business and also have an average annual turnover of Rs.5 crore or above during the preceding three licensing years.

51. (c) Supply of goods to projects funded by UN agencies does fall under the category of ‘deemed exports’.

52. (e) All the alternatives are correct.

Documentary Credits 53. (c) Cost and Freight means that the seller must pay the costs and freight necessary to bring

the goods to the named port of destination, but the risk of loss or damage to the goods, as well as any additional costs due to events occurring after the time the goods have been delivered on board the vessel, is transferred from the seller to the buyer when the goods pass the ship’s rail in the port of shipment.

54. (a) Documentary credits are governed by UCPDC 500. 55. (a) The bank that opens a letter of credit in favor of the beneficiary is called the issuing

bank. 56. (c) Letter of credit is opened in favor of the person who is supposed to receive money in a

sale transaction. In case of trade, the exporter of goods is supposed to receive payment for goods exported.

57. (d) In a letter of credit, the advising bank is the bank which advises the credit to the exporter. It is convenient if the advising bank is situated in the supplier’s country. Hence, an advising bank is usually situated in the supplier’s country.

58. (c) In documentary credit operations, all parties deal with documents and not with goods, services or performances to which the goods relate to. Hence, a letter of credit is independent from the sale contract or any other contract on which it is based.

59. (e) A revocable letter of credit is one which can be revoked by the issuing bank without giving notice to any of the parties concerned. Also, an LC which does not indicate whether it is revocable or irrevocable will be treated as an irrevocable LC.

60. (c) An irrevocable letter of credit can be amended only with the consent of all the parties concerned. Given this fact, such an LC is favorable to the exporter.

61. (c) In an acceptance credit, it is mandatory for the beneficiary to draw a draft on the specified bank for a specified tenor.

62. (e) Confirming banks are usually located in the country of the supplier (i.e. the exporter). 63. (d) In case of an acceptance credit, the beneficiary is required to draw a draft. As such a

credit is a usance credit, the buyer need not make payment immediately. 64. (e) A credit can have more than one amendment. As per UCPDC, the beneficiary should

give notification of acceptance or rejection of amendment(s). 65. (c) A confirmed irrevocable credit is the best form of credit available to the exporter as it

insures the exporter not only against the failure of the importer but that of the issuing bank also.

66. (d) The advising bank will add its confirmation only when there is a specific request from the issuing bank.

67. (d) Under a revolving letter of credit, the limit under the credit is renewed as and when bills drawn under it are paid, to the extent of such bills. Where there are continuous transactions between the exporter and the importer, a revolving letter of credit will be advantageous to the exporter. He need not wait for the receipt of letter of credit every time he exports and since the same credit covers all the transactions, the terms and conditions do not change. It is easier for him to prepare documents as required by the credit.

68. (c) Transferable credit is different from back-to-back credit. In a transferable credit, the second credit is only an extension of the first credit. A back-to-back credit has an existence independent of the original credit.

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69. (d) As per UCPDC, a credit can be transferred only if it is expressly designated as ‘transferable’ by the issuing bank. Usage of terms such as ‘divisible’, ‘fractionable’, ‘assignable’, and ‘transmissible’will be disregarded. Also, the Transfering bank shall be under no obligation to effect transfer except to the extent and in the manner expressly consent to by such bank. Fractions of a transferable credit (not exceeding in the aggregate the amount of the credit) can be transferred separately, provided partial shipments are not prohibited and the aggregate of such transfers will be considered as constituting only one transfer of the credit.

70. (e) A back-to-back credit is opened against the security of the main credit. It may be opened when the beneficiary does not want to reveal the source of supply to the buyer.

71. (c) While opening a back-to-back credit, care should be taken to ensure that the original credit is an irrevocable credit.

72. (d) Under anticipatory credit, payment is made to the exporter at the pre-shipment stage in anticipation of export of goods and submission of bills at a later stage. Anticipatory credit may be a red clause letter of credit or a green clause letter of credit. As of now, anticipatory credits are outdated and are very rarely used.

73. (e) All the alternatives given are correct. 74. (c) As per Article 9(d)(iv) of UCPDC, partial acceptance of amendments that are contained

in one and the same advice by the beneficiary is not allowed and consequently will not be given effect.

75. (d) Under an open account, goods are dispatched directly to the buyer who takes delivery of them without making payment. The exporter bears the entire risk and meets fully the financial requirement of the trade. The exporter loses control over the goods and relies on the integrity of the importer to receive payment. Hence, this method is the most riskiest.

76. (c) In case of imports on cash basis, remittance should be completed within 6 months from date of shipment or the due date for payment whichever is earlier.

77. (c) Value indicated on import licenses is always for CIF (Cost, Insurance and Freight) value of goods authorized to be imported.

78. (e) If the beneficiary is from an ACU country, the LC should be denominated in ACU dollar which is equivalent value-wise to one US dollar.

79. (b) The bill of exchange should be drawn unconditionally and should be free from any extraneous conditions.

80. (a) The commercial invoice should be made out in the name of the applicant ( i.e. the importer).

81. (d) The primary function of a bill of lading is to serve as a receipt by the shipping company acknowledging that the goods have been received for transportation. A bill of lading is a document of title to the goods. The effect is that possession of a bill of lading confers the right to the goods covered by it.

82. (b) A bill of lading should show the name of the carrier and must be issued by a named carrier or his agent. Regarding the other alternatives, a bill of lading can be transferred by endorsement and delivery. A bill of lading has to indicate the name of the consignor and the consignee. When presented, it should be in a full set of originals (full set comprises of two or more originals issued to the consignor of goods, all of which are made as ‘originals’ and signed. It is enough if a brief description of goods is made in the bill of lading.

83. (b) The temporary receipt issued by the shipping company when goods are delivered for transportation is the mate’s receipt.

84. (e) A mate’s receipt is not a substitute for a bill of lading. It is not a document of title to goods. The transfer of a mate’s receipt does not pass title in the goods, nor is its possession equivalent to possession of the goods. Its statement does not bind the shipping company. It is, however, prima facie evidence of the quantity and condition of the goods received.

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85. (d) Alternatives given against (a) and (b) are correct. Regarding alternative (c), unless otherwise specified, the insurance document should be issued for an amount of 110% of CIF/CIP value of the goods.

86. (e) A documentary letter of credit offers advantages both to the exporter and importer of goods. The exporter is absolved of the botheration of knowing in detail the exchange control regulations of the importer’s country and is also insured to some extent against changes in such regulations. The bank which issues the letter of credit would take care to see that the goods covered by the letter of credit would be permitted to be imported under the exchange control regulations.

87. (b) In a standby letter of credit, the credit is payable upon certification of a party’s non-performance of the agreement, upon adducing evidence to the effect that payment has indeed been defaulted.

88. (c) In a transit credit, the services of a bank situated in a third country will be used. In such credit, the advising bank will be situated in a country other than the beneficiary’s.

89. (b) When a credit is denominated in the currency of a third country, such credit is termed as reimbursement credit.

90. (a) Documentary credits are regulated by UCP 500. 91. (b) Once documents under the letter of credit are received from the negotiating bank, the

opening bank should scrutinize them, within 7 days from the date of receipt. 92. (a) Commercial invoice is prima facie evidence of the contract of sale and purchase. 93. (b) Bill of lading is the document of title to goods. 94. (e) The insurance document submitted by the supplier of goods should satisfy certain

conditions. Cover notes issued by brokers will not be accepted unless specifically authorized by the credit. Moreover, the insurance document should indicate the nature of risks covered , which should be those specified in the letter of credit.

95. (a) Unless specified, the insurance document should be issued for an amount of 110% of CIF/CIP value of goods.

96. (c) The insurance documents should be issued and signed only by insurance companies or underwriters or their agents.

97. (b) Free on Board (FoB) means the sellers is said to have delivered once the goods cross the ship’s rail at the named port of destination.

98. (c) Under CIF ( Cost , Insurance and Freight), in addition to the obligations under CIF the seller has to procure marine insurance against the buyer’s risk of loss of or damage to the goods during the carriage.

99. (b) The UCP first appeared in the year 1933. 100. (b) The advising bank or any other bank so authorized by the issuing bank may assume the

role of a confirming bank and add its confirmation to the letter of credit opened by an issuing bank.

101. (e) All the alternatives given are true as per the Uniform Customs and Practice for Documentary Credits (UCPDC).

102. (d) As per UCPDC, all credits must clearly indicate whether they are available by sight payment, by deferred payment, by acceptance or by negotiation. Also, mere examination of documents without giving value does not constitute a negotiation.

103. (d) Alternatives (a) and (c) are valid as per UCPDC. 104. (a) As per UCPDC, documents submitted by the beneficiary should be consistent with each

other. Documents which appear inconsistent with each other will be rejected by the bank. 105. (c) Notice of refusal to take up the documents should be given to the bank from whom

documents are received or to the beneficiary, if the documents are received directly from him.

106. (e) All the alternatives given are valid as per Article 19 of UCPDC. 107. (e) All the alternatives given are acceptable documents as per UCPDC.

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108. (e) Alternatives (b) and (c) are true as per Article 20 of UCPDC. 109. (c) As per Article 33(a) of UCPDC, unless otherwise stipulated in the credit, or

inconsistent with any of the documents presented under the credit, banks will accept transport documents stating that freight or transportation charges have still to be paid.

110. (e) As per Article 37 of the UCPDC, unless otherwise stipulated in the credit, commercial invoices must appear on their face to be issued by the beneficiary named in the credit. Also, banks may refuse commercial invoices issued for amounts in excess of the amount permitted by the credit.

111. (d) Alternatives (a) and (c) are true as per Article 18 of UCPDC. 112. (e) The question should read as ‘Which of the following statements are true as per

UCPDC?. All the alternatives given are true as per Article 35 of UCPDC. 113. (c) As per Article 39(a) of UCPDC, the words ‘about’, ‘approximately’, ‘circa’, or similar

expression used in connection with the amount of the credit or the quantity or the unit price stated in the credit are to be construed as allowing a difference not to exceed 10% more or 10% less than the amount or the quantity or the unit price to which they refer.

114. (e) All the alternatives are valid as per Article 40 of UCPDC. 115. (b) This condition is valid as per Article 41 of UCPDC. 116. (e) All the alternatives gives are not valid as per UCPDC. It is preferable but not

mandatory for the letter of credit to indicate the date within which documents are to be submitted. If no date is indicated, banks will not accept documents presented to them later than 21 days after the date of shipment. Also, as per Article 44, if the last day for presentation of documents falls on a day on which the bank is closed for reasons other than those mentioned in Article 17 of the UCPDC, then the date for presentation of documents will be shifted to the first following day on which such bank is open.

117. (b) As per Article 47 of UCPDC, the term ‘first half’of a month shall be construed as the 1st to the 15th, both dates inclusive.

118. (e) As per Article 2(b) of URC 522, promissory notes and bills of exchange are financial documents.

119. (a) As per Article 3(a)(i) of URC 522, the ‘principal’ is the party entrusting the handling of a collection to a bank.

120. (e) Information given against alternatives (a), (b) and (c) should be included in a collection instruction.

121. (e) All the alternatives given are true as per Article 5 of URC 522. 122. (d) Alternatives (a) and (b) are valid as per article 7 of URC 522. 123. (d) Alternatives (b) and (c) are valid as per Article 10 of URC 522. 124. (d) Multimodal transportation means carriage of goods by two or more modes of transport

from the place of acceptance of goods to the place of delivery. A multimodal transport document may be negotiable or non-negotiable. A non-negotiable multimodal transport document means a document which indicates only one named consignee.

125. (c) Every carrier of goods by air has the right to require the consignor to make out and hand over to him a document called the ‘airway bill’. The air way bill is made out in three originals and handed over to the carrier along with the cargo.

126. (b) Unlike a bill of lading, an airway bill is not a document of title to goods. 127. (b) As per Article 48(e) of UCPDC, if a credit is transferred to more than one second

beneficiary(ies), refusal of an amendment by one or more second beneficiary(ies) does not invalidate the acceptance(s) by the other second beneficiary(ies) with respect to whom the credit will be amended accordingly.

128. (e) The UCP 500 is applicable to all documentary credits (including to the extent in which they may be applicable, standby letter(s) of credit where they are incorporated into the text of the credit.

129. (c) A bank advising the credit to the beneficiary, need not confirm it.

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Export Finance and Exchange Regulations Governing Exports 130. (d) In case of export of computer software in non-physical form, the export declaration

form to be used is the SOFTEX form. 131. (b) Form SDF is to be submitted by an exporter for declaring exports in the case of

specified customs offices and specified categories of shipping bills under the EDI systems. 132. (b) VP forms are to be submitted in a single copy. 133. (b) Exporters intending to participate in trade fairs conducted abroad may open temporary

foreign currency accounts for depositing the foreign exchange obtained on sale of goods at the trade fairs.

134. (a) Escrow accounts opened in India with regard to adjustment of value of goods imported into India against value of goods exported from India should be in US dollars.

135. (c) When GR forms are submitted to the customs by the exporter, the customs allot a 10 digit code number to the GR form.

136. (d) Normally, export proceeds are to be realized on the due date for payment or within 6 months from the date of shipment of goods whichever is earlier.

137. (e) 100% Export Oriented Units can retain 70% of export proceeds in foreign currency in the EEFC account.

138. (c) In a consignment sale, goods are dispatched to the exporter’s agent abroad and are then sold by the agents on behalf of the exporter. As and when the sale proceeds are received, they are remitted to the exporter.

139. (e) As per FEMA, only authorized dealers are permitted to deal in foreign exchange. It means that any foreign exchange that is required for import payment can be acquired only from an authorized dealer. Also, utilization of foreign exchange for a purpose other than what was intended is an offense under FEMA.

140. (d) Usance bill is a bill of exchange that is payable after a specified period of time. 141. (b) In case of exports to Indian-owned warehouses abroad established with the permission

of the Reserve Bank of India, a maximum period of 15 months is allowed for realization of export proceeds.

142. (a) Nostro account is an account maintained by a bank in India with a bank abroad. 143. (b) Exporters having a good track record may be permitted to open foreign currency

accounts with banks abroad for crediting the export proceeds. Exporters intending to avail this facility have to make an application on Form EFC which has to be submitted through the designated branch to the Exchange Control Department under whose jurisdiction the exporter is functioning.

144. (e) All the conditions given against alternatives (a), (b) and (c) are to be fulfilled in case exporters receive advance payments against exports.

145. (c) Reduction in value of the bill, after the bill has been sent for negotiation/collection will be permitted is the exporter is not on the caution list of the Reserve Bank of India.

146. (e) Write off of unrealized export bills will be made if conditions given against alternatives (b) and (c) are fulfilled.

147. (b) SOFTEX form is used for declaration of export of computer software in non-physical form.

148. (d) Conditions given against alternatives (a) and (b) have to be fulfilled in case of agency commission on exports.

149. (c) R-returns have to be submitted by all category A and B branches of authorized dealers. 150. (d) Banks have to extend a minimum of 12% of net bank credit to the export sector. 151. (c) Pre-shipment finance can be availed by exporters who are not on the caution list of the

Reserve Bank of India. 152. (e) All the alternatives (a), (b), and (c) are true with respect to packing credit.

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153. (c) Packing credit can be extended at a concessional rate of interest for a maximum period of 180 days or for the operating cycle of the particular activity whichever is lower.

154. (e) In case of packing credit, concessional rates of interest will be applicable only if export of goods takes place within 360 days from the date of availing finance.

155. (e) Pre-shipment finance under the running account facility will be granted only in case of a genuine need, only if the exporter’s track record is good and provided the letter of credit is submitted within a reasonable period of time.

156. (c) Packing credit not liquidated by export proceeds will not be eligible for concessional rate of interest.

157. (e) Pre-shipment Credit in Foreign Currency (PCFC) can be extended in one convertible currency in respect of an export order invoiced in another convertible currency. It is made available to the exporter with an intention of providing finance at internationally competitive rates.

158. (b) Non Resident External (NRE) Accounts are not a source of fund for banks under Preshipment Credit in Foreign Currency (PCFC) scheme.

159. (a) Pre-shipment finance can also be extended against duty drawback entitlements provisionally certified by the customs.

160. (e) All the alternatives given are true.

161. (b) Post-shipment finance is also made available to deemed exporters.

162. (e) All the alternatives given are true.

163. (d) A sight bill is a bill that is payable immediately on presentation. In case of a usance bill, the terms of payment are specified on the bill. Hence, a sight bill is charged lower rates of interest when compared to a usance bill.

164. (a) Normal transit period is the period of transit allowed by FEDAI for bills drawn on different countries. This transit period is dependent on the geographical location of each country.

165. (b) The Reserve Bank of India is the authority that governs exchange control regulations in India.

166. (b) R-returns have to be submitted to the Reserve Bank of India every fortnight.

167. (e) All the conditions given should be fulfilled for availing packing credit.

168. (a) If no export takes place within 360 days of availing finance under the PCFC scheme, PCFC will be adjusted at the TT selling rate of the currency concerned.

169. (b) In case of usance bills under post-shipment finance, concessional rate of interest is applicable up to the notional due date. However, the maximum period for which lower rates are charged cannot exceed 90 days.

170. (b) The Rediscounting of export bills abroad scheme is available to both authorized dealers as well as exporters.

171. (d) Proposals for export on elongated credit terms should be submitted in Form ECT through the exporters banks to the concerned regional office of the Reserve Bank for consideration.

172. (b) In certain lines of trade, it is customary for exporters not to draw bills for the full invoice value. In such cases, Authorized Dealers will accept part drawings provided the undrawn balance is in conformity with the normal level of balance in that particular line of trade, subject to a maximum of 10 percent of the export value.

173. (e) A request for write off of unrealized export bills will be accepted by the authorized dealer if the aggregate amount of write off during a calendar year does not exceed 10% of the total export proceeds realized during the previous calendar year. Write off will also be permitted in case of insolvency of the overseas buyer and a certificate has been obtained to that effect.

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174. (b) Where the exporter is unable to realize the export proceeds within six months but expects to do so provided extension is granted to him, then he should make an application (in duplicate) for this purpose to the RBI in Form ETX along with necessary documentary evidence.

175. (e) The rate of agency commission on exports should not exceed 12.5% of invoice value. 176. (a) Shipping bill is the main document required by customs authorities for permitting

export of goods from India. 177. (d) Where an export sight bill denominated in foreign currency is not paid within 30 days

after normal transit period, the unrealized foreign currency amount will be crystallized by the bank at the prevailing TT selling rate by effecting a notional sale.

178. (a) Export bills up to a usance period of 180 days from the date of shipment including normal transit period and grace period will be covered under this scheme.

179. (b) In case of consignment exports, freight and marine insurance should be arranged in India.

180. (e) Packing credit is available manufacturer-exporters, merchant-exporters and export houses.

181. (d) The question should read as “Which of the following is true regarding packing credit? Packing credit advances are normally granted on secured basis. However, in the initial stages of disbursement of funds it takes the form of an unsecured/clean loan. The period of packing credit depends upon the circumstances of each individual case like time required for procuring, manufacturing or processing and shipping the related goods.

182. (a) ECGC stands for Export Credit Guarantee Corporation. 183. (d) Exporters are permitted to retain 50% of export proceeds in foreign currency in the

EEFC account. 184. (b) The EEFC account can be maintained as current, savings (without cheque facility and

for individuals only) or term deposit account. 185. (d) Category B branches are those that are not maintaining independent foreign currency

accounts but are having powers of operating on the accounts maintained abroad by their head/principal offices of any other link offices. R-returns should be submitted twice a month at the close of business as on 15th and the last day of the month.

Import Finance and Exchange Regulations Relating to Import Finance 186. (d) Import of goods into India should be made within three months from the date of

remittance. 187. (b) Applications connected with import remittances including advance remittances must be

made in Form A1. 188. (b) Form A2 should be used in respect of import payments connected with merchanting

trade transactions. 189. (d) Details about drawal and utilization of loan amount in respect of import under foreign

loans/credits should be furnished to the RBI by means of quarterly statements in Form ECB2 in duplicate.

190. (a) Forward contracts for imports can be booked only in case of genuine transactions and where there is exposure to exchange risk.

191. (c) If the supplier of goods is from an ACU country, the letter of credit will denominated in ACU dollars.

192. (b) The rate prevailing on the date of presentation of bill of entry to the customs authorities will be the rate applicable to imports into India (for home consumption).

193. (a) Where the advance remittance in case of imports into India, exceeds US dollars 25000, guarantee from an international bank of repute situated outside India should be obtained.

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194. (a) Foreign exchange for import payment can be sold by an authorized dealers only to persons resident in India. For this purpose, persons, firms, companies or other organizations resident in Nepal and Bhutan should be treated as non-resident.

195. (e) While making payments towards imports, importers are permitted to withhold a small part of the cost of goods not exceeding 15% towards the guarantee of performance.

196. (c) On the amount withheld by the importer as guarantee of performance, no interest will be payable.

197. (d) Details about drawal and utilization of loan amount in respect of import under foreign loans/credits should be furnished to the RBI by means of quarterly statements in Form ECB2 in duplicate.

198. (c) In case of advance remittances to overseas suppliers by merchant exporters, a guarantee from a reputed international bank located outside India should be obtained from the overseas seller if the amount of advance remittance exceeds US dollars 15000.

199. (b) In case of imports under penalty, remittance will be up to the C.I.F value of the goods mentioned in the exchange control copy of the customs bill of entry evidencing import of goods into India.

200. (b) Cancellation of forward contracts by authorized dealers need not be reported to the Reserve Bank of India.

Part II: Problems

Documentary Credits 1. Bank ‘B’ has been asked to add its confirmation to an irrevocable letter of credit by the

issuing bank. How will Bank B deal with such a request?

2. Midland Bank has been requested to add its confirmation to a revocable letter of credit by the beneficiary of the LC. How would the bank deal with such a request?

3. Bank B negotiated an export bill under an irrevocable letter of credit covering export of industrial batteries to Saudi Arabia. The negotiating bank then claimed reimbursement from the opening bank. However, as the ship carrying the goods sank in midstream, the opening bank refused to make payment to the negotiating bank. As per UCPDC, what would be the position of bank B, given the fact that the documents submitted by the exporter comply with the terms and conditions of the letter of credit.

4. Bank B, negotiated an export bill for one of its valued customers under reserve and against an indemnity from the customer as certain discrepancies were noticed in the documents in terms of the letter of credit. The documents were forwarded to the issuing bank with necessary instructions. After 2 months, the issuing bank informs Bank B that there are discrepancies in the documents and hence not acceptable. Moreover, Bank B is also informed that in order to protect the goods and avoid demurrage charges, the issuing bank has cleared and stored the goods on behalf of Bank B, awaiting further instructions. What is the position of both the banks as per UCPDC.

5. Bank ‘A’ opened an ‘operative letter of credit’ through Bank ‘B’ via telex which was advised to the beneficiary. However, documents submitted in conformity with the letter of credit was rejected by the issuing bank on the ground that the consular invoice was not submitted. It was then observed that there had been a transmission error and the telex message did not contain this requirement. As per UCPDC, what is the responsibility of the negotiating bank and the opening bank in this respect?

6. Bank ‘B’ received an import bill drawn under an irrevocable letter of credit from its correspondent bank. On receipt, the following discrepancies were noticed:

a. The bill of exchange was not drawn on the opener.

b. The description of the goods on the invoice differed from the letter of credit.

c. The certificate of origin of goods was not submitted.

As an opening bank, what are the responsibilities of Bank B as per UCPDC?

7. Bank ‘B’ received a cable from the opening bank of a revocable credit, informing that the letter of credit has been revoked. After going through its records, it is observed that Bank B had negotiated documents under this LC the previous day, and documents are still in the bank’s dispatch department. What action can the bank take? Can it claim refund of the amount from the opening bank. Discuss in the context of UCPDC 500.

8. As a negotiating banker, should Bank ‘B’ accept the following bill of lading. Bill of lading is dated 19th January whereas the letter of credit calls for shipment towards the ending of January, 2001.

9. Bank ‘B’ receives a bill of lading for negotiation. The description of goods on the bill of lading is indicated as 200 bags as per “Shippers Load and Count” Soda Ash. However, the letter of credit calls for 200 bags light Soda Ash. Should Bank B accept the given bill for negotiation. Discuss in the light of UCPDC 500.

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10. Bank ‘B’ has received a bill drawn under an irrevocable letter of credit opened by it on behalf of its customer ‘A’ covering shipment of diamonds from Australia to Hyderabad. On scrutiny of the documents, Bank B finds that the certificate of specification and fineness has not been submitted by the supplier. Discuss the position of Bank B in such a case, in the light of UCP 500.

11. ‘A’ who is a client of Bank ‘B’ submits to it on 21st January, 2001, export documents under an irrevocable LC opened by a Bank in Dubai. One of the documents, required by the letter of credit is indicated as follows: ‘On board full set of bill of lading in triplicate evidencing shipment not later than 16th January, 2001, 150 cartons containing batteries from Mumbai to Dubai, marked ‘freight prepaid’. The full set of bill of lading in duplicate is submitted by ‘B’ and is dated 14th January, 2001 covering 150 cartons containing batteries from Mumbai to Dubai showing ‘Freight prepaid’ and stamped ‘Loaded on Deck’. Moreover, the consignor as indicated in the bill of lading and the beneficiary of the credit are different. Discuss the issues involved with specific reference to UCPDC 500.

12. Bank ‘B’ negotiated a bill for USD 45,000 under an irrevocable letter of credit, covering export of textiles from Mumbai to Dubai. However, it later transpired, that the ship carrying the goods neither touched Mumbai or Dubai. It was then realized that all the documents submitted to the bank were forged. What is the position of Bank B (the negotiating bank) in such a case. Discuss in the light of UCPDC guidelines.

13. Bank ‘B’ had confirmed a transferable LC for $250,000 allowing single shipment (partial shipment prohibited). The beneficiary of the LC approaches Bank B and requests the bank to transfer the LC in favor of 7 second beneficiaries, assuring the bank that shipments will be made on the same ship. Bank B, however, refuses the transfer. What could be the reasons for refusal and what is the alternative available to the beneficiary in such a case?

14. Bank ‘B’ issued an irrevocable letter of credit in favor of an Australian Exporter through one of its branches in Australia, which confirmed the letter of credit. The goods underlying the LC were computers. The beneficiary of the credit refused to accept it, on the ground that the LC is not confirmed by another bank but by a branch of the issuing bank. Discuss.

Export Finance and Exchange Control Regulations Governing Exports 15. Bank ‘A’ had booked a forward purchase contract of DM 75,000 delivery 22nd January at

Rs.22.227. However, on the due date, the customer requested the bank to cancel the contract as his customer had canceled the order. Assuming DM are quoted in the Frankfurt market as under:

Spot DM/$ 2.0863/0883

One month forward 2.1563/2.1603

Two months forward 2.2028/2.2073

And the US dollars were quoted in the interbank market as under:

Spot Rs./$ 46.371/3785

Swap points February 3400/3600

What will be the cancellation charges payable by the customer, if any, assuming that exchange margin required by the bank is 0.15%?

‘A’ is a corporate customer of Bank ‘B’.

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The foreign exchange market on 31st October was as under:

Date: 31st October, 2000 Spot Date: 2nd November, 2000 Rs./$ 46.4225/4250 Interbank November Rs./$ 46.4275/4325 Swap points 50/75 December Rs./$ 46.4425/75 200/225 January Rs./$ 46.4825/75 600/625 February Rs./$ 46.515/525 925/1000 March Rs./$ 46.5695/58 1475/1550 April Rs./$ 46.6225/63 2000/2100 DM/$ Spot 2.2496/2.2506 Int Market 1 Mth DM/$ 2.2533/2.255 1 Mth Swap Points 37/44 2 Mth DM/$ 2.2571/85 2 Mth Swap Points 75/79 3 Mth DM/$ 2.2598/2.2615 3 Mth Swap Points 102/109

Bank Margin 0.15% on cover rate. The questions 19 to 22 are based on the above given information. 16. ‘A’ is expecting an import of raw material worth US$ 250,000 sometime in the first half of

January. In order to avoid exchange risk, he decides to buy US$ forward from Bank B for delivery January. What is the rate that the bank should quote to the customer.

17. ‘A’ has sent an export bill for collection in respect of which payment is expected to be received sometime in January. ‘A’ requests Bank B to book a forward contract for the amount of bill i.e. DM 500,000. What rate will the bank quote?

18. A had earlier bought US$ 250,000 from B for delivery October at the rate of Rs.46.655. As the commercial transaction between A and the supplier was called off, A decides to cancel the forward contract with ‘B’. What rate will the bank quote for cancellation and what are the cancellation charges if any to be payable by ‘A’ to the bank?

19. A had earlier sold DM 750,000 to Bank B against US$ for delivery 2nd November @ 2.2246. As the export is delayed by a month, A extends the contract for delivery 2nd December. What rate will the bank quote to ‘A’.

20. Bank B entered into a contract for forward purchase of US$ 300,000 at Rs.46.63 covering a TT remittance against a bill for collection. However, on the maturity date, the customer requests for extension of the contract by one month. On that date, the rates for US dollars were as under:

Spot Rs./$ 46.84/905 One month forward 400/500 Two months forward 700/800 Three months forward 1100/1200 What will be the extension charges payable by the customer if the bank requires an

exchange margin of 0.08% for TT buying and 0.15% for TT selling? 21. An export customer of Bank ‘B’ has booked a forward sale contract of Swiss Francs

1,50,000, delivery 29th November at Rs.26.978. However, on 28th November, he requests Bank ‘B’ to extend the contract, as the anticipated payment has not been received. Bank B is therefore required to extend the contract by one month i.e. 28th December.

On 28th November, the rates for Swiss francs were quoted as under in the Singapore Market.

Spot CHF/$ 1.7594/1.7609 One-month forward 140/130 Two months forward 287/270 Three months forward 400/390

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And US dollars were quoted in the local interbank market as under: Spot Rs./$ 46.885/900 One-month swap points 1100/1200 Two months swap points 2500/2700 Three months swap points 4300/4700 What will be the extension charges, if any, payable by the customer? Exchange margin 0.15% on buying as well as selling. 22. On 15th November, Bank ‘B’ entered into a forward purchase contract for US dollars

750,000 with its customer at the rate of Rs.46.70 delivery 15th February. On 15th January, the bank is requested by the customer to extend the contract by one month i.e. 15th March. What are the extension charges to be paid by the customer assuming the following rates on 15th January:

Spot Rs./$ 46.65/67 February forward rate 46.69/71 March forward rate 46.73/75.

Import Finance and Exchange Regulations Relating to Import Finance 23. An Indian customer approaches a bank for a 2-month forward contract to help it to settle

∈ 200,000 payable maturing on 1/10/2000. The bank quotes a rate of Rs.38.77/∈. On 1/10/2000, the customer requests the bank to extend the contract for one month. If the rates prevailing on 1/10/2000 are as follows, what should be the bank charge for extending the contract?

Spot: Rs.46.47/$; $ 0.8390/∈ One-month forward: Rs.46.53/$; $ 0.8403/∈. Ignore interest rates. 24. On 19th January, Bank A entered into a forward contract with its corporate customer for a

forward sale of USD 7000 delivery 20th March at Rs.46.67. On the same day, it covered its position by buying forward from the market due 19th March, at the rate of Rs.46.655. On 19th February, the customer approaches the bank and asks for early delivery of US dollars. Rates prevailing in the interbank market on that date are as under:

Spot Rs.46.5725/5800 March Rs.46.3550/365 Interest on outlay of funds at 16% and on inflow of funds at 12%. What is the amount that would be recovered from the customer on the transaction? 25. On 12th January, Bank ‘A’ booked a forward sale contract for Euros 150000 for its import

customer at Rs.43.202 delivery 12th February. The contract is canceled by the customer on the due date.

Assuming that rates prevailing in the London foreign exchange market on 12th February is as under:

Spot ∈/$ 1.0764/1.0769 One month 1.0923/1.093 Two months 1.1375/1.1384 And US dollars quoted in the local interbank market is as under: Spot Rs./$ 46.504/5115 Swap points March 30/35 Swap points April 60/65 What will be the cancellation charges to be paid by the customer? Assume that the

exchange margin required by the bank is 0.15%.

Part II: Solutions Documentary Credits 1. By confirming a credit, the confirming bank undertakes to accept or pay bills provided the

terms and conditions of the credit are satisfied. Before adding its confirmation, the confirming bank should take into account the credit risk as well as the country risk involved. Only after being satisfied about the same, confirmation can be made. An irrevocable letter of credit cannot be amended unilaterally by the issuing bank, and hence to this extent, the interest of the confirming bank is protected. In case Bank B has no intention of confirming the credit, it should inform the issuing bank about its decision without delay.

2. Midland bank will not entertain such a request for two reasons. Firstly, the request for confirmation has come from the beneficiary, whereas as per the UCPDC guidelines, the request for confirmation should emanate from the issuing bank.

Secondly, the letter of credit in question is a revocable letter of credit which can be amended or canceled without informing the parties concerned. In such a case, the bank adding its confirmation will not be sure of getting reimbursement from the issuing bank in respect of payments made by it under the credit.

3. As per the Uniform Customs and Practice for Documentary Credits, all parties deal with documents alone and not with the goods/services or performance to which the documents may relate. Also, if the negotiating bank makes payment on the premise that documents comply with terms and conditions of the credit, then the issuing bank is bound to reimburse the bank which has effected payment/negotiated the documents. Irrespective of the condition of the goods, the issuing bank will have to reimburse the negotiating bank if such bank has made payment against complete and correct documents.

4. Documents submitted by the exporter for negotiation should strictly comply with the terms and conditions of the letter of credit. In case there are discrepancies in the documents, the negotiating bank may refuse to negotiate. However, in certain cases (where the customer is a valued customer), the bank may negotiate the documents, and make payment under reserve. In such a case, the customer will have to execute an indemnity in favor of the bank where the bank will have recourse to the customer, in case the issuing bank fails to make payment.

The negotiating bank can get payment from the issuing bank only if the documents are complete. However, as per UCPDC, the issuing bank will have a reasonable time not exceeding 7 banking days following the receipt of documents to scrutinize them and convey to the negotiating bank whether the documents are acceptable or not. In this case, the issuing bank informs the negotiating bank about the rejection of documents, after a delay of three months. If the bank had not accepted the documents, it was unwarranted on its part to clear the goods and store them, even though it was done keeping in mind the interests of the negotiating bank. Hence, the claim of the issuing bank cannot be accepted.

5. As per article 16 of UCPDC, banks assume no liability or responsibility for the consequences arising out of delay and/or loss in transit of any message(s), letter(s) or document(s), or for delay, mutilation or other error(s) arising in the transmission of any telecommunication. Banks assume no liability or responsibility for errors in translation and/or interpretation of technical terms and reserve the right to transmit credit terms without translating them. The negotiating bank has fulfilled the requirements of the letter of credit and is entitled to reimbursement from the opening bank.

6. As per UCPDC, in credit operations, the parties concerned deal with documents alone. As an opening bank, Bank ‘B’ has the obligation to scrutinize the documents that it has received from its correspondent bank. The discrepancies cited above are major discrepancies and Bank B has the right to refuse payment on this ground. However, the fact of rejection of documents should be conveyed to the other party within a reasonable time. While conveying rejection of documents, the opening bank should also make clear the grounds on which the documents are being rejected.

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7. As per Article 8 of the UCP 500, a revocable credit may be amended or canceled by the Issuing Bank at any moment and without prior notice to the Beneficiary. However, the Issuing Bank must reimburse another bank with which a revocable credit has been made available for deferred payment, if such a bank has, prior to receipt by it of notice of amendment or cancellation, taken up documents which appear on their face to be in compliance with the terms and conditions of the credit. In the given instance, the negotiating bank has made payment prior to receipt of notice of revocation. Hence, it is entitled to claim reimbursement from the opening bank.

8. As per Article 47(d) of UCPDC 500, the terms "beginning", "middle", or "end" of a month shall be construed respectively as the 1st to the 10th, the 11th to the 20th and the 21st to the last day of such month, all dates inclusive. As the LC calls for shipment towards the end of January, 2001, and the bill of lading is dated 19th January, 2001, it cannot be accepted for negotiation by Bank B.

9. As per Article 31(ii) of UCPDC, banks will accept a transport document which bears a clause such as "shipper's load and count" or "said by shipper to contain" or words of similar effect unless otherwise stipulated in the credit. Moreover, as per UCPDC, description of the goods in the commercial invoice should correspond with the description in the credit. In all other documents, the description can be given in general terms not inconsistent with the description of the goods in the credit. Hence, Bank B can accept for negotiation, the document submitted to it.

10. Persons dealing with documentary credits are concerned only with documents and not the underlying goods/performance or services. If on the receipt of the documents, the issuing bank is of the view that they do not appear on their face to be in accordance with the terms and conditions of the credit, it can reject the documents, but should inform the same to the negotiating bank without delay. In the given case, as the certificate of specification is not submitted, Bank B will reject the documents. Bank B should, however, inform the fact of rejection to the negotiating bank without delay.

11. The bill of lading submitted to the bank contains three discrepancies. Firstly, the letter of credit requires the bill of lading to be submitted in triplicate. However, the bill of lading submitted to the bank is a set in duplicate. Secondly, the bill of loading is stamped ‘Loaded on Deck’. Thirdly, the name of the consignor and the beneficiary of the credit are different. Given these discrepancies, Bank B has every right to reject the documents and refuse to negotiate.

12. As per article 13(a) of UCPDC, banks must examine all documents stipulated in the credit with reasonable care to ascertain whether or not they appear, on their face, to be in compliance with the terms and conditions of the credit. Documents which appear on their face to be inconsistent with one another will be considered as not appearing on their face to be in compliance with the terms and conditions of the credit. Article 15 states that ‘Banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any document(s), or for the general and/or particular conditions stipulated in the document(s) or superimposed thereon; nor do they assume any liability or responsibility for the description, quantity, weight, quality, condition, packing, delivery, value or existence of the goods represented by any document(s), or for the good faith or acts and/or omissions, solvency, performance or standing of the consignor, the carriers, the forwarders, the consignees or the insurers of the goods, or any other person whomsoever’. Given the above two articles, if Bank B has examined the documents with reasonable care and without any negligence, it is entitled to be reimbursed by the opening bank.

13. As per Article 48(g) of UCPDC, fractions of a transferable credit (not exceeding in the aggregate the amount of the credit) can be transferred separately, provided partial shipments/drawings are not prohibited, and the aggregate of such transfers will be considered as constituting only one transfer of the credit. However, in the given case, LC provides for single shipment and it may not be wise on the part of the transferring bank to agree to the beneficiary’s request because failure by the second beneficiaries to effect shipment on the same vessel and the same date would constitute a violation of the terms and conditions of the LC. The only alternative to the beneficiary, in such a situation, would be to request the opening bank to amend the credit permitting partial shipments.

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14. The reasons given by the beneficiary for refusing the documents are not valid. As per UCPDC, branches of a bank in different countries will be considered as another bank. It is, therefore, not necessary for the opening bank in question to request another bank to issue or confirm the credit, as its branches in another country are considered as another bank.

Export Finance and Exchange Control Regulations Governing Exports 15. Since this is a forward purchase of DM, the contract will be canceled at the TT selling rate

for DM on 22nd January. The TT selling rate for DM is obtained as under:

A $ will fetch 2.0863 DM in the international market and one US dollar can be obtained in the local interbank market at the offer rate of 46.3785. Hence, 2.0863 DM = Rs.46.3785.

DM = 46.3785/2.0863 = 22.23

Considering exchange margin required by the bank, the cancellation rate will be 22.23 (1 + 0.0015) = Rs.22.26

DM sold to the customer at TT selling rate Rs.22.26

DM bought from him under forward contract at Rs.22.227

Net amount payable by customer per DM Re.0.033

At 0.033 per mark, the customer has to pay Rs.2575 (including a flat charge of Rs.100) as cancellation charges.

16. Bank B will have to make a forward purchase of US$ from the market in order to sell US$ to A for delivery January. This is a contract of option of delivery and as between A and B the right to exercise the option will rest with A as he is the buyer. As between B and the market the right to exercise the option rests with ‘B’. The market is selling dollar at Rs.46.4875/$ for delivery January.

Cover Rate 46.4875 Add: Margin 0.06973 T Rate 46.5572 Rounded off to 46.56

17. Bank B will cover the exposure by selling DM in the market for delivery January against Indian rupees. However, as there is no direct DM/INR price, B will first have through the DM/$ route and then the INR/$ route.

The market is buying DM against US$ @ 2.2615. The market is buying US $ against INR @ 46.4425

Cover Rate 46.4425/2.2615 = 20.5361 Margin 0.0308 TT Rate 20.5053 Rounded off to 20.51

18. As A had bought forward US dollars from the bank, cancellation of the contract would mean that A sells back the dollars to the bank. The cancellation will be done at the TT buying rate prevailing on the date of cancellation. Bank B will cover the exposure by selling US $ to the market for value spot. The market buys US $ at the rate of Rs.46.4225 for delivery spot.

Cover Rate 46.4225 Margin 0.15% 0.0696 T. Rate 46.3529 Rounded off to 46.35

The contract rate is 46.655 and the cancellation rate is 46.35. Cancellation charges to be paid by A will be Re.0.305/$ i.e. Rs.76,250.

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19. Extension of the contract would mean that B cancels the original contract and enters into a forward sale of DM for delivery 2nd December. Even though A has requested for an extension of the contract, ‘B’s obligation for sale of DM against US$ to the market under the original contract still remains. Hence, B will buy DM spot against US $ from the market and make delivery to fulfill the forward sale. B will then enter into a forward purchase of DM from A against US$ @ 2.255 for delivery 2nd December.

Date DM Flows Rate $ Flows

Under original contract 2nd Nov. (750,000) 2.2246 337,139

First leg of swap 2nd Nov. 750,000 2.2496 (333,392) Cancellation gain payable to the customer will be 3,747. 20. The contract will be canceled at the TT selling rate for US$ i.e. Rs.46.905 prevailing on the

due date. The bank will buy US $ spot at Rs.46.905 and deliver against the forward sale which it had entered into to cover the exposure.

The bank buys at 46.63

The bank sells at 46.905

Cancellation charges per

US dollar payable by the customer is 0.275 which is Rs.82500.

Total cancellation charges will be Rs.82600 (including a flat charge of Rs.100).

The bank will book a fresh forward purchase contract for the customer at the rate of Rs.46.88 (spot rate 46.84 + one month premium 0.0400).

21. The forward purchase contract of 150,000 Swiss Francs by Bank B will be canceled at the selling rate for Swiss francs on 28th November which is (46.900/1.7594) Rs.26.656.

The bank buys Sw Francs at Rs.26.978

The bank sells Sw Francs at Rs.26.65

Exchange difference payable to the customer 0.322 per Sw Franc i.e. Rs.48,300.

The bank will book a fresh forward purchase contract of Sw francs delivery 28th December, at the rate of Rs.26.8865 (46.995/1.7479)

22. The bank would have covered its exposure by a forward sale of dollars delivery 15th February. However, as the customer has requested extension of the contract, the bank will cancel the original contract at the forward selling rate of Rs.46.71. The bank will rebook a fresh forward purchase contract with the customer at the rate of Rs.46.73, delivery 15th March.

The bank buys under the original contract at Rs.46.70

The bank sells at Rs.46.71.

Exchange difference payable by the customer 0.01 Re. per dollar.

Amount payable by the customer will be Rs.7600 (including Rs.100 flat charges).

Import Finance and Exchange Regulations Relating to Import Finance 23. The bank has to sell ∈200,000 to the customer. So, it would have covered itself by buying

a forward. On 1/10/2000, the bank takes delivery and sells ∈2,00,000 in the spot market at a rate of 46.47 (0.8390) = Rs.38.99/ .∈

It will then buy ∈ forward at 46.53 (0.8403) = Rs.39.09/∈ .

So, the cash flow on account of this transaction, ignoring interest:

200,000 (38.99 – 38.77) = Rs.44,000.

As per FEDAI, the bank charges a one time fee of Rs.100 for cancellation.

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24. On 19th February, the bank will sell dollars to the customer as per the agreed rate of Rs.46.67. For making this sale, the bank will have to purchase dollars spot from the market at the market selling rate prevailing on that date. The market selling rate of dollars on 19th February is Rs.46.5800.

Inflow/Outflow of funds will be as under: The bank buys at Rs.46.5800 The bank sells at Rs.46.6700 Inflow of funds per US dollar Rs.0.0900 Hence, inflow of funds for $7000 will be Rs.630. Interest on Rs.630 for one month is Rs.6.3. The bank will also enter into a forward sale of US dollars delivery 19th March. Swap loss/gain owing to this will be as under: The banks buys from the market at Rs.46.5800 The bank sells at Rs.46.3550 Swap loss per dollar Re.0.225 Swap loss for USD 7000 is Rs.1575. Charges for Early Delivery Swap loss Rs.1575.0 Flat charge Rs.100.0 Rs.1675.0 Less: Interest on inflow of funds Rs.6.3 Net Charge for early delivery Rs.1668.7 The customer’s account will be debited by Rs.3,26,690 and Rs.1668.7 for early delivery

charges. 25. The sale contract will be canceled at the TT buying rate for euro which will be calculated as

under: 1.0769 ∈will fetch 1 $ in the London foreign exchange market. This will be exchanged for

rupees in local interbank market at the bid rate i.e. 46.504. Hence 1.0769 ∈= Rs.46.504. ∈= 46.504/1.0769 = Rs.43.18 Given the fact that the bank requires a margin of 0.15%, the TT buying rate for cancellation

of the sale contract would be 43.18(1 – 0.0015) = Rs.43.115 Euro is sold to the customer at Rs.43.202 It is bought at Rs.43.115 Net amount payable per Euro Rs.0.087 The customer will hence have to pay 13,150 (including cancellation charges of Rs.100).

Part III: Applied Theory (Questions)

1. One of the customers of Bank B who maintains a current account with the bank, requests the bank to open an irrevocable letter of credit for US $ 500,000 in respect of import of goods from the US. What procedure should the bank follow and what are the precautions to be taken by the bank while opening a letter of credit?

2. Adequate availability of export credit at competitive interest rates is indispensable to accelerated export growth. In this context you are required to discuss in detail about pre-shipment finance.

3. The Exim Policy 1997-2002 was a conscious effort to dismantle various protectionist and regulatory policies and to accelerate progress towards a free and a transparent trade regime. In the light of this, discuss in brief the measures taken as part of the liberalization process as well as the objectives of the Exim Policy 1997-2002.

4. ‘A’ a corporate customer of Bank B submits export documents to it under an irrevocable letter of credit, covering a shipment of computers to the Middle East. Bank ‘B’ negotiates the documents and sends them to the opening bank ‘C’ in the Middle East. Discuss the liabilities and responsibilities of the opening bank in terms of the UCPDC guidelines.

5. Star Limited plans to enter into the business of import of textiles. The Managing Director of the company approaches you to explain to him in brief the various trade regulations governing imports into India.

6. Your friend who is of the view that the diamond industry has good future prospects is contemplating an entry into the field of import of rough diamonds. However, he is unaware of the incentives available to importers in this sector. You are required to explain to him the various incentives provided by the Government of India to give a boost to exports of diamond, gem and jewelry.

7. Exports from India are governed by various trade regulations. These trade regulations are periodically announced/amended in the exim policy. Discuss in brief the various categories of exports and trade regulations governing exports as per the current exim policy.

8. Ravi, an exporter, has been availing of pre-shipment finance from his bank, but is concerned about the high rates of interest charged by the bank. He is of the view that his competitors in other countries are better placed, given the fact that they are able to access capital at a cheaper rate of interest. After having explored various alternatives, he has zeroed in on the Pre-shipment Credit in Foreign Currency scheme (PCFC). You are required to brief him about the pre-shipment credit in foreign currency scheme (PCFC), its benefits, and the terms and conditions applicable to such credit.

9. One of the post-shipment finance schemes introduced by the Reserve Bank of India for early realization of export proceeds is the ‘Rediscounting of Export Bills Abroad’ Scheme. What are the terms and conditions applicable to this scheme.

10. Suresh, an importer of leather goods, was asked by his authorized dealer to submit the exchange control copy of the bill of entry evidencing the fact that the goods (recently imported by him) in respect of which payment was made have in fact been imported into India. The reason given to the importer was that the authorized dealer has to give information regarding the same to the RBI. In this context, you are required to explain briefly about BEF statements.

11. Naveen, an exporter who is relatively new to the export business is keen on finding information about the post-shipment credit facility available to exporters. You are required to explain to him the terms and conditions applicable for availing post-shipment credit.

12. Sundar, a prospective exporter, wants information on the exchange control regulations relating to the methods of repatriation of export proceeds as well as the time limit for realization of export proceeds. He has approached you to brief him on the same. Discuss.

13. X, a new entrant to the export business, has been informed that a letter of credit is the most common mechanism used for making international trade payments. He wants to familiarize himself about the rights and responsibilities of every party associated with an LC. Elaborate.

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14. Bank ‘B’ has opened an irrevocable letter of credit on behalf of its customer ‘A’, and in favor of his supplier ‘C’ in Sharjah. Mr. X who has been recently transferred to the exports department of ‘A’ would like to be informed about the various types of credit based on the scope of cancelation as well asmode of payment. Explain.

15. Amendments to exchange control regulations are made on a continuous basis depending upon the need. ‘X’ an import unit has been requested by its supplier to make advance payment in respect of imports. What are the exchange control regulations relating to advance payment made to suppliers in respect of imports into India.

16. ‘A’ is required to make a remittance in respect of imports made into India. What are the forms used for remittances connected with imports. Explain.

17. ‘X’ an exporter is required to submit export documents in respect of an irrevocable letter of credit opened in his favor. What precautions should ‘X’ follow, before submitting documents to the banker. Also, elucidate the safeguards to be maintained by the supplier in respect of the commercial invoice.

18. ‘Incoterms’ – an acronym for International Commercial Terms – are a series of trade terms used in international sales contracts to clearly divide the risks and responsibilities of buyers and sellers with regard to the movement of goods between both parties. Explain briefly the following incoterms:

a. FOB Free on Board (…. named port of shipment) b. CIF Cost, Insurance and Freight ( … named port of destination) c. FAS Free Alongside Ship (… named port of shipment). 19. Exporters in India are permitted to receive advance payment from the overseas buyers.

What are the rules governing this provision? 20. X, an exporter, has failed to realize part of the export proceeds in respect of a shipment

made from India. He has now requested his banker to write off the unrealized portion. Under what conditions will the banker accept his request.

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Part III: Applied Theory (Answers)

1. Whenever an importer approaches a bank for opening an import LC, banks usually subject the request for scrutiny under the premises of

a. Trade Control Requirements b. Exchange Control Requirements c. Credit Norms of R.B.I d. U.C.P.D.C Provisions and FEDAI e. Bank’s Internal Procedures. f. besides appraising its very creditworthiness. According to the exchange control guidelines banks are required to open letters of credit for

their own customers known to be participating in the trade. The opening of a letter of credit involves two stages wherein the importer is first required to make an application in the required format to the bank for opening the LC. Along with the application the applicant is also required to submit certain important documents like • The exchange control copy of the import license/open general license declaration

form, in case the items to be imported are not covered under OGL. • Letter of authority signed by the licenser in favor of the applicant, in case the

applicant is not the holder of the license. • Pro forma invoice/indent/sale contract, etc. covering the goods to be imported. • Board Resolution in the case of limited companies authorizing the company to

establish the letter of credit. • Board Resolution for availing of import loan wherever necessary. • Evidence of the Import-Export Code Number allotted by the Director General of

Foreign Trade (DGFT) to the importer. Moreover,

• The application form should be duly stamped according to the law of the concerned state and dated.

• The application form should be signed on all pages by the authorized signatory. • The application should be filled in completely and any corrections or alterations are

duly authenticated. • Particulars furnished should conform to the pro forma invoice/contract/indent

backing the letter of credit. • The tenor of the bill of exchange should not exceed that provided by the exchange

control regulations in force. • Currency in which payment is to be made should be in conformance with the

permitted methods of payment. • Goods should be consigned only in the name of the LC opening bank. Similarly,

documents of title to goods should be in the name of the LC issuing bank and never directly to the importer.

• The LC application should clearly mention the origin of the goods. • The indent/contract should be valid. • Terms and conditions mentioned should be compatible with each other. • The rate of interest, if any, for the usance period should not exceed the prime rate of

interest in the country of the currency in which goods are invoiced. The importer should be in possession of an importer-exporter code issued by the Director

General of Foreign Trade.

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As the exchange control copy of the import license should be submitted to the authorized dealer, the import license should • Be valid. • Be issued on security paper and have a printed number and date. • Have a security seal. • Be in the name of the importer or properly transferred in his name with proper

transfer letters authorizing him to effect import and open letter of credit, etc. by the licensee as per provisions of ITC policy.

• Commodity specified in the license should be the same as that indicated in the application. Similarly, quantity or amount limits specified in the license should be in agreement with that mentioned in the application. Also, irrespective of the sale terms for which the letter of credit is proposed to be opened, the import license should have adequate value to cover CIF value plus agency commission and interest, if any.

• Country of origin of goods authorized in the license and country of shipment as authorized should be in agreement with that which is stated in the letter of credit agreement.

• The license should be valid for shipment at least up to the last shipment date requested for in the letter of credit application.

• If license is issued under any bilateral or multilateral agreement, the conditions stated in the concerned agreements and the relative ITC notification are complied with.

• If license stipulates placement of order within a specified time limit, the sale contract submitted must confirm compliance of the condition.

Similarly, an import letter of credit will have to comply with certain exchange control aspects and hence the importer should be aware that • LCs will be opened by bankers only in favor of their customers who are known to be

participating in the trade. • For those goods which are covered under the negative list of imports, LC will be

opened only if the importer submits a license marked “For Exchange Control Purposes”.

• Where goods are imported from Nepal or Bhutan, payment will be made in rupees and such an LC would be treated as a domestic LC.

• If the beneficiary is from an ACU country, the LC should be denominated in ACU dollar which is equivalent, value-wise, to one US dollar.

• If import is made under a foreign loan or credit agreement and payment is authorized under letter of commitment method, letter of credit should not envisage any remittance from India. In the case of import licenses where reimbursement method applies authorized dealers will make appropriate stipulations to ensure that the prescribed documents are submitted to them without fail.

• In case of import of technology and drawings, the applicant will be required to pay Research and Development Cess, before allowing remittance. An undertaking to this effect is required to be given by the importer at the time of opening the LC.

• In case of imports on cash basis, remittance should be completed within six months from the date of shipment. However, in a situation where there is undrawn balance, payment for such amount can exceed six months, but no interest will be paid on such amount withheld.

• If a letter of credit is to be opened for transaction of merchanting or intermediary trade, a letter of credit for the other leg of the transaction on back-to-back terms will have to be opened or full advance payment should be made. Moreover, banks will open LCs only in favor of their clients who are genuine traders in goods and not mere financial intermediaries.

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If the Letter of Credit application is found to be in order after scrutiny from all angles, the bank will open the LC in favor of the supplier of goods.

2. Pre-shipment finance is basically a short-term finance (inventory finance) extended to exporters in anticipation of export of goods. This finance enables exporters to procure raw materials, process, manufacture, warehouses, ship the goods meant for export.

Pre-shipment finance can be classified as

a. Packing credit

b. Advance against incentives receivable from Government covered by ECGC Guarantee

c. Advance against cheques/drafts received as advance payment.

Packing Credit It is a loan or advance granted to the exporter for purchase of raw materials/processing/packing

based on Letter of Credit (LC) opened in his favor by the importer. The LC/Confirmed order will be retained by the bank and will be endorsed accordingly indicating that packing credit has been availed of by the exporter.

Eligibility An exporter who wants to avail of pre-shipment finance should obtain an importer-exporter

code number from the DGFT. In addition, the exporter should not be under the caution list/special approval list of RBI/ECGC.

Usually, packing credit is extended to exporters who have the export order/letter of credit in their name. It can also be extended where the contract is concluded by exchange of messages between the two parties, with the opening of LC to be followed later on provided the track record of the exporter is good. In such instances banks may grant packing credit based on the communication, provided the following information is made available:

a. Name of the overseas buyer

b. Particulars of goods to be exported

c. Quantity and unit prices or value of order

d. Dates of shipment

e. Terms of sales and payments.

Packing credit is also extended to supporting manufacturers/suppliers of goods who do not have LCs in their own name but orders have been placed on them for supply of goods by an LC holder.

Type of Finance Packing credit is normally a funded advance. It takes the form of an unsecured/clean loan

in the initial stages of disbursement of funds (i.e. when raw materials are yet to be procured). It is called extended packing credit. When the exporter gets a title to the goods it becomes a secured advance.

At times pre-shipment finance will be extended in a non-fund form, like issuing LCs favoring the suppliers of raw materials, opening guarantees for credit purchases, etc.

Quantum of Finance Quantum of loan will not normally exceed FOB value of goods or domestic market value of

goods whichever is lower. However, there are certain exceptions to this. Packing credit may be granted up to the domestic cost of goods even if it is higher than the FOB value, provided the goods are covered by export incentives of the Government of India and availability of Export Production Finance Guarantee offered by ECGC. The excess of advance over FOB value should be adjusted from the cash incentives/duty drawback received.

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Margin Requirements Pre-shipment finance being a need based finance, banks have the freedom to determine the

margin that is to be brought in by the exporters. The percentage of margin will depend on the nature of the order, commodity, capability of

the exporter, etc. Disbursement of funds under packing credit takes place in phases depending on the length of the operating cycle. Period of Finance

Packing credit can be extended at a concessional rate of interest for a maximum period of 180 days or for the operating cycle of the particular activity whichever is lower. Banks may further extend this period to an additional 90 days (i.e. 180 + 90 = 270 days). Alternately, banks may extend packing credit for a maximum period of 270 days from the beginning itself. If the packing credit is outstanding after the due date it is called overdue packing credit. Overdue packing credit is not eligible for concessional rate of interest.

It should be noted that concessional rates of interest will be applicable only if export of goods takes place within the time stipulated. This period has been fixed as 360 days from the date of availing the finance. In case export of goods do not take place within the stipulated period, banks are eligible to charge interest from the very first day of advance at a rate prescribed for ‘Export credit not otherwise specified’. Liquidation of Packing Credit

All packing credit advances should be liquidated from funds received by the exporter from either one or a combination of any of the following sources:

a. Proceeds of export bills negotiated, purchased, or discounted b. Proceeds of payments receivable from the Government of India, in the form of duty

drawback or a payment from the Market Development Fund (MDF) of the Central Government or from any other relevant source.

If a packing credit advance is not liquidated by export proceeds, that particular advance will not be entitled for concessional rate of interest. Advances against Incentives Receivable from Government of India

These advances are generally granted at post-shipment stage. However, in exceptional cases, where the value of material to be procured for export is more than the FOB value of the contract and considering the availability of receivables from Government of India, advances are granted for a maximum period of 90 days for more than the FOB value. These advances are liquidated by negotiation of export bills and out of proceeds of receivables from Government of India. Advance against Duty Drawback

Pre-shipment finance can also be extended against duty drawback entitlements provisionally certified by the Customs. The loans so extended will be adjusted when the final assessment is made by customs and duties are refunded by them. Duty drawback loans are normally granted by banks at the post-shipment stage for a period not exceeding 90 days at lower interest rate as specified.

3. In the years 1990-1991 drastic measures (like pledging of gold by RBI to borrow foreign exchange) were introduced to tide over the severe balance of payments crisis which had reached dangerous levels because of the Gulf crisis. Even though the crisis was resolved, a need was felt to be better equipped for any such future recurrences. As a corollary, the Liberalized Exchange Rate Management System (LERMS) was introduced. The scheme came into effect on 1st March, 1992. As per this scheme, 40% of current account receipts were required to be converted/surrendered to RBI at official rate prescribed by RBI and the balance at market determined exchange rates. The success of this scheme led to the introduction of Unified Exchange Rate System which came into effect from 1st March, 1993. Since then, all foreign exchange transactions are being put through by authorized dealers at market determined rates.

The other notable fall out of this crisis was the launching of economic and financial reforms by the Government of India. The main objective of the liberalization process was to

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increase the wealth of the nation by higher economic growth that would bring about better income and living standards to the population. In the interdependent world of the 90s, it was felt that economic growth could only be achieved by integrating the Indian economy with global economy in terms of free movement of goods, services and capital.

The liberalization process was aimed at • Freeing Industry from Licenses, Permits and Government Control. • Reforming Fiscal and Monetary Policies. • Reforming the Banking and Financial Sectors and the Capital Market. • Creating vital infrastructure such as telecommunication, power and roads to

facilitate economic growth. • Removing foreign exchange control barriers to the movement of Investment and

Capital. • Removing quantitative and tariff barriers on International Trade and rationalizing

Tariffs. As a sequence to the liberalization process, the Government of India had introduced

significant changes in the import-export policy also. The Export-Import Policy 1992-1997 was born in this context where an attempt was made to align India's international trade policies and practices to the overall liberalization process and getting closer to free international trade. The trade policy that was hitherto called as import-export policy was rechristened as export-import policy. The long-term export-import policy for a period of five years was announced synchronizing with the 8th five year plan. The exim policy 1992-1997 saw the introduction of numerous changes and modifications. Beginning from 1st April, 1992 the policy is being announced on a five-year basis and the policy currently in effect is the Export and Import Policy 1st April, 1997 to 31st March, 2002. Revisions during the five-year period generally are published on 1st April of subsequent years during the five-year period, although changes may be made and announced by means of public notices/amendment orders at any time. Objectives of the Exim Policy 1997-2002

The major thrust of the new exim policy for the period 1997-2002 is the acceleration of India's exports. In this direction, the policy has laid down a wide range of measures to restructure the various export promotion schemes. It has also advocated simplification and streamlining of procedures so as to inject greater transparency into the system, besides ensuring ‘speed’ in carrying out transactions.

Continuing with the process of trade reforms and liberalization, the policy aims at consolidating the achievement made possible during the preceding 5-year Exim Policy for 1992-97. The need to ease controls as well as procedural bottlenecks was realized. Another focus area of the new Exim Policy was to enable domestic industry realize its full potential and improve its competitiveness in the global arena.

Putting it briefly, the major objectives of the new exim policy can be enumerated as under: i. Accelerating the country's transition to a globally oriented vibrant economy in order

to derive maximum benefits from expanding global market opportunities. ii. Stimulating sustained economic growth by providing access to essential Raw

Materials, Intermediates, Components, Consumables and Capital Goods, derived from augmenting production.

iii. Enhancing the technological strength and efficiency of Indian agriculture, industry and services, thereby improving their competitiveness while generating new employment opportunities.

iv. Encouraging the attainment of internationally accepted standards of quality and providing consumers with good quality products at reasonable prices.

The exim policy 1997-2002 basically aims at imparting operational flexibility to the exporters. The changes brought about will enable exporters to tap new markets and help them improve exports both in terms of quality and quantity.

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4. The opening bank is primarily responsible for payment under the LC to the beneficiary. It is required to nominate the bank which is authorized to pay or to accept drafts or to negotiate, unless the credit allows negotiation by any bank. Any amendments made to a letter of credit by the issuing bank should be complete and clear. Also, if an opening bank uses the services of an advising bank to advise the credit to the beneficiary, it should use the services of the same bank for advising any amendments.

When the documents are received by the opening bank, it should scrutinize them to determine whether they are in conformity with the terms and conditions of the LC. The bank is given a reasonable time not exceeding seven banking days to examine the documents after receipt of the same. If the documents do not comply with the conditions specified in the LC, and the bank decides to refuse the documents, it must give notice to that effect without delay. Such a notice must clearly indicate the discrepancies in respect of which the issuing bank refuses the documents and must also state whether it is holding the documents at the disposal of, or is returning them to the presenter.

If the opening bank fails to act in accordance in the manner indicated, it will be precluded from claiming that the documents are not in compliance with the terms and conditions of the LC.

5. Imports into India are regulated by certain trade regulations. Import trade control is exercised by the Director General of Foreign Trade functioning under the Ministry of Commerce. As per FEMA ‘import’ means bringing into India, any goods or services. Imports to India can be classified into two categories:

a. Freely importable items or the open general license (OGL). The OGL includes those items which are freely importable and do not require import licenses.

b. The negative list: Import of those items which are not regulated by the OGL fall under the negative list category. This category of items are broadly grouped under 3 heads: Prohibited, Restricted and Canalized.

i. Banned or Prohibited Items are not permitted to be imported at all. They include tallow fat, animal rennet and unprocessed ivory.

ii. Restricted Items are generally those for which demand can be adequately satisfied, in normal circumstances, by local production in India. These are permitted to be imported only against a license, and include certain categories of consumer goods, precious stones, seeds, animals, insecticides, certain electronic items, drugs and chemicals.

iii. Canalized Items are those items which are importable only by government trading monopolies. They are mostly commodity imports and any import of these items must be channeled through these agencies. Some of the canalized items include petroleum products to be imported only by the Indian Oil Corporation, nitrogenous phosphatic, potassic and complex chemical fertilizers by the Minerals and Metals Trading Corporation and cereals by the Food Corporation of India.

Some of the trade regulations governing imports are discussed below. Importers who desire to import goods falling in the negative list of imports should possess a

valid import license. Goods which require import license can be imported only by an actual user, unless the actual user condition is specifically dispensed with by the licensing authority.

Every license has a validity period which is specified therein. For example, the validity of the Export Promotion Capital Goods license (EPCG) is 24 months. Only those items or category of items mentioned on the license can be imported under that license. A license is issued subject to the provisions of the policy applicable as on date of issue of the license. Every license bears the security seal of the office of issue as well as the signature of the issuing authority. As per the present rules import licenses issued under various provisions of the policy indicate the value in Indian rupees and in foreign currency at the exchange rate prevailing on the date of issue of the license.

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There are different categories of licenses. Regular licenses are licenses issued for the import of goods which fall under the normal

import policy. Advance licenses are issued under the duty exemption scheme. Under advance licenses,

duty free imports of inputs are permitted on fulfillment of value addition and export obligation within a certain time-frame.

Certain licenses are issued with a rider, like ‘export obligation’ which means importers of capital goods are required to export to a place outside India, a certain proportion of goods manufactured by the use of imported capital goods. In case of importers rendering services, export obligation means receiving payments in freely convertible foreign currency for services, rendered through the use of such capital goods. License where export obligation is imposed, indicates value of export obligation both in free convertible currency and Indian Rupees equivalent thereof at the exchange rate prevailing on the date of issue of the license. It also indicates exchange rate used for arriving at the rupee value of license. Value indicated on import licenses is always for CIF (Cost, Insurance and Freight) value of goods authorized to be imported.

Special Import License is used to import, among other items, certain consumer goods. The SIL is like an import permit and is traded in the market, at a premium on its value. It is issued to Indian exporters as an export incentive, and its value is tied to export earnings. SIL licenses are freely transferable and thus can be easily procured in the market by any prospective importer. The Special Import License shall be valid for import of items appearing in the ITC(HS) classification of Export and Import items.

Import licenses are issued in duplicate. One copy is marked for "Customs purposes" and has to be presented to the customs authorities at the time of clearance of goods. The other copy is marked for "Exchange control purposes" and has to be presented by the importer to the authorized dealer while opening a Letter of Credit (LC) or making payment for import of goods.

After the fulfillment of export obligation and other conditions laid down, the holder of a transferable license may transfer it to a third party. However, a request for endorsement of transferability should be made to the licensing authority within 36 months of the date of issuance of license. When the import license is so endorsed, the license holder may transfer the license in full in case he has not made any imports or where imports have already been made, the license may be transferred in part excluding the value and quantity of imports already made or the materials or the balance already imported.

The license transferred will be valid for the balance period of its validity or six months from the date of endorsement whichever is later.

Where a license is transferable, the fact of transferability will be indicated on the body of the license. In such case the license holder may effect part or full transfer of the license to other eligible importers in conformation with the various provisions of the policy. Duty Entitlement Passbook Scheme (DEPB)

The objective of Duty Entitlement Passbook Scheme is to neutralize the incidence of Customs duty on the import content of the export product. The neutralization shall be provided by way of grant of duty credit against the export product.

Under the Duty Entitlement Passbook Scheme (DEPB), an exporter may apply for credit, as a specified percentage of FOB value of exports, made in freely convertible currency. DEPB credit is available on export of goods. However, only those goods specified in the list of goods notified by the Director General of Foreign Trade by way of a public notice issued in this behalf will be eligible for credit. It, thus, becomes clear that unless the item is specified in the list notified by the DGFT, no DEPB credit can be availed of.

The exim policy 1997-2002 had introduced a new duty entitlement passbook scheme in place of the old passbook scheme. Under this scheme the exporter is issued a passbook. The scheme can be availed of under pre-export basis or on post-shipment basis.

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DEPB on Pre-export Basis Manufacture exporters and merchant exporters tied with supporting manufacturer and

having export performance in the preceding 3 licensing years are eligible to claim DEPB on pre-export basis. The entitlement shall be 10% of the average export performance of the applicant during the preceding three licensing years. It will carry an export obligation which has to be offset by the DEPB holder by making exports and it shall be offset within a period of 12 months. The DEPB on pre-export basis shall be non-transferable and items imported against it shall be subject to actual user condition even after offsetting their obligation against such DEPB.

DEPB on post-export basis shall be granted against exports already made. Both Merchant and Manufacturer Exporters are eligible for this type of DEPB. DEPB on post-export basis and items against it are freely transferable upon realization of export proceeds.

The exim policy 2000-2001 has done away with the DEPB scheme on pre-export basis as very few exporters were availing of the scheme.

6. To give a boost to exports of diamond, gem and jewellery for which India enjoys a special advantage of skilled labor, exporters under these sectors have been offered two special schemes viz: • Replenishment (REP) licenses and • Diamond Imprest Licenses,

for importing their inputs like raw/cut and polished diamonds, gold, etc. A brief summary of the provisions under these schemes are discussed hereunder. Replenishment License

Eligibility: Exporters of gem and jewellery products listed in Appendix 3D-A of the Handbook (Vol 1) are eligible for REP licenses at the rate and for the items mentioned in the said Appendix to import and replenish their imports. Exports made through third parties are also eligible for REP licenses. Procedure for obtaining REP Licenses • An application has to be made to the competent authority in the form given in

Appendix-15A of the handbook of procedures. • Such applications are to be made within 6 months following the month/quarter in

which export proceeds were realized. • A consolidated application is to be made for all the exports realized in a

month/quarter. • To claim REP licenses against third party exports, the EP copy of the shipping bill

must show the names of both i.e. the name of the manufacturer and the 3rd party through whom it was exported. Secondly, a disclaimer should be furnished from the third party.

Diamond Imprest License Under this scheme, diamond exporters can obtain Diamond Imprest License in advance, for

import of rough diamonds from any source. Such licenses, however, carry an export obligation, which the licensee has to fulfill.

Eligibility: An exporter can apply for a license for import of rough diamonds a. Equal to the best performance of cut and polished diamonds in any licensing year

during the preceding three licensing years, if he has a minimum of three licensing years of export performance.

b. Against a valid export order in his own name. Procedure for obtaining a Diamond Imprest License

Application has to be made in the prescribed format to the Regional licensing authority along with name and address of his banker and bankers certificate to the effect that there are no overdue export bills beyond a period of six months.

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Export Obligation: It carries an export obligation fixed in the inverse ratio of 65% of replenishment. It must be fulfilled within 5 months from the date of clearance of such consignment through customs. Bank Guarantee and Legal Undertaking(LUT)

The licensee is required to execute a bank guarantee/legal undertaking before the first consignment of import is cleared. However, this requirement will be waived in case the export obligation is fulfilled before any imports are made.

LUT/Joint LUT limits for different categories of exporters is indicated in the table below. Type of Exporter Limits

1. Super Star Trading House and Units within the same group/public sector undertaking and units within the same group.

Unlimited

2. Export House/Trading House/Star Trading House and units within the same group

Up to five times of FOB value of exports effected in the preceding licensing year/current year.

3. Exporters having performance of past exports but not covered under Sl. 1 and 2 above

Up to two times of FOB value of exports made during the preceding licensing year.

4. Any overseas company with its branch office in India with an annual average turnover in diamonds during preceding three licensing years not less than Rs.150 crore.

Up to 50% of annual average turnover of the preceding three licensing years.

If a licensee does not have LUT limit he is required to execute Bank Guarantee for 50% of the CIF value of the license in the prescribed form. Extension of Export Obligation Period

The Licensing Authority will allow extension in export obligation period for a period of four months against one or more consignment/sight on payment of penalty of 1% on the unfulfilled FOB value of export obligation with reference to CIF value of the imports made for which extension is being sought. Any request for extension beyond a period of four months will be considered only by a Committee headed by the Director General of Foreign Trade. Diamond Dollar Account

Diamond exporters enjoy several benefits including the right to open diamond dollar accounts which was introduced in the Exim Policy 1997-2002. Diamond dollar accounts allow exporters to retain their proceeds in dollars. However, opening of this account is optional, and diamond exporters can continue to use their rupee accounts if required.

The criteria specified by RBI for operating diamond dollar accounts include • Firms/companies should be dealing in the purchase/sale of rough or cut and polished

diamonds. • A track record of at least 3 years in import or export of diamonds. • An average annual turnover of Rs.5 crore or above during the preceding three

licensing years. Firms and companies maintaining foreign currency accounts, excluding Export Earners’

Foreign Currency (EEFC) accounts, with banks in India or abroad, are not eligible to maintain Diamond Dollar Accounts. Eligible firms or companies can have the diamond dollar account with not more than two authorized dealers. The Diamond Dollar Accounts have to be maintained in the form of current accounts.

7. FEMA defines ‘export’ as the taking or sending out of goods by land, sea or air, on consignment or by way of sale, lease, hire purchase, or under any other arrangement by whatever name called, and in the case of software, also includes transmission through any electronic media.

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Exports may be of different types. They could be Cash Exports: Cash exports are those exports where the proceeds are realized within 6

months from the date of shipment or the due date for payment whichever is earlier. As per FEDAI rules, the normal transit period and the notional due date of the bill will be taken into consideration to determine the due date of payment.

Project Exports: Export of engineering goods on deferred payment terms and execution of turnkey projects and civil construction contracts abroad are collectively referred to as 'Project Exports'. These contracts are usually of very high value.

Deemed Exports: Goods under this kind of export do not leave the shore of the country. Any such supply to be eligible for labeling as deemed exports should comply with the following:

a. Supply of goods is to a project that is funded by multilateral/bilateral agencies like IBRD/ADB/OPEC, etc. and any other such projects notified by the Government of India from time to time.

b. Goods are supplied against an order received under international competitive bidding and to this effect the supplier of goods should submit a certificate from his buyer.

The central idea of this arrangement is that supply of goods has indeed facilitated inflow/retention of forex into/within the country.

The current trade policy allows for the free exportation of all goods, except to the extent such exports are regulated by the ITC(HS) classification of export and import items or any other provision of the policy or any other law for the time being in force. Exports from India are categorized into two (i.e. the Open General license and the negative list) on the same lines as imports. The negative list consists of those goods which are permitted for export under license (restricted) or canalized or prohibited.

Some of the goods which are included under the restricted list are cattle, deoiled groundnut cakes containing more than 1% oil, fur of domestic animals excluding lamb fur skin, fodder including wheat and rice straw, etc. Canalized exports include export of petroleum products, mica waste, mineral ores, onions, etc. The prohibited list includes all forms of wild life, exotic birds, human skeletons, etc.

The Director General of Foreign Trade lays down conditions according to which certain items may be exported without licenses. Such terms and conditions generally include minimum export price, registration with specific authorities, quantitative ceilings and compliance with other laws. A person wishing to export an item on the negative list of exports must have a registration and membership certificate from the relevant export promotion council. He should also be in possession of a license issued by the licensing authority for the said purpose. An export license contains all the terms and conditions laid down by the licensing authority. Some of the details which are included in an export license are the quantity, description and value of the goods, actual user condition, export obligation, value addition to be achieved by the exporter, and the minimum export price. It should be noted that an export license cannot be claimed as a right. The licensing authority has the power to refuse, grant or renew a license as per the provisions of the Act. All export contracts must be denominated in freely convertible currencies.

In addition to possessing an export license, exporters are also required to register themselves with any one of the export promotion councils (EPC) and obtain Registration and Membership Certificate (RCMC). Export promotion councils help in promoting and developing the exports of the country. Each council is responsible for promotion of a particular group of products, projects and services. EPCs are non-profit organizations registered under the Indian Companies Act or the Societies Registration Act as the case may be and are supported by financial assistance from the Government of India. An exporter who wishes to avail of the various exim benefits will have to mandatorily register with the Export promotion council. The RCMC issued by the Export Promotion Council is valid for a period of 5 licensing years.

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Prior to any export, an exporter is required to give a declaration that the full export value of the goods or if the value is not ascertainable at the time of export, the value which the exporter expects to receive from the export has been or will be paid within the stipulated time and in the prescribed manner.

Also, the export of goods to countries other than Nepal and Bhutan can be made only if a declaration in the prescribed form is furnished to the ‘prescribed authority’.

However, declaration forms are not required in certain cases. Exports where declaration form is not required are

a. Trade samples supplied free of payment b. Personal effects of travelers, whether accompanied or unaccompanied c. Ships stores, transhipment cargo and goods shipped under the orders of the Central

Government or of such officers as may be appointed by the Central Government in this behalf or of the military, naval or air force authorities in India for military, naval or air force requirements

d. Goods or software accompanied by a declaration by the exporter that they are not more than twenty five thousand rupees in value

e. By way of gift of goods accompanied by a declaration by the exporter that they are not more than one lakh rupees in value

f. Aircrafts or aircraft engines and spare parts for overhauling and/or repairs abroad subject to their re import into India after overhauling/repairs within a period of six months from the date of their export

g. Goods imported free of cost on re-export basis h. Goods not exceeding US$ 1000, or its equivalent in value per transaction exported

to Myanmar under the Barter Trade Agreement between the Central Government and the Government of Myanmar

i. The following goods which are permitted by the Development Commissioner of the Export Processing Zones or Free Trade Zones to be re-exported namely:

i. Imported goods found defective for the purpose of their replacement by the foreign suppliers/collaborators

ii. Imported goods which were imported from foreign collaborator on loan basis iii. Surplus goods which were earlier imported from foreign suppliers or

collaborators free of cost, after production operations j. Replacement goods exported free of charge in accordance with the provisions of the

exim policy in force, for the time being. 8. Exporters 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 Currency (PCFC) is made available to cover both the domestic as well as imported inputs 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 to the 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.

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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 cancelation 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 date of liquidation. In such cases, interest will be payable on the rupee equivalent of 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 cancelation of PCFC was due to genuine reasons and not for speculative purposes.

Rates of Interest Applicable under PCFC Period between date of extending pre-shipment credit till the date the export takes place

Interest rate Chargeable Current Rate

Up to 180 days L + 200 to 250 bp 181-360 days 2% over the rate charged

up to 180 days LIBOR based

Export does not take place within 360 days

PCFC is adjusted at selling rate

LIBOR based

Interest will be charged on the Rupee equivalent of the principal amount at “Export Credit not otherwise specified “ + 2% after adjustment of the interest of PCFC already recovered.

Not more than 20%

9. The scheme was introduced by the Reserve Bank of India on 6th October, 1993. It serves as an additional window for early realization of export proceeds. Under this scheme, authorized dealers in India and exporters can have an access to the overseas market for rediscounting of export bills. Authorized dealers can have the eligible export bills in their portfolio for rediscounting abroad. Exporters also have been permitted for discounting their export bills directly subject to the following conditions:

a. Direct discounting of export bills by exporters with overseas bank and/or any other agency will be done only through the branch of an authorized dealer designated for the purpose.

b. Discounting of export bills will be routed through designated bank/authorized dealer from whom the packing credit facility has been availed of. In case, these are routed through any other bank/authorized dealer, the latter will first arrange to adjust the amount outstanding under the packing credit with the concerned bank out of the proceeds of the rediscounted bills.

Source of Funds Authorized dealers can utilize the foreign exchange resources available with them in

Exchange Earners Foreign Currency Accounts (EEFC), Resident Foreign Currency Accounts (RFC), Foreign Currency (Non Resident) Accounts (Banks) Scheme and Escrow Accounts to discount usance bills and retain them in their portfolio without resorting to rediscounting. In the case of demand bills these may have to be routed through the existing post-shipment credit facility.

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For rediscounting of bills, authorized dealers may, wherever necessary, access the local market, which will enable the country to save foreign exchange to the extent of the cost of rediscounting.

It is comparatively easier to have a facility against bills portfolio (covering all eligible bills) than to have a rediscounting facility abroad on bill by bill basis, as various rediscounting agencies may require detailed information relating to the underlying transactions, such as names of exporters and importers, commodities exported, letter of credit details, etc.

Authorized dealers can therefore arrange a "Bankers Acceptance Facility" (BAF). Each authorized dealer can have his own BAF limits fixed with an overseas bank or a rediscounting agency or an arrangement with any other agency such as a factoring agency.

Under the scheme, rediscounting is available in any convertible currency. Eligibility Criteria

Export bills up to a usance period of 180 days from the date of shipment including normal transit period and grace period will be covered under this scheme. Spread

Where the rate of interest on rediscounting does not exceed 1 percent over the six months LIBOR in case of rediscounting of bills with recourse basis and not more than 1.5 percent in case of bills without recourse basis, prior permission of RBI is not required for arranging BAF or similar facility.

Where the rediscounting facility is arranged by the exporter himself, rate of remuneration for the bank will be decided between the bank and the exporter. Refinance

Banks will not be eligible for refinance against bills discounted/rediscounted under this scheme and hence the bills discounted/rediscounted in foreign currency should be shown separately from the export credit figures reported for purposes of drawing export credit refinance.

10. Importers are required to submit the exchange control copy of the bill of entry for home consumption/postal wrappers to the authorized dealers as evidence that the goods against which payment has been made are actually brought into the country. Authorized dealers acknowledge evidence of import by issuing acknowledgement slips containing details like importer’s full name, address, code number, import license number and date, bank’s reference number (LC number, etc.), number and date of the exchange control copy of the bill of entry/postal wrapper, value and particulars of the imported goods.

In case the importer fails to furnish evidence of import within three months from the date of remittance, the AD will issue a reminder to the importer insisting him to produce the evidence. On failure to respond to this reminder by the importer, a second reminder by registered post acknowledgement due will be sent to the importer not later than one month from the date of the first reminder. If the importer fails to furnish evidence within a period of 21 days from the date of the second reminder, the AD will include details of the defaulting importer as well as the import transaction in the BEF statement (which is a half-yearly statement submitted as at the end of June and December every year) to be forwarded to the Reserve Bank of India. The Reserve Bank of India may initiate penal proceedings against the defaulting importer based on the details given in the BEF Statement.

11. Post-shipment finance is defined as "any loan or advance granted or any other credit provided by an institution to an exporter from India from the date of shipment of the goods to the date of realization of the export proceeds. It is basically meant for financing export sale receivables of the exporter. Post-shipment finance can be availed on submission of commercial documents evidencing export to the authorized dealer. The exporter is required to submit the documents to the bank within 21 days from the date of shipment of goods. The documents to be submitted include all shipping documents and an extra copy of invoice, relating to any export declaration form endorsed by Customs/Postal authorities.

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Post-shipment finance can be classified as under • Negotiation/Payment/Acceptance of export documents under letter of credit • Purchase/discount of export documents under confirmed orders/export contracts,

etc. • Advances against export bills sent on collection basis • Advances against exports on consignment basis • Advances against undrawn balance on exports • Advances against receivables from the Government of India • Advances against retention money relating to exports • Advances against approved deemed exports. Eligibility for Post-shipment Finance

Post-shipment finance is extended to the actual exporter or to an exporter in whose names the export documents are transferred. In case of deemed exports, finance is extended to the deemed exporters. In case of cash exports, exporters should submit GR/PP/VP/SOFTEX forms, as applicable along with the shipping documents for negotiation. Quantum

Post-shipment finance can be extended up to 100% of the invoice value of the goods. However, banks are free to stipulate margin requirements as per their lending norms. Period of Finance and Interest Rates Applicable

Post-shipment finance may be availed of either in Indian rupees or by using the rediscounting of export bills abroad scheme.

Even though post-shipment finance is a working capital finance, it may be offered on short-term basis or on a long-term basis depending upon the payment terms offered by the exporter to the overseas buyer.

The rate of interest depends on the nature of the bills, i.e. whether it is a demand bill or usance bill. A demand bill or a sight bill is one which is payable immediately on presentation. In case of a usance bill, the terms of payment are specified on the bill. Under this arrangement the importer is allowed a grace period for payment of the bill. Export finance availed against sight bills will be charged lower rates of interest for a maximum period of the normal transit period (NTP) stipulated for the concerned bill as per FEDAI rules. FEDAI has fixed different transit periods for export bills drawn on different countries. The export bill (Demand) should normally be realized within that period. The transit period so fixed by FEDAI is known as 'Normal Transit Period' and mainly depends on geographical location of a particular country. Concessional rates of interest will be charged by banks up to the actual date of realization of export proceeds or NTP stipulated for the bill, whichever is earlier. Where the sight bill is not paid on or before the normal transit period, it will be considered as an overdue bill. The rate of interest charged for the overdue period i.e. from the due date to 180 days from the date of shipment will be "Export credit not otherwise specified". For the period beyond 180 days from the date of shipment, higher rate of interest as given in the interest rate directive will be charged.

In case of usance bills, concessional rate of interest is applicable up to the notional due date. However, the maximum period for which lower rates are charged cannot exceed 90 days. While determining the notional due date of a usance bill, three components have to be taken into consideration

i. Normal transit period as fixed by FEDAI ii. Usance period of the bill iii. Grace period if applicable in the country on which the bill is drawn. Where an export bill has a usance period of more than 90 days, such a bill will not be

eligible for concessional rates of interest. In this situation, banks are free to determine the rate of interest on such credit.

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Where an export sight bill denominated in foreign currency purchased/discounted/negotiated is not paid within 30 days after normal transit period and 30 days after notional due date in the case of usance bills, the foreign currency amount has to be reversed from export bills. The unrealized foreign currency amount will be crystallized by the bank at the prevailing TT selling rate by effecting a notional sale. The rupee equivalent amount so converted should be shown in the advances portfolio of the bank under the head “Advances against overdue export bills realizable” account. When the bills are actually realized, purchase should be reported in respective R-returns under the head “Purchases relating to reversed export bills”.

12. Exchange control regulations relating to methods of repatriation of export proceeds are as follows.

i. Export proceeds should be received through the medium of an authorized dealer. Where the exporter has received payment directly in the form of bank draft, pay order, banker's cheque, personal cheque, etc. the authorized dealer will handle export documents only if the exporter's track record is good. The authorized dealer should also be convinced that the instrument represents payment for exports.

ii. Proceeds of goods sold to overseas buyers on their visits to India may be received by the exporter either by reimbursement against charge slips signed by the International Credit Card (ICC) holders (overseas buyers) or as instantaneous credit to the exporter's bank account in India. Authorized dealers will handle export documents even in such cases. Form GR (duplicate) will be released by the authorized dealers on receipt of funds in their Nostro account or on production of a certificate by the exporter from the Credit Card Servicing bank in India to the effect that it has received the equivalent amount in foreign exchange, if the authorized dealer concerned is not the credit card servicing bank.

iii. Funds held in the Foreign Currency (Non-resident) account and Non-resident (External) Rupee Account may also be utilized for payment of export proceeds.

iv. Payment towards export proceeds from a rupee account, held in the name of an exchange house with an authorized dealer, is also permissible up to Rs.2,00,000 per annum.

v. Export proceeds may also be paid by foreign currency notes/foreign currency traveler cheques by the buyer on his visit to the country.

Time Limit for Realization of Export Proceeds Export proceeds have to be realized on the due date of payment or within six months from

the date of shipment whichever is earlier. In case of exports to Indian-owned warehouses abroad established with the permission of the Reserve Bank of India, a maximum period of 15 months is allowed for realization of export proceeds.

13. The rights and responsibilities of every party associated with an LC have been defined in the UCPDC 500. It is necessary that every party dealing with an LC keep himself informed about these responsibilities. These rights are briefly discussed below. • All parties dealing with an LC are dealing only with documents and not with

goods/services, or performances to which the documents may relate. • Exporter/Beneficiary of LC has a right to receive payment against submission of

prescribed documents under the LC. It is the exporter’s duty to ship the goods as per the LC and submit the documents within the stipulated time for negotiation.

• Negotiating bank: Once documents under the LC are submitted, the negotiating bank has to ascertain that they appear on their face to be in accordance with the terms and conditions of the credit and if found agreeable should effect payment as per the LC terms and dispatch documents to the opening bank as instructed. Once the amount under the LC is paid to the beneficiary, the negotiating bank is entitled to get reimbursement from the opening bank for the payment, provided documents are in conformity with LC terms.

• Opening bank: Once documents under the LC are received from the negotiating bank, it should scrutinize them, within 7 days from the date of receipt. If it finds any discrepancy in the documents, it must convey the same to the negotiating bank

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through the fastest means available advising that it is holding documents in want of disposal instructions.

• Advising bank: Once LC opening instructions are received from the opening bank, the advising bank should, if it so desires to act as advising bank, verify the veracity of the LC and advise the beneficiary about the LC and its terms. It is entitled to receive advising charges for having advised the LC from the LC opening bank.

• Confirming bank: If, at the request of the issuing bank, the advising bank chooses to add its conformity to the LC, it is taking upon itself, the responsibility of paying the beneficiary against presentation of stipulated documents. Upon payment, it is entitled to receive, reimbursement from the issuing bank. It is also entitled to receive confirmation charges.

• Applicant to the LC: The importer is responsible for making payment under the LC, against release of stipulated documents, to the opening bank.

14. Various types of LCs are in operation depending upon the need. Based on scope for cancelation

a. Revocable Letter of Credit: A revocable letter of credit is one which can be revoked (either canceled or amended) by the issuing bank without giving notice to any of the parties concerned. Here the issuing bank reserves the right of revocation. A revocable letter of credit is disadvantageous from the exporter's point of view. By opening a revocable letter of credit, the issuing bank does not make a definite undertaking to effect payment to the exporter. However, if a nominated bank has made payment to the beneficiary, prior to receipt of the notice of cancelation or amendment, then the issuing bank will be responsible to reimburse the claim that has been presented to it.

Every letter of credit should clearly specify whether it is revocable or irrevocable. According to the UCPDC guidelines, if no such indication is observed, the credit will be deemed to be an irrevocable letter of credit.

b. Irrevocable Letter of Credit: Almost all LCs opened in the course of international trade are irrevocable letters of credit. Cancelation or any amendment to such an LC cannot be made without the prior acceptance of all the parties to the said LC like the applicant, the confirming bank, if any and the beneficiary. It is important to note that cancelation or amendment can be made only if all the parties consent to the same. An irrevocable letter of credit is more desirable from the exporter's point of view.

c. Confirmed Letter of Credit: Here, in addition to the issuing bank, another bank will add its confirmation to the LC. In other words, a confirmed letter of credit will have the guarantee of not only the issuing bank but also of the confirming bank. It should be noted that only irrevocable letters of credit can be confirmed. The confirming bank will add its confirmation only if requested by the issuing bank. Confirming banks are usually located in the country of the beneficiary.

This works to the convenience of the beneficiary, as he will have to deal with a local bank rather than a bank situated in another country. A confirmed letter of credit is slightly costlier, owing to the charges that will have to be paid to the confirming bank for confirmation.

Based on Mode of Payment a. Payment Credit: Under this credit, payment will be made to the beneficiary on

submission of the required documents provided they are in compliance with the LC terms. Payment credits do not usually call for drawing of bills. Under payment credit, the issuing bank nominates a bank in the exporter’s country to effect payment on its behalf if the documents are in conformity with the LC. The bank which paid the amount under the LC gets reimbursement from the issuing bank.

b. Deferred Payment Credit: This type of credit is a usance credit, where payment is made on the due dates specified in the credit. The beneficiary may or may not be required to draw drafts. However, under this credit, the maturity dates at which

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payment has to be made and how such maturity should be determined should be clearly indicated. The drawee bank itself may draw promissory notes and pass on to the beneficiary for claiming payments on the due date.

c. Acceptance Credit: This credit is a usance credit, where it is mandatory for the beneficiary to draw a draft on the drawee/specified bank for a specified tenor. The drawee bank will accept such drafts and make payment on the respective due dates on presentation of the relevant bill of exchange.

d. Negotiation Credit: This credit may be a sight credit or a usance credit. Under a sight credit, payment is made immediately, while under a usance credit payment is made after a specified tenor. A negotiation credit may be freely negotiable in which case the beneficiary may approach any bank for presentation of documents. This implies that when a credit is freely negotiable, any bank is a nominated bank.

On the other hand, when a credit is restricted for negotiation, the issuing bank authorizes certain specified banks as the nominated banks. In such case, the beneficiary is required to present the stipulated documents only to such banks as they alone are authorized to negotiate the documents under LC.

When a bank nominated to make payment refuses to do so, then it is the responsibility of the issuing bank to make such payment. Hence, in a negotiation credit, under all circumstances, it is the responsibility of the issuing bank to pay, and it cannot avoid its responsibility by stating that the negotiating bank is required to pay. A nominated bank, which effectively negotiates documents, buys the same from the beneficiary, thus becoming a holder in due course.

15. Authorized dealers may allow advance remittances for import of goods without any ceiling subject to the following conditions: • Firstly, evidence should be produced to show that the overseas supplier is insisting

on advance payment. • In case the goods fall under the negative list, the importer should hold the exchange

control copy of a valid import license. • Payment should be made directly to the overseas supplier. In case the advance

remittance exceeds US dollars 25000, guarantee from an international bank of repute situated outside India should be obtained.

• Import of goods into India should be made within three months from the date of remittance (12 months in case of capital goods). The importer is also required to furnish documentary evidence of import within 15 days from the close of the relevant period.

• Where capital goods are imported, a certified copy of the contract or any other evidence regarding terms of payment is required.

• In case of import of books, list of books to be imported should be obtained by the authorized dealer.

• Where goods are eventually not imported into India, authorized dealers should ensure that the advance remittance is repatriated into India.

16. Applications connected with import remittances, including advance remittances must be made in Form A1 (Annexure). This form is prescribed by RBI for import payments. It is a simple application for remittance in foreign currency to be made by an Indian importer.

It is obligatory for persons, firms and companies making payment towards import into India to apply in form A1. There are three variants of Forms A1 printed in three different colors to be used for different types of remittances.

a. Remittance in foreign currency – printed on white paper

b. Remittance by transfer of rupees to non-resident bank accounts – on light blue paper

c. Remittance through Asian Clearing Union – on light yellow paper

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Form A2 (Annexure) should be used in respect of the following payments: a. Import payments connected with merchanting trade transactions. b. Payment towards import of technical services/collaboration or any other type of

services c. Overseas bank charges connected with import transactions, when the remittance is

made separately d. Installments and interest on short-term foreign currency loans/credit with maturities

up to one year and loans raised by export oriented units on self liquidation basis. e. Repayment of loan/credit and payment of other charges requiring RBI approval for

remittance. In case the remittance is within the powers of the authorized dealer, the authorized dealer

will sell the required foreign exchange to the importer provided he is satisfied with the bona fides of the application.

However, if the remittance is outside the purview of the authorized dealer, an application in duplicate will be obtained from the importer. This application will be verified as to its correctness and will be certified and forwarded to the RBI for approval. The authorized dealer will not sell foreign exchange until a copy of the application (i.e. Form A1 or A2) has been returned by the RBI together with a permit authorizing remittance.

17. In case of shipment under Letter of Credit, the supplier should prepare documents strictly in accordance with the terms and conditions of the Letter of Credit and submit them to his bank for negotiation. The negotiating bank will examine these documents and if found in order, negotiate the same.

If there are any discrepancies in the documents presented by the exporter, the negotiating bank • May return the documents to the exporters for rectification of defects or • May refuse to negotiate the documents and advise the exporter to send them on

collection basis or • Contact the issuing bank for authorization for negotiation in case of minor

discrepancies or • Make payment ‘under’ reserve against exporter's indemnity and send the bills to the

issuing bank. The documents to be submitted by the exporter to his banker would include a commercial

invoice, transport document which is usually the bill of lading (or seaway bill or airway bill), insurance document, certificate of inspection, packing list and in some cases a certificate of origin of goods if any as stipulated in the LC.

Before submitting the documents to the bank, the exporter should follow certain safeguards, which are indicated below. • Documents called for should be submitted and in the requisite number. • Documents should be issued by persons required to issue. • Documents should be dated wherever required. • Documents should be manually signed wherever stipulated. • Any material alterations to the documents should be properly authenticated. • Documents should be consistent with each other. • Shipment should take place within the time stipulated in the LC. In case of installment

credit, the requisite quantity should be shipped within the stipulated time. • If partial shipment is effected, the same should be permitted under the LC. • Documents should be presented at the place stipulated. • Documents should be presented within the expiry date of the LC and if no expiry

date is stipulated it should be within 21 days from the date of shipment.

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Guidelines to be kept in mind with respect to the commercial invoice are enumerated below. A commercial invoice is prima facie evidence of the contract of sale and purchase. It is a

document made by the exporter on the importer indicating details like description of the goods consigned, consignor's name, consignee's name, name of the steamer, number and date of bill of lading, country of origin, price, terms of payment, amount of freight, etc. • The invoice should be made out in the name of the applicant. • It should be signed by the maker. Description of goods specified in the invoice

should correspond to the description given in the letter of credit. Similarly, other conditions like quantity of goods, unit price, delivery terms, etc. should conform to those stipulated in the Letter of Credit.

• The invoice should be drawn in the same currency of LC unless otherwise specified. • The invoice should not include any charges not stipulated in the LC. Also, the gross

value of invoice should not exceed the credit amount. • The invoice should show deductions towards advance payment made, agency

commission payable, etc. as applicable. • Final amount of invoice or the percentage of drawing as permitted in the LC should

correspond with the draft amount. • If partial shipments are effected, amount of drawings should preferably correspond to

proportionate quantities shipped (where only quantity is mentioned without unit price). • If invoice is issued for an amount in excess of the amount permitted by the credit,

the drawings should not exceed the amount of credit. • Details stated on the invoice should correspond to details specified in all other

documents. Also, the invoice should certify to facts like origin of goods, etc. as stipulated in the LC.

18. FOB Free on Board (... named port of shipment) The seller is said to have delivered once the goods cross the ship’s rail at the named port of

shipment. From that point onwards all the risks and expenses are to be borne by the buyer. The FOB price is inclusive of ex-works price, packing charges, transportation charges up to the place of shipment, wharfage and portage, customs dues, export duties, cost of checking of quality measure, weight or quantity, if any which an exporter incurs while delivering the goods to the buyer on board the ship. CIF Cost, Insurance and Freight (... named port of destination)

"Cost, Insurance and Freight" (CIF) means that in addition to the obligations under cost and freight (CFR) the seller has to procure marine insurance against the buyer's risk of loss of or damage to the goods during the carriage. The seller contracts for insurance and pays the insurance premium. FAS Free Alongside Ship (... named port of shipment)

Free Alongside Ship means that the seller delivers when the goods are placed alongside the vessel at the named port of shipment. This means that the buyer has to bear all costs and risks of loss of or damage to the goods from that moment. Free alongside ship does not include charges for loading the goods on board the vessel. It also does not include ocean freight charges and marine insurance premium. The FAS term requires the seller to clear the goods for export. This is in contrast to the earlier requirement where the buyer was required to arrange for clearance of the goods.

19. a. Exporters are permitted to receive advance payments from the overseas buyers provided

i. the goods are shipped within one year from receipt of advance payment ii. the rate of interest payable does not exceed LIBOR + 100 basis points and iii. the shipments are monitored by the AD through whom advance payment is

received.

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In the event of the exporter's inability to make the shipment partly or fully, within one year from the date of receipt of advance payment, no remittance towards refund of unutilized portion of advance payment or towards payment of interest, shall be made after the expiry of the said period of one year, without the prior approval of the Reserve Bank.

b. Notwithstanding anything contained in clause (i) of subregulation (1) where the export agreement provides for shipment of goods extending beyond one year from the date of receipt of advance payment, the exporter shall require the prior approval of the RBI.

20. In case the outstanding export dues are not realized in spite of the efforts of the exporter, he may request the concerned AD for write off of the unrealized portion. Appropriate supporting documentary evidence should be submitted in proof of the same.

The request may be agreed provided a. The amount has been outstanding for 360 days or more. b. The aggregate amount of write off during a calendar year should not exceed 10% of

the total export proceeds realized during the previous calendar year. c. The exporter submits evidence to prove that he has made all efforts to realize the

dues. d. Write off will also be permitted in case i. of insolvency of the overseas buyer and a certificate has been obtained to that

effect ii. it is not possible to trace the buyer over a long period of time and supporting

documentary evidence is provided to that effect iii. the goods exported have either been auctioned or destroyed by the authorities

in the importing country and a certificate to that effect has been issued iv. the unrealized amount represents the balance due in a case settled through the

intervention of the Indian Embassy, Foreign Chamber of Commerce or similar organization

v. the unrealized amount represents the undrawn balance of an export bill (not exceeding 10 percent of the invoice value) and has been unpaid and turned out to be unrealizable despite all efforts made by the exporter

vi. where the legal expenses likely to be incurred for recovering the said amount would be disproportionate and where the exporter in spite of the court order in his favor is not able to execute the same due to reasons beyond his control

vii. bills are drawn for the difference between the letter of credit value and actual export value or between the provisional and the actual freight charges but the amount has remained unrealized consequent on dishonor of the bills by the overseas buyer and documentary evidence is produced to show that there are no prospects of realization

e. The case is not the subject matter of any civil or criminal suit which is pending. f. The exporter has not come to the adverse notice of the Enforcement Directorate or

the Central Bureau of Investigation or such other law enforcement agency. g. The export incentives availed of have been surrendered by the exporter. Where there is no further amount to be realized against the GR/PP form covered by the

write off, the authorized dealer will submit the duplicate copy of the same to the RBI along with R-return with their certification, stamp and signature that

“Write off of _____________________ (Amount in words and figures) permitted in terms of paragraph 6C.14 of Exchange Control Manual”.

International Finance and Trade

Part IV: Case Studies (Problems) Case Study 1

Read the case carefully and answer the following questions. 1. Estimate the working capital needs of Neetu to execute this order.

2. How should Neetu present her requirements to a banker?

3. Would you advise Neetu to go in for Pre-shipment Credit in Foreign Currency or packing credit in rupees? Substantiate your advice with necessary arguments.

4. What kind of LC terms should Neetu ask for? “Least costs with maximum benefits” should be the approach.

5. How should Neetu go about opening the LC for importing machinery? Do you advise her to retire the bills from the current sale proceeds or take a term loan?

6. What are the financial risks Neetu is exposed to? Do you think she should use any hedging techniques? If so, how should she go about it. Reason out.

Neetu, a fashion graduate from the National Institute of Fashion Technology, Hyderabad is planning to introduce her designer wear to the overseas market. Having completed a three-year course from NIFT, she decided to venture out on her own which led to the setting up of ‘Raaga’ a showroom stocking ethnic and designer wear in the year 1999. In a short span of time, she has managed to create a strong design identity and has fairly established herself as a designer. Clothes designed by her are a mix of both traditional and modern styles. They have excellent wearability and are in tune with modern fashion. Apart from Raaga, she also retails from her studio at Banjara Hills, Hyderabad.

As part of her business plan to expand, she has sent a few samples to some of the retail outlets in USA and the Middle East. In response to this, she has received orders from a retail chain in the US requesting for supply of specified designs worth $100,000 per month. The supply is to be made in the months of October, November and December. The order received is worth $3,00,000. The owner of the retail outlet in the US has expressed his willingness to open an LC. However, he has requested Neetu to specify the terms and conditions that are to be inbuilt in the LC.

Financial Position At the time of receiving the order, the financial position of the unit was as under:

Capital 30,00,000 Cash and B/K A/c 4,00,000

Loan from family members 15,00,000 Inventory 6,00,000

Creditors 5,00,000 Receivables 20,00,000

Fixed Assets 20,00,000

50,00,000 50,00,000

Neetu is hopeful of realizing the receivables by October.

Currently, she is maintaining her Current Deposit account with Syndicate Bank, Banjara Hills. She is not enjoying credit facilities from any bank. The activities of her unit are predominantly financed by equity/equity like investments.

Neetu, having entered the market two years back, does not want to ignore the domestic market. In fact, she wants to make further inroads into the domestic market. The domestic business is growing at the rate of 20% per year. She wants to maintain the growth rate at the same level, if not surpass it. Therefore her desire is to execute the export order while of course catering to the demand from the domestic market. She strongly believes that she cannot compete globally unless she is on a strong ground domestically. All this boils down to the fact that she wants to execute the export order in addition to her already existing market share and the potential for further growth.

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Infrastructure The unit has well equipped infrastructure for carrying out the order. However, machinery worth $ 30,000 is to be imported from Switzerland. Enquiries with the manufacturer have revealed that the machinery can be supplied off the shelf and the lead-time for dispatch and receipt will not take more than one month from the date of placement of order. Neetu has placed a purchase order for the machinery. However, the supplier has requested her to open an LC. The supplier of the machinery is willing to give Neetu three months credit provided an LC is opened. Staff Position The unit employs skilled laborers from the local market. The export order can be executed with the present infrastructure by working 2 shifts. Neetu has to, however, appoint additional skilled labor to run the industrial sewing machines in the 2nd shift. Efforts are already afoot to hire new workers. There is no dearth of skilled labor in Hyderabad. Yet she wants to bifurcate her existing work force into two teams and deploy them in the proposed 2 shifts, so that the new recruits can fall in line with that of the unit’s production style/quality with ease. Cost of Production The cost of production includes design expenses, cloth expenses and labor charges. The MRP of each piece is expected to be Rs.5000. The exports are dollar denominated and the profit margin is expected to be at an average of 17.6% at the current exchange rate of Rs.45.6/$. Neetu feels this margin is adequate. Cost Break up per Piece Fixed expenses Rs.750 (taking into consideration the proposed 2 shifts) Variable expenses Rs.3500 Funding Pattern Neetu is of the opinion that the equity brought in is more than enough to execute the order. Nor is she in a position to bring in additional capital. However, she is contemplating to approach her banker to discuss about her working capital requirement and ascertain the best way of availing finance as also the likely terms and conditions to be complied with for availing such facilities. The banker has given her the necessary application forms and has asked her to submit a detailed note on the cash flows – both existing and projected, along with copies of the export order, etc. Interest Rates on Packing Credit The bankers have apprised Neetu that she has an option of availing packing credit either in rupees or in foreign currency under the PCFC scheme. They also informed her that current interest rates prevailing in the market for rupee credit is 9%, while a dollar denominated loan would cost Neetu 6%. The market expects the rupee to depreciate and settle down to a level of Rs.46.7/$ by the end of December 2001. By January 2002, the rupee is expected to further depreciate vis-à-vis the dollar. On the other hand, interest rates on rupee credits are likely to continue at the same subdued level till the next active season/the Finance Minister announces the budget/The RBI governor announces the next credit policy. Of all the points raised by the bank, the low interest rates on $ denominated packing credit attracted her immediate attention. Business Prospects After proper execution of the current order, Neetu is confident of receiving continuous orders from other well known outlets in the US. She also plans to start her own outlets abroad. Her cousin, who is pursuing a management course at Stanford University, is likely to join her as a partner after completion of her degree. Additional Information At a social gathering, Neetu met Sangeeta, an old pal of hers, who had incidentally branched off into management. After exchange of the usual pleasantries, their discussion settled on the present venture of Neetu. Neetu was told by her friend that exports involve various financial risks, the most important being credit risk, interest rate risk and exchange risk. Sangeeta, her friend did in fact tell Neetu that she cannot be so happy about the estimated profit margin as it can get eroded within no time if the dollar depreciates. She even told her that dollar is indeed weakening against the other currencies like yen and euro. Market analysts even believe that the dollar has to further

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weaken with the lull in the American economy being what it is today. Neetu being a novice to all this was attentively listening to her friend. Being encouraged by her friend’s interest, Sangeeta suggested that she may explore the possibility of hedging from the exchange risks. Neetu was also told that hedging would involve additional costs and it was necessary to factor this into the profit margin. All this sounded quite shuddering to Neetu. Next day morning, Neetu phoned up her cousin in Stanford University, USA and narrated the whole game plan about export order and sought her help in tiding over the loose ends. After a considerable exchange on the matter, her cousin promised to e-mail a detailed note on the current dollar market scenario and the prospects of the dollar weakening or strengthening in the coming 2 quarters. As promised, she mailed. a note to Neetu the next morning, and the substance of the communication was • The dollar may weaken by around 10%-15% against other world currencies like the Euro,

the Pound Sterling and the Japanese Yen in the coming two quarters. • It does not mean that the Rupee will also appreciate against the dollar, as the dollar-rupee

exchange rate is more linked to demand/supply position within the Indian interbank market rather than what is happening at the global level.

• Thirdly, as rupee is not traded in the global market, the volatility in international currencies may not have a similar effect on the rupee dollar rate.

With all these conflicting views coming from different sources, Neetu became restless.

Case Study 2 Read the case carefully and answer the following questions keeping in view the various export finance guidelines. 1. How much packing credit will the bank sanction?

2. How should the company go about procuring finance for import of cartons?

3. What type of limits the exporters should have to avail the finance for the above purposes, keeping in view post-shipment requirement also?

4. How should the company comply with the requirements of the suppliers?

5. What precautions will the bank take for release of packing credit?

6. Discuss the various exchange control guidelines which have to be kept in mind.

M/s Vijaya Enterprises Pvt. Limited (VEPL) set up in the year 1999 is engaged in the business of export of quality natural produce. Tobacco is one of the main products that is grown and exported by them. The unit uses state-of-the-art machinery for processing tobacco which is transported in perfect condition to countries abroad. In a short span of time the company has succeeded in earning the patronage of major international companies. The unit has managed to retain its prestigious clientele because of its commitment to quality and efficient response to the requirements of the customer. The Middle East has proved to be their biggest market. Besides the Middle East, the company has managed to carve a niche for itself both in the US as well as in several European markets.

Promoters

The company has been promoted by Mr Kishore Raju and his brother Mr Veera Raju who have a majority stake in the company. The promoters hailing from a family of farmers, have many years of experience in the relevant field.

Location of Plant and Installed Capacity

The operations of the company are head quartered at Guntur. The company has its own redrying factory and huge godowns located at Guntur. It also has around 15 branches located all over India. The company also has a sophisticated quality control lab to ensure that the required standards are maintained.

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Employee Position The company employs around 10,000 skilled workers for grading, stripping, and trimming all varieties of Indian tobaccos. In addition, about 75 supervisors and 300 staffers are on the permanent rolls of the company. The labor is basically sourced from the local market at reasonable rates given the fact that there is no dearth in availability of skilled labor. Sales Domestic sales form a very small portion of the company’s total sales. A major portion of its sales revenue is generated from exports because of its strong position in the overseas market. For the year ended March 2001, the company’s sales revenue stood at Rs.26 crore. The sales of the company has been growing at a CAGR of 8.4% compared to the industry growth rate of 10.5%. The company is hopeful of improving upon its sales performance. Cost and Profitability Details The operating profit margin of the company for the year ending March 31, 2001 stood at 11.5% of sales. For the financial year 2000-2001, the company’s cost overheads stood as under: Processing Cost: 4.5% of sales Employee cost: 6.5% of sales Selling expenses: 16% of sales. The net profits of the company have registered a CAGR of 20%. However, it may be difficult for the company to maintain the same level in the coming years. Future Outlook In recent years, the anti-smoking lobby is gaining ground all over the world. There have been protests from various quarters against the tobacco industry. In the coming years, the company is likely to encounter a decline in its profit margins owing to increase in Government intervention as well as an increase in taxes. Additional Information The company has been enjoying substantial export finance facilities with AB bank. They have negotiated an export order on 11.8.2000 covering export of 1,00,000 kgs of Virginia tobacco to Russia at Rs.100 per kg CIF, Moscow and 1,00,000 kgs of Burley tobacco at Rs.40 per kg CIF Moscow on the following terms and conditions. a. Virginia Tobacco should be packed in imported cartons (made in UK) of 200 kg capacity

each and Burley tobacco in seaworthy gunny packing. b. Shipment should take place only after completion of the pre-shipment inspection by the

local representative of the importers. c. LC will be opened by the importer after completion of pre-shipment inspection for 85% of

invoice value. d. The balance 15% of invoice value will be settled by the importer directly on receipt of

goods at destination and basing on the quality analysis reports issued by their quality control department. Penalties are stipulated if the goods are not in conformity with the quality specifications as per the approved samples.

e. Virginia Tobacco is quoted in a range of Rs.55-60 per kg depending on the quality and soils on which it is grown in the Tobacco Board Auction Platforms.

f. Ocean Freight from Chennai to Moscow is estimated to be around 6%, marine insurance at 1%, inland freight 2%, processing charges at 5% of export value and wastage 10%. A. The company has requested the bank to release the eligible packing credit. B. The company has requested the bank to remit GBP 750 to the supplier in UK to the

debit of packing credit A/c towards advance remittance for import of 500 Nos of cartons at GBP 1.50 each CIF, Chennai, for which the party is holding an advance license.

C. The company wanted to procure the Burley Tobacco from a supplier from Jangareddygudem, who is willing to supply the stock on credit basis at Rs.25 per kg, but wanted a letter of disclaimer to avail the packing credit with his bankers. On these stocks wastage is 15% and other costs are same as per Virginia.

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Part IV: Case Studies (Solutions) Case Study 1

1. The worth of the order received by Neetu is $ 1,00,000 per month which at an exchange rate of Rs.45.6/$ works out to Rs.45,60,000. The selling price of each piece is Rs.5000 and the variable expense per piece is Rs.3500. Given this, the working capital requirement of Neetu works out to (3500/5000 x 45,60,000) Rs.31,92,000 per month. Normally packing credit will not exceed FOB value of goods or domestic market value of goods whichever is lower. In this case, since the value of 31,92,000 is lower than the FOB value of the goods, packing credit may be granted to the extent of Rs.31,92,000. However, there is a possibility of the bank demanding a margin from Neetu. As Neetu has already invested some amount for the existing operations, that amount may be treated as margin and finance may be provided to the extent of 100% of cost of production.

2. Till now, Neetu has been managing the show with her own resources. If the order received is to be executed, she would require additional working capital. In such a situation, the bank is likely to insist on a margin. Working capital can be granted against a collateral of inventory and receivables which works out to Rs.26,00,000. In an extreme situation, fixed assets may also be offered as security. However, Neetu can put forth her case and request the bank to grant her packing credit without any margin on the basis that she will be presenting the export bill for negotiation every month out of which the packing credit may be liquidated. On payment of the bills, the limit of revolving credit will be reinstated to $ 1,00,000.

3. It is preferable for Neetu to opt for pre-shipment finance in rupees. Even though the pre-shipment credit in foreign currency (PCFC) interest rates are lower when compared to rupee credit, the viability of the scheme will depend on the forward dollar i.e. whether the dollar is appreciating or depreciating. Given a situation where the dollar is appreciating, it is advisable to borrow in rupees, as an appreciating dollar would result in additional rupees to the borrower. In the given case, if Neetu opts for PCFC, she will have to borrow dollars at an interest rate of 6% as against 9% payable on rupee funds. Secondly, as Neetu’s sale proceeds are denominated in dollars, she is not subjected to exchange risk. The net result would be a lower cost of capital. This obviously improves the profit margin.

On the other hand, if rupee depreciates by the time her sale proceeds are received, she will get more rupees than what she contemplated while arriving at the 17.6% profit margin. If excess flow of funds in terms of rupees is more than the outflow towards interest payment on rupee packing credit, the borrowing in rupees makes sense. Looking at the past trend and current fiscal/monetary policies of the country, we can presume that the rupee will continue to slide vis-à-vis the dollar. Hence, borrowing in rupees will be more profitable than packing credit in dollars.

4. Neetu should ask the owner of the retail outlet in the US for opening a revolving letter of credit of $1,00,000 operative between October 2001 and December 2001. A revolving letter of credit is comparatively cheaper than three LCs for a total amount of $3,00,000. It is also cheaper and hassle free when compared to three separate LCs for value of $1,00,000 each. Opening a single LC for a value of $3,00,000 would require incorporation of various terms and conditions like allowing shipments in installments, etc. calling for additional commission, etc. In view of this it is preferable to ask for a revolving LC for 3 months.

5. Every importer in India is required to possess a valid import license as well as an importer-exporter code issued by the licensing authority. Hence, before proceeding to import machinery, Neetu should make sure that these conditions are fulfilled. The opening of a letter of credit involves certain formalities. Neetu should first make an application in the required format to the banker requesting for opening the LC. Along with the application she should submit certain important documents like • The exchange control copy of the import license if required. • Pro forma invoice/indent/sale contract, etc. covering the goods to be imported.

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• Evidence of the Import-Export Code Number allotted by the Director General of Foreign Trade (DGFT) to the importer.

While submitting these documents she should take care to ensure that the • Application form is duly stamped and signed on all pages. • Application form is filled in completely and any alterations made are duly

authenticated. • Particulars furnished conform to the pro forma invoice underlying the letter of

credit. • Currency in which payment is to be made is in conformance with the permitted

methods of payment. If her application fulfills the trade control requirements, exchange control requirements, the

credit norms of Reserve Bank of India, the UCPDC and FEDAI guidelines and other internal procedures of the bank, an import LC may be opened by the bank in favor of the supplier of machinery.

Regarding the point as to whether she should retire the machinery bills from the current sale proceeds or by taking a term loan, Neetu would be well advised to take a term loan for retiring the bills. This is based on the view that as her business prospects seem to be bright and as she plans to expand in a big way in the near future, using the sale proceeds to retire the bills would most likely lead to a liquidity crunch which needs to be avoided by any entrepreneur. Hence, it makes more sense to take a term loan to repay the bills.

6. The various financial risks Neetu is exposed to are credit risk, interest rate risk and exchange risk. Credit risk is the possibility of the importer failing to make payment due to unforeseen circumstances. Similarly, interest rate risk is the risk of an adverse effect of interest rate movements on a unit’s profits. Neetu will be exposed to exchange risk because of the fluctuations of the rupee vis-à-vis the dollar. In case the dollar appreciates, the inflow of funds will increase, improving her profit margin. On the other hand, in case the dollar depreciates, then Neetu will find that her profit margins have shrinked. Neetu can hedge her exchange risk by entering into a forward contract. By entering into a forward contract, she locks-in the exchange rate at which she will buy or sell the currency.

Alternatively, Neetu can remain unhedged for the simple reason that the dollar has not depreciated/ traded at less than the previous day’s closing price. That being the reality, she need not go in for a forward contract.

Secondly, booking a forward sale contract would mean fixing up the rupee equivalent of the export order today itself and hence Neetu loses an opportunity to capitalize on market gains. This could be avoided if she can purchase a put option i.e. by paying an upfront premium, she can fix up her export bill value in rupees today itself while retaining the scope to capitalize from market opportunities. However, as this facility is still not available in the Indian markets, she has to choose between a forward contract or no forward contract (i.e. keeping her position open). As forward contracts can be bought any day after an export bill is raised, she may watch for the developments and if the dollars lose ground, then she may buy a forward contract instead of keeping her position open.

Case Study 2 1. Virginia Tobacco:

Cost of procuring Virginia Tobacco for executing the current order will be Rs. 60 x 1,00,000 kgs Rs.60,00,000

Additional raw material to be procured owing to wastage of 10% 11,111 kgs

Cost of procuring additional raw material Rs.60 x 11,111 6,66,660 Processing Charges 5% = 100,00,000 x 5/100 5,00,000 Inland Freight 2% = 100,00,000 x 2/100 2,00,000 Ocean Freight 6% = 100,00,000 x 6/100 6,00,000 Marine Insurance 1% = 100,00,000 x 1/100 1,00,000 Working capital requirement 80,66,660

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Burley Tobacco:

Cost of procuring Burley Tobacco Rs. 25 x 1,00,000 kgs Rs.25,00,000

Additional tobacco to be procured owing to wastage of 15%

100,00,000 x 100/85 – 1,00,000

= 17,650 kgs

Cost of procuring additional raw material Rs. 25 x 17,650 4,41,250

Processing Charges 5% = 40,00,000 x 5/100 2,00,000

Inland Freight 2% = 40,00,000 x 2/100 80,000

Ocean Freight 6% = 40,00,000 x 6/100 2,40,000

Marine Insurance 1% = 40,00,000 x 1/100 Rs.40,000

Working capital requirement 35,01,250

Total working capital requirement for executing the order (Virginia + Burley)

1,15,67,910

Add: Cost of cartons (750 GBP @ *Rs.66.75/£) 50,062.5

Total working capital requirement 1,16,17,972.5

* The Rs./£ is assumed to be Rs.66.75/£. The bank may sanction packing credit by keeping 10% or 15% margin as it deems fit,

against the estimated working capital of Rs.1,16,17,972.5. Working capital estimated and sanctioned for procurement of Burley Tobacco, though sanctioned need not be disbursed till the stocks are received from Jangareddy supplier.

2. The cost of the cartons is already inbuilt into the packing credit. As the company has a valid advance license for import, it may request the bank to remit advance payment by debiting packing credit and purchasing GBP in the spot market.

3. In order to execute the contract, VEPL will have to procure tobacco, process the same and export it to Moscow. The processed tobacco is to be shipped in cartons to be imported from UK. As procurement of raw material involves expenditure, the company is required to have packing credit limits with the bank. The packing credit limits are already calculated in Q. No. 1. Secondly, as cartons are to be imported from UK against advance remittance, the bank shall be asked to debit packing credit account and remit the amount to the supplier of cartons. Thirdly, the firm will be required to have post-shipment finance limits for negotiation of export bills under the LC.

In summary, VEPL should seek the following facilities: • Packing Credit (taking 10% as margin): Rs.1,04,56,175.25 • Letter of disclaimer stating non availment of packing credit on Burley Tobacco. • Post-shipment finance limit (85% of the value of export bill since LC itself is for

85% of invoice value): Rs.1,19,00,000 4. The company may request its banker to issue a letter to the supplier’s bank stating that no

packing credit has been availed against purchase of Burley Tobacco. Also, the supplier’s bank may be directed to send the invoice/bills, the documents to title, etc. to VEPL’s bank, against which the payment shall be made by the buyer’s bank on the due date. The purchase of Burley tobacco is on credit basis. However, the period of credit is not indicated in the case. On the assumption that the credit granted by the supplier is for one month and the LC to be opened by the importer of tobacco is a payment LC, then VEPL can be expected to receive the export proceeds within a period of one month. In such a case, it is not necessary for VEPL to avail packing credit against purchase of Burley tobacco as the realized export proceeds can as well be used to pay the supplier of Burley Tobacco.

Contrary to this, if the credit granted by the supplier is for one month and the export proceeds are expected to be realized within a period of 2-3 months from the date of

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shipment, then payment to the supplier of Burley tobacco (on the due date) can be made by debiting the packing credit account of VEPL. Incidentally, we have factored this into our estimate of packing credit limit under Q. No. 1. The packing credit may then be liquidated from the proceeds received on negotiation of export bills.

5. With regard to purchase of Virginia tobacco, the bank should release the stated cost in a phased manner to enable the party to procure the raw material. Packing credit in respect of incidental expenses will be released only at the time of incurring such charges.

As the bank has to make advance remittance of 750 GBP to the supplier of cartons, it is advisable to obtain a status report on the supplier of cartons.

In case of Burley tobacco, the bank shall issue a letter, stating that no packing credit has been availed by the buyer against procurement of the raw material. A request may be made to the supplier asking him to send the bills and the LR/RR to the bank. On receipt of the bills, the PC account may be debited and the amount remitted to the supplier. Packing credit in respect of other charges may be released only after the goods are received at the godowns of VEPL.

Similarly, disbursements towards freight charges, insurance, inland transport charges shall be disbursed at the appropriate time. Disbursements shall be preceded by inspection to the factory to verify the work in progress.

6. The exchange control regulations which are required to be adhered to are as follows. Since, the company has asked the bank to remit 750 GBP towards advance payment in

respect of import of cartons, the bank should ensure that the exchange regulations pertaining to this aspect are fulfilled. The importer is required to possess a valid import license for import of goods. VEPL will be required to produce evidence that the overseas supplier is insisting on advance payment. The goods should be imported within 3 months from the date of remittance (12 months in case of capital goods). The importer is also required to furnish documentary evidence of import within 15 days from the close of the relevant period.

In case goods are eventually not imported into India, the proceeds of advance remittance should be brought back into the country.

The stipulation that LC will be opened by the importer only after completion of pre-shipment inspection by the local representative of the importer is a risky proposition. It is as good as not opening an LC. This enjoins upon the importer the comfort of opening an LC at his own will. Given such a situation, the exporter having procured, processed and made the raw material ready for packing will be subjected to great financial strain as he has to look for a new buyer. Instead, the importer may be insisted upon to open the LC with a stipulation that the bills will be negotiated only upon the exporter submitting an inspection report from their local representative. This will protect the exporter’s interest. VEPL may be advised to take up this clause with the importer. Ultimately, it is up to VEPL and the level of confidence that VEPL has on the importer. Usually, in such cases, some banks may refuse to grant packing credit as there is no certainty of the export taking place.

Part V: Caselets (Questions) Read the caselets carefully and answer the questions preceding each caselet.

Caselet 1 1. FERA, the draconian law, has been replaced by FEMA with the objective of facilitating

external trade and payments and promoting the orderly development and maintenance of the foreign exchange market in India. Enumerate the major changes brought about with the introduction of FEMA.

2. The transition from FERA to FEMA has seen the Government of India revising the existing policy on outbound investments by introducing the automatic route in order to yield greater flexibility to the Indian businesses to undertake capital account transactions. List out the measures taken in this direction.

A LITTLE bird told me that exchange control in India had just vanished. The Foreign Exchange Management Act (FEMA), said the bird, had replaced the Foreign Exchange Regulation Act (FERA). Not that I don't trust the bird, but if we were really saying goodbye to exchange control, what did we need a new act for? All we had to do was to throw the old one away and forget all about it. Don’t be a cynic said the bird; look at the name of the new act; the word ‘regulation’ has gone and we have the word ‘management’ instead. It was true but I was still a bit confused. To my mind, Foreign Exchange Management was what the smart guys in bank and corporate treasuries did and this topic probably does not deserve a whole Act. The bird then added, “people say we are now convertible on the current account”. This whole thing deserved a closer look and since the word ‘management’ had replaced the word ‘regulation’ in the title of the act, I thought that I should begin by checking out the meaning of these two words. I am not sure if Webster’s New World dictionary is the last word on what words mean, but it is the only dictionary I have. I looked up the words ‘regulation’ and ‘regulate’ and found myself being led to the word ‘control’ to describe which the dictionary freely used terms like ‘to exercise authority’, ‘to direct or command’, ‘direct or regulate’ and ‘to curb or to restrain’. This fitted FERA to at. I had now to set aside the dictionary and start reading the new Act and the notifications that the Government and the RBI had issued. The objective of the new Act, I read, is “to facilitate the external trade and payments and promote the orderly development and maintenance of the foreign exchange market in India”. This is dramatically different from the objectives of the old Act, which made it clear that exchange control was the one thing it had in mind. Reading further I found that I could enter into foreign exchange transactions only with persons authorized by the RBI. I cannot ask my friend in the U.S. to buy me that special bird feed for the little bird and settle his dues by giving my hard-earned rupees to his parents here. The Act also told me that, ‘save as otherwise provided in this Act’ I could not “acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property outside India”. After reading just four out of the 49 sections that comprise FEMA I realized that exchange control was still lurking around. If the Act insists on telling us what we can do and what we cannot do, then we’re not talking foreign exchange management; we are talking exchange control. The bird was trying to swallow his disappointment when his eyes suddenly lit up. ‘look, look’, he said, “Sec. 5 says clearly that current account transactions are freely allowed. We are now convertible on the current account”. For a moment it looked like the bird was right; then I saw the second part of the section. It said that ‘in the public interest’, the Union Government, in consultation with the RBI, may, impose ‘reasonable’ restrictions on current account transactions. Foreign exchange can be drawn for all current account transactions, except those that are prohibited, while on the capital account, forex outflow is allowed only for transactions that are permitted. The Government and the RBI have issued a number of notifications under FEMA and these tell us what is permitted and what is not. It seemed while reading the bare Act that exchange control under FEMA could be almost as bad as under FERA, however, it was when the bird and I read the notifications that the full impact of the new regulatory regime hit us. Words like ‘considerable’, ‘substantial’ and ‘significant’ can be used to truthfully describe the liberalization that has been brought about.

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Caselet 2 3. On March 31, 2001 India crossed a crucial threshold in its decade-long journey of

integration into the global economy. The Exim Policy for 2001-2002 promises a sea change in the fortunes of several crucial sectors of the nation's economy. What are the main features of the Exim Policy 2001-2002.

4. Even though QRs have been dismantled to meet the WTO obligations, various safeguards have been put in place to protect domestic industry. Discuss.

A policy is as good as it finally emerges in actual effect. In a pervasive culture of incentives and concessions avidly lobbied by trade and industry, there are several announcements made with good intentions, many of which only engender cynicism. The hiatus between what is intended and what really materializes is not bridged. It is crucial that the evolution of the country’s trade policy keeps in constant focus the global context. The categorical imperative for the Indian Industry and business is to move up the value chain to get a higher return on exports. The bottlenecks which impede exports are both internal and external. In the external sphere, overt obligations and covert protectionism in diverse forms and dimensions demand utmost vigilance and skills on the part of the government and industry to pre-empt the onslaughts and push the country’s cause forward. Internal factors are more awesome. The country having lived for long on slogans and shibboleths now needs political dexterity and administrative acumen to alter the environment. An important character of the policy has to be of composite sanction of the entire government. Trade policy cannot be developed in isolation from other policies. The constraints to better export performance are deeply structural rather than those which can be redressed through marginal changes in trade policies and procedures. The EXIM policy must perforce enshrine a vision, a dream, a perspective and a focus for a quinquennium, clearly enunciating long-term perspective. It must also be explicit and unambiguous.

Caselet 3 5. What are the implications of WTO rules to Indian industries. Explain. 6. The world trade talks at Seattle saw open protests by representatives of many small

developing countries, at the undemocratic manner in which the meetings were being conducted and the complete neglect of their interest. Discuss the reasons for these protests and the predicament of developing countries on whether to join the WTO or not.

Trade in goods and services between countries has grown in complexity and dimension. Application of several legal procedures unique to countries have added more complications to international trade. Bilateral trade between countries means negotiation of terms and conditions for each country with several other countries. About five decades back, a need to standardize, regularize and make goods and services flow easily across borders was felt by several countries and they started negotiations on international trade. The period 1947 to 1993 witnessed eight rounds of negotiations to lay down a set of multilaterally agreed rules to govern international trade, through General Agreement on Tariffs and Trade (GATT). Started in Geneva with the participation of 23 countries in 1947, the negotiations were completed in 1993 in Geneva in the Uruguay round with the participation of 117 countries covering more than $300 billion worth of trade across borders. This final round also paved the way for the establishment of the World Trade Organization (WTO) from January 1, 1995 to facilitate implementation of all the agreements reached, regulate trade and to provide a common institutional framework for the conduct of trade and settlement of disputes between member countries. The final act signed at Marrakesh, Morocco consists of 15 separate agreements, negotiations, decisions and understanding. These agreements aim to provide more market access across member countries for products ranging from agriculture to industrial goods including special provisions related to textile and clothing. The increased and free trade between members shall take place with their commitment to reduce tariffs for goods, in some cases even zero tariff and also reducing or removing non-tariff barriers like surcharge, variable levies, price-control measures, quantitative restrictions etc. the members shall provide Most Favored Nation (MFN) status to other members and extend national treatment for imported products.

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Caselet 4 7. Discuss the impact of trade restrictions and explain how consumers will benefit with the

removal of quantitative restrictions. 8. What could be the possible reasons for opposition to QRs. In what situations does WTO

permit imposition of QRs. PROTECTIONISM is a burning issue in world trade today. Despite the repeated assertions by economists that world trade should be purged of this problem, it continues to affect commercial relations among nations and prevents the betterment of developing countries through greater participation in world trade. First, why the craving for free trade? First, freer the world trade, higher is the output likely to be. The emphasis of countries on their comparative advantages in production, would prevent wasteful diversion of resources. Second, being able to buy commodities from the world market at the best price will benefit consumers. Moreover, the higher the freedom in trade, the greater the probability of producers sacrificing leisure to innovate and improve the production process. Trade freedom would also arrest the growth of monopolies. The genesis and strength of protectionism in world trade has been explained differently by different authors. Traditional arguments center around the infant industry argument. However, while explaining the institutionalization of protectionism, Baldwin propounded that domestic trade barriers were purchased by domestic producers to maximize profits. The domestic demand for protection arises from the fact that huge rents would be lost in the absence of protection. In recent times, the barriers have been built into domestic competition policy. That trade protection would not have been effective but for the active role of the World Trade Organization in aiding and abetting this malaise must not be forgotten. The original GATT (48) had provisions for differential tariff structures within the Custom Union and Free Trade Areas. The 1948 GATT version also had specific provisions for government procurement, which was included in Article 3(8). Its most cardinal provision is that all those goods which the government procures not for resale and production should fall outside GATT. This was significant because trillions of dollars worth of goods and services were open to discrimination. Moreover, issues relating to the safeguard clause (Article 19, GATT-1948), exceptions for National Security and under Article 20 afforded protection. The final act of the Uruguay Round reduced the scope for protection in certain areas, but was equally responsible for increasing it in others. Its anti-dumping code requires special mention.

Caselet 5 9. Discuss some of the factors which make a country internationally competitive. 10. With respect to exports, the factors of competitiveness have radically changed, and those

other than prices can more than overcome the relative price disadvantage. Explain. GLOBAL competitiveness is not a new subject. The classical economists always judged and interpreted global competitiveness of a country with regard to a product by referring to the theory of comparative cost advantage which focussed on the natural resource endowment. Michael Porter, a contemporary authority on the subject, has condemned this traditional wisdom and talks of innovation and technology as determinants of global competitiveness. Porter is so obsessed with his conviction, that in one of his articles on ‘The Competitive Advantage of Nations’ published in the Harvard Business Review, he writes: “National prosperity is created and not inherited... A nation's competitiveness depends on the capacity of its industry to innovate and upgrade. Companies gain advantage against the world's best competitors because of pressure and challenge. They benefit from having strong domestic rivals, aggressive home-based suppliers and demanding customers.” A study of companies which have achieved international leadership will indicate that individually they might have followed different strategies in every respect, but their mode of operation will relate to creating something new which could be anything in terms of a product design, manufacturing process or marketing approach. The ultimate success is, however, linked with the industry-friendly environment in a given country.

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All these details are extremely relevant to our ongoing process of development and growth. We are now in the seventh year of structural economic adjustment. The basic objective of this exercise is to make India globally competitive and bring prosperity to the country. A new zeal for international trade development and growth is clearly discernible in the Indian industry and trade. Since this process or adjustment was launched, there was a fairly drastic change in the growth- and trade-related policies. Various policy initiatives which came about with liberalization included the deregulation of industries, scrapping of MRTP limit, devaluation of the rupee, withdrawal of cash compensatory support, marked changes in import trade regime, dilution of FERA and foreign exchange regulations, reduction of customs and excise duties and convertibility of the rupee.

In the wake of these changes, there has been a considerable pressure on the corporate sector to modernize, expand and cut costs. To take on this challenge, a number of companies are now entering into strategic alliances. Press reports often talk about mergers and acquisitions taking place in the country. With the fructification of capital account convertibility and services/sector reforms, this process is likely to gather momentum.

These developments apart, the international environment is characterized by a number of factors such as the establishment of the WTO, emergence of trading blocs and the disintegration of the Soviet Union, which further complicated the trading system. Given the situation, the only option available with the Indian corporate sector is to strengthen its international competitiveness and plunge into the global arena. Unfortunately, technology and innovation, which provide the basic strength to a company, were given a stepmotherly treatment in India.

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Part V: Caselets (Answers)

Caselet 1 1. With the introduction of FEMA, an attempt has been made to simplify the provisions of

FERA. The salient features of the act include –

• Full freedom to a person resident in India who was earlier outside India to hold or own or transfer any foreign security or immovable property situated outside India and acquired when he/she was resident there. Similar freedom is also given to a resident who inherits such security or immovable property from a person resident outside India.

• A person resident outside India is also permitted to hold shares, securities and properties acquired by him while he/she was resident in India. Similarly, a person resident outside India is also permitted to hold such properties inherited from a person resident in India.

• Exchange drawn can also be used for purpose other than for which it is drawn provided drawal is otherwise permitted for such purpose.

• The EEFC account holders and RFC account holders are permitted to freely use the funds held in EEFC/RFC accounts for payment of all permissible current account transactions.

• The rules for foreign investment in India and Indian investment abroad permit Indian companies engaged in certain specified sectors to acquire shares of foreign companies engaged in similar activities by share swap or exchange through issue of ADRs/GDRs up to certain specified limits.

• Proceeds of exports have to be brought in within 180 days but the reference to the due date has been deleted.

• The limit for permitting overdraft against NRE account balance has been raised from Rs.20,000 to Rs.50,000.

• The ceiling permitting overdraft in NRO accounts has been dispensed with. ADs may permit overdraft in such accounts as per their discretion and commercial judgement.

• The scheme for raising of foreign currency loans by residents from Non-resident Indians not exceeding US$ 250,000 would continue to be operated by Reserve Bank.

• The FEMA has placed more responsibility on the shoulders of the Authorized Dealers. RBI informed that it no longer will prescribe documentation for various categories of current account transactions which the authorized dealers will handle. The ADs will not only have to prescribe the documents, which their branches will have to ask for from their customers and verify but will also have to safe keep the same till verification by the Reserve Bank. The ADs will henceforth have an added responsibility to refuse in writing if they believe that the transactions offered was violative of the provisions of the Act and shall also have to report the details of the transaction to RBI if the AD has reason to believe that any contravention/evasion is contemplated by the customer.

• The definition of the term ‘person’ has been made fairly wide and it includes companies, firms, etc.

• A major change brought about is the definition of the term ‘person resident in India’. As far as individuals are concerned, now, such a person would be resident in India as soon as he has been in India for 183 days or more in any period of 365 days. The 183 days are to be reckoned, not with the financial year, but any period.

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2. As per the new policies, foreign direct investment can be effectuated under two broad categories viz., the ‘automatic’ route and the ‘normal’ route. Under the automatic route, investment not exceeding $ 50 million in a block of three years in JV/WOS abroad (not engaged in real estate or banking business) only requires filing of intimation with the RBI through an authorized dealer at the time of making remittance, or within 30 days of making investments in cases not involving remittance.

Accordingly, no prior permission is required to be obtained from the RBI for making investments under this route. Such investments may be funded either by the balance in exchange earner’s foreign currency (EEFC) account or internal accruals not exceeding 25 percent of net worth or up to 50 percent of the proceeds of ADR/GDR issues or a combination of any of the three sources. In order to meet the requisite net worth criteria, net worth of the holding company or the subsidiary company may be considered, subject to certain conditions.

Although the amended guidelines have liberalized investments, under this route in terms of amounts and procedures, the same will be subject to certain significant conditions which are as follows:

• The investing entity has earned profits during the preceding three years.

• Investment is in foreign entity engaged in core activity area (i.e. activity which constitutes at least 50 percent of the average turnover of the applicant in the previous accounting year). Therefore, it appears that investments proposed to be routed through an apex holding company outside India in downstream ventures will not satisfy this requirement.

However, in case of investment being made entirely from the EEFC account, the above conditions will not be applicable.

Financial services companies are permitted to invest in JV/WOS outside India, subject to the following additional conditions:

• The investing company is registered with the appropriate regulatory authority in India (against the earlier requirement of being registered either as Category I merchant banker with SEBI or as an NBFC under NBFC directions).

• It has a minimum net worth of Rs.150 million as per the latest balance sheet.

• It has fulfilled the prescribed capital adequacy requirements (against the earlier capital adequacy ratio of 8 percent).

Indian companies engaged in the sectors of information technology, entertainment software, pharmaceuticals and bio technology will now (in addition to the above automatic route) be permitted to acquire shares of a foreign company engaged in similar business in exchange of ADRs/GDRs issued to the foreign company, subject to the following conditions:

• The company has already made an ADR/GDR issue, which is listed on any stock exchange outside India.

• The investment does not exceed $100 million or an amount equivalent to 10 times the export earnings during the preceding financial year.

• At least 80 percent of the turnover in previous three financial years is from the above activities/sectors or the company has annual average export earnings of Rs.100 crore in the previous three financial years from those activities.

• The total holding in the Indian company by non-residents after the ADR/GDR issue does not exceed the sectoral cap prescribed by the foreign investment regulations.

• The valuation of shares is made in the prescribed manner.

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Caselet 2 3. Some of the main features of the exim policy 2001-2002 announced on March 31, 2001 are

as under:

• Quantitative restrictions totally dismantled.

• Standing group to be set up for monitoring import of 300 sensitive items.

• Policy focuses on accelerating export growth to achieve 1 percent of global trade by 2004-2005.

• Export growth rate targeted at 18 percent for the year 2001-2002.

• Import of new and second hand automobiles allowed, but subject to certain conditions.

• Exim policy schemes like duty exemption scheme and export promotion capital goods to be applicable to the agro sector.

• Promotion of agricultural exports through agri-economic zones and agricultural export policy.

• Import of agricultural products like wheat, rice, maize, other coarse cereals, copra and coconut oil been placed in the category of state trading.

• Market access initiative through a plan scheme.

• Strengthening of annual advance license scheme as part of changes in the exim policy.

• Extension of validity of duty free replenishment certificates from 12 to 18 months.

• Imports of moulds up to full CIF value of license allowed.

• FDI permitted under automatic route in SEZs except for small negative list.

• License for setting up units for items reserved under SSI not required.

• SEZ developers to get infrastructure status under IT Act.

• Rationalization of duty entitlement passbook scheme rates in line with changes in customs duty proposed in the Union Budget.

• Procedures simplified, exporter-DGFT interface cut down by reducing the number of committees from nine to four.

• Dialogue with the Finance Ministry and the Reserve Bank of India on re-phasing of Section 80 HHC, removal of anomalies in customs and excise duty structures with respect to electronic hardware sector.

• Extension of diamond dollar account scheme to diamond-studded jewellery exporters with average annual turnover of Rs.5 crore.

• Exporters allowed to carry gems and jewellery of up to $2 million value for overseas exhibitions.

• Export Oriented Units allowed to achieve minimum export performance of three times the value of capital goods over five years.

• Value restriction of $20 million for EOU project approval by development commissioner removed.

• Free imports of second hand capital goods up to 10 years old.

• Import of textile materials using prohibited dyes like AZO not allowed.

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4. The exim policy 2001-2002 has opened up the domestic industry to imported goods. However, domestic industry can take comfort in the fact that various safeguards have been put in place to protect them from this deluge. For instance, even though import of goods are permitted, the duties on such goods are set at very high levels. Similarly, take the case of second-hand car imports. Even though the exim policy allows import of second-hand cars, various conditions have to be fulfilled. The cars should not be more than three years old, must be right-hand drive and imported through the Mumbai port after paying a duty of 180 percent. Apart from this, a watch list of 300 items has been made and this list will be constantly reviewed and updated depending on the import patterns by a panel headed by the commerce secretary. QRs on a temporary basis will be imposed in case it is observed that imports are threatening the domestic industry. The government would also increase tariffs to bound rate levels wherever possible and make use of anti-dumping measures if required.

Caselet 3 5. WTO rules have facilitated free movement of goods and services across borders with rule

based system. In industrialized countries tariffs have been reduced on manufactured products by an average of 40 percent. This has resulted in the reduction of effective tariff from the pre-Uruguay round of 6.2 percent to the post Uruguay round of 3.7 percent. This reduced tariff provides greater opportunities to Indian products for export to developed member countries. The reduction in tariff shall also encourage the production of higher value-added items.

As per WTO agreements member countries should not prohibit or restrict trade by imposing quotas, licensing, or by any other measures. In tune with the WTO obligations, India has dismantled QRs on 715 items effective April 1, 2001.

Presently, there is a distortion in the international trade in agriculture. This is due to massive domestic subsidies given by industrialized countries to their agricultural sector over the decades. Since India is under BOP cover, it has not made any commitments regarding market access, reduction of subsidies or tariff. India has only bound tariff at 100 percent for primary products, 150 percent for processed products and 300 percent for edible oils. As developed countries have committed a reduction of subsidies and tariff, better market access should be available for our agricultural products.

The implementation of Trade Related Intellectual Property Rights (TRIPs) shall give a minimum international standard of protection concerning the availability, scope and use of Intellectual Property Rights (IPR) for each category of IPR, viz., copyright, trademarks, layout designs, etc. The implementation of IPR is likely to encourage domestic research, ease technology transfer and improve foreign direct investment.

India is required to implement product patents only in the year 2005. This requirement will have implications for food, pharmaceutical and chemical products and technological processes.

The Uruguay round brought the service sector for the first time into the multilateral system. The two obligations that apply to all services are Most Favored Nation (MFN) treatment and transparency by way of publication of all laws and regulations. Due to liberalization in the service sectors and the opening of the service sector to other member countries, many foreign service providers are likely to enter the country.

Though market access have improved for products from developing countries like India, if they are dumped in other countries, they will face anti-dumping duties. As soon as any anti-dumping action is initiated on any product imported from a developing country, the damage is inflicted on exports from that country. However, some relief is available to developing countries where the import of the product in a developed country does not exceed 3 percent from a developing country and does not exceed 9 percent for all developing countries, the affected developed country cannot claim for protection. As India’s export in many products is below the 3 percent level, at least in the early years, Indian companies would benefit.

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To sum up, domestic industries will be facing competition from imported goods flowing freely from other countries due to lower tariff. Goods produced within the country for domestic consumption by foreign companies using their own trademark and technology can also affect domestic producers. Outside India, our industries will face competition from other developing countries and also due to non-tariff barriers like environment, health, safety, prohibition of use of child labor and technical standard requirements.

6. The Uruguay Round negotiations resulted in an agreement that had little or nothing to offer smaller developing countries, especially the least developed countries. This was even officially acknowledged, in the form of a special clause promising ‘special and differential treatment’ to LDCs and giving them some concessions in the matter of opening up their own economies. In addition, some of the most well-publicized promises of the Uruguay round have failed to materialize. Even as the growth in value of world trade has decelerated and even turned negative since 1995, the situation of smaller and less developed countries has worsened within the overall deceleration. The inequalities of the international trading system appear to have been strengthened, rather than diminished. Also, since the WTO came into existence, in the four years that followed, the average rate of export growth of developing countries was actually lower than in the previous four year period. Given all this, it was but natural for the developing nations to protest at the unfair treatment being meted out to them.

Regarding, the predicament of developing countries, it is observed that if they stay out of GATT and WTO membership, they would be forced into costly and unbalanced bilateral negotiations which they cannot afford and in which they would be severely disadvantaged. On the other hand, inside the WTO, they find that their legitimate concerns are not met. In spite of this, many LDCs are still eager to become members of the WTO, because the fragility of their economic conditions make them long for some degree of multilateralism and basic ground rules. Given this fact, the only hope for the developing countries would be greater unity and an emphasis on concerted positions in international forums to press for their common interests.

Caselet 4 7. Imposition of quantitative restrictions on goods has negative effects for consumers. While

tariffs increase the cost of imports, quantitative restrictions are basically aimed at restricting volumes. Impositions of QRs restricts the supply, thus increasing prices significantly.

To explain this, let us take a scenario where there is free trade. Assuming that the international price of a particular product is P, domestic consumers will be able to procure that product at a price of P plus other costs like freights, local levies, etc. When trade restrictions are imposed, the supply-demand equilibrium is disturbed and the equilibrium is achieved at higher prices.

Imposition of import duties increases the price to P1 (higher than P) which is the price domestic consumers have to pay to procure that product. The difference between P and P1 is the import duty. In such a case, the competitiveness of the domestic industry increases and the share of the supply for quantity demanded increases further in favor of domestic producers. In the case of a tariff-based protection, the higher costs imposed by the tariffs partly accrues to the government in the form of customs revenues.

When quantitative restrictions are imposed, supply of goods by international producers is limited. Because of this, the price at which goods can be supplied increases to P2, (higher than P1). Moreover, domestic industry acquires a major share of the quantity supplied. The higher cost paid by the consumers accrues to the domestic industry and stakeholders in the industry.

When QRs are removed, the increase in prices as a result of trade restrictions is reversed. The transition from quantitative restrictions to a regime where free trade prevails, results in decline in prices, increase in imports and reduction in the market shares of domestic

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producers. However, competitive domestic producers benefit as a decline in prices also expands the volume of trade.

Against this backdrop, with tariff-based protection replacing non-tariff based protection on around 714 items this year (mostly consumer goods) there is the possibility that imports might increase and depress the domestic prices to the advantage of the consumer. However, this will be possible only if tariffs are at levels at which imports can be competitive. As such even with the removal of QRs, the level of protection to the domestic producers is high in the form of tariffs.

Irrespective of this, the removal of quantitative restrictions is bound to have a positive fallout. With price increases being dictated by international trends and, impact of technology on international production practices, prices of most consumer goods is expected to come down.

8. The opposition to QRs stems from economic theories supporting the cause of free trade and the law of comparative advantage, which states that countries should focus on activities in which they are cost-competitive. This will help countries profit from their exports. Apart from this, wastage of precious resources used in the manufacture of products can be avoided by importing the same at a lower cost. In order to benefit from this, free trade or at least trade with fewer restrictions is required. The WTO is said to be moving in this direction, though its critics have claimed that WTO is a platform used by developed countries who are interested only in monopolizing trade.

WTO allows QRs in certain exceptional instances which are classified into economic and non-economic reasons. The former include critical shortages of foodstuffs; to protect balance of payments; for instituting restrictions that are necessary for international trade; and import restrictions on agricultural and fisheries products. The latter include measures intended to protect public morals, or protect the life or health of humans, animals or plants, and security reasons.

Caselet 5 9. One of the factors which determine a country's global competitiveness is its share in world

export. Availability of abundant natural resources can only give a kickstart to international competitiveness. Sustaining it requires updated technology, better productivity and product differentiation.

Another factor which determines global competitiveness is the scale of operation. The scale of operation in international industries is many times larger when compared to India. This gives them a distinct cost advantage.

The huge local market is yet another factor which helps generate global competitiveness. The available business opportunities can be exploited by investing in mega size plants and inducting new technology. This helps a country to get prior information of the customer’s need than what the foreign buyer can provide.

Intense competition among domestic rivals also helps in achieving global competitiveness. All nations with leading international positions have strong local rivals. For example, take the case of television and camera industries in Japan. In both these sectors, there are at least a dozen vigorously competing units. This example belies the notion that limiting the number of competing industries to one or two gives a country the benefit of scale of economy.

The competence of supplier industries is another factor that determines the competitive advantage in international markets. Modern and technically advanced supplier industries have helped the Italian stone industry, the American computer and Japanese fascimile machines attain the top position in international markets. India can attain the same provided it makes optimum use of its resources to develop its capital goods and other supplier industries.

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10. In recent years, the factors of competitiveness have radically changed. It is developing capabilities to withstand unfavorable prices by differentiation and through getting together, more crucially through investing in knowledge of the emerging market, and recognizing the need for customization which are likely to determine competitiveness. Export empirics are such that the natural resources and cheap labor in themselves are no more the sources of comparative advantage. Capital also is mobile around the world. Technology is unbundled and can be bought. In respect of cost of capital and risk management, exporters need to take advantage of special products offered by the banking system particularly in the face of global recession. The special products include export factoring, forfaiting and electronic banking. There has been a radical change in business paradigm in the changing world. Incentives and other exemptions have been pared as they increase transaction costs and make the business complacent, dependent on crutches for initiatives.

Part IV: Model Question Papers (with Suggested Answers)

Each model question paper consists of two papers – Paper I and Paper II. Paper I contains three parts – A, B and C. Part A is intended to test the conceptual understanding of the students. It contains around 30 multiple-choice questions carrying one point each. Part B contains problems and caselets with an aggregate weightage of 46-50 points. Part C consists of essay-type questions with emphasis on practical applications carrying about 20-24 points. Paper II consists of a Case Study and Caselets to test the skills of the candidates in adopting an integrated approach to either real or simulated situations. The case study tests primarily the quantitative abilities of the candidates whereas the caselets test qualitative aspects. Students are requested to note that this is an indicative format of the question paper in general and that the ICFAI University reserves the right to change, at any time, the format and the pattern without any notice. Hence, the students are adivsed to use the model question papers for practice purposes only and not to develop any exam-related patterns out of these model question papers. The suggested answers given herein do not constitute the basis of evaluation of the students’ answers in the examination. These answers have been prepared by the Faculty Members of the ICFAI University with a view to assist the students in their studies. And, they may not be taken as the only answers for the questions given.

Model Question Paper 1 Time: 3 Hours Total Points: 200

Paper I Part A: Basic Concepts (30 Points)

Answer all the questions. Each question carries one point. 1. If India runs a current account deficit it implies that a. The Indian Government is running a budget deficit b. India is running a trade deficit c. Tax revenues are not enough to meet the Indian Government’s expenditures d. The capital account balance combined with change in RBI’s reserves has a positive

value, if there are no statistical discrepancies e. Capital inflows are not adequate. 2. Deregulation and globalization of the financial markets increase the volatility in a. Interest rates b. Exchange rates c. Prices of financial assets d. All of the above e. Both (a) and (b) above. 3. Which of the following transactions is not recorded in the current account section of the

BoP statement? a. Portfolio investment by foreign institutional investors. b. Remittances made by non-resident citizens of the country into non-repatriable bank

accounts opened in the country. c. Dividend and interest income repatriated by foreign institutional investors. d. Repayments by the government of foreign currency debts. e. Both (a) and (d) above.

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4. A country which has instituted a Currency Board would

a. Increase money supply if home currency tends to depreciate

b. Decrease money supply if foreign currency tends to depreciate

c. Decrease money supply if home currency tends to depreciate

d. Adjust the peg if home currency tends to fluctuate

e. None of the above.

5. Which of the following is an instrument designed by the IMF to overcome the international liquidity problem?

a. ADR

b. GDR

c. SDR

d. Eurodollar

e. Euro.

6. Which country’s Central Bank has built up a high level of credibility for fighting inflation?

a. England

b. India

c. France

d. Denmark

e. Germany.

7. Currency A appreciates by 50% against currency B. Which of the following will then be correct?

a. B depreciates against A by 50%.

b. B depreciates against A by 40%.

c. B depreciates against A by 35%.

d. B depreciates against A by 33%.

e. Data given is insufficient.

8. You have collected the following quotes.

SF/$: 1.50/1.52 FF/$: 5.80/5.90

What is the FF/SF cross rate?

a. 3.82/3.93

b. 3.82/3.87

c. 3.87/3.93

d. 3.82/3.84

e. None of the above.

9. The inflation in India is 8% and that in US is 3%. The Indian rupee can be expected to depreciate over a period of 1 year by:

a. 4.5%

b. 4.6%

c. 4.7%

d. 4.9%

e. 5.0%.

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10. If interest rate in UK is 10% and in US 6% and the dollar is trading at a 3-month forward premium of 3% against the sterling, it makes sense to:

a. Borrow dollars and invest in sterlings

b. Borrow sterlings and invest in dollars

c. Invest in sterlings

d. Invest in dollars

e. None of the above.

11. The DM is trading at a 3-month forward discount of 5% against the sterling. If the sterling interest rate is 6%, what should be the DM interest rate?

a. 10.95

b. 11.00

c. 11.05

d. 11.10

e. 11.15.

12. The equality of the forward premium/discount between two currencies and the interest rate differential between those currencies is known as

a. Purchasing power parity

b. Interest parity

c. Expectation theory

d. Fisher open hypothesis

e. None of the above.

13. If the interest rate parity and relative purchasing power parity hold good then

a. Absolute purchasing power parity holds good

b. Real interest rates are equal to nominal interest rates

c. Real interest rates are approximately equal to the difference between nominal interest rates and inflation rates

d. Both (a) and (b) above

e. All of (a), (b) and (c) above.

14. The important principles of international product life cycle theory are

a. Technical innovation

b. Perfect competition

c. Market structure

d. All of the above

e. Both (a) and (c) above.

15. The various reasons for the imposition of trade barriers are

a. To protect an infant industry with tremendous growth potential

b. To increase the demand for domestic products

c. To improve the BOP situation

d. Tariffs are a source of revenue for the government.

e. All of the above.

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16. Which of the following theories of international trade explains the trade between two countries having similar factor endowments and consumer tastes?

a. Theory of absolute advantage.

b. Theory of comparative advantage.

c. Heckscher-Ohlin model.

d. Imitation gap theory.

e. International product life cycle theory.

17. If we know that American agriculture is the most efficient in the world, we may say that

a. If America is also more efficient in the production of all other goods, there could be no gains from trade

b. It would never pay America to import food

c. It would always pay America to import food

d. America might or might not be a food importer

e. America clearly never exports food.

18. While quoting exchange rates, authorized dealers deal with exchange margins and bid-ask spreads. Which of the following is/are true?

a. Exchange margins and bid-ask spreads are subject to a cap prescribed by FEDAI.

b. Bid-ask spreads are subject to caps by FEDAI.

c. Exchange margins are subject to caps by FEDAI.

d. Bid-ask spreads are subject to cap prescribed by RBI.

e. Both (c) and (d) above.

19. International transfers from abroad means transferring of

a. Goods produced by the developed countries to underdeveloped countries without consideration

b. Goods from one country to another due to bilateral agreement

c. Transfer of assets from one country to another country without consideration

d. Both (a) and (c) above

e. All of (a), (b) and (c) above.

20. Which of the following is not a current account item in the Indian Balance of Payments statement?

a. Receipts in foreign exchange from foreign travelers.

b. Premium on all kinds of insurance provided by Indian insurance companies to non-resident clients.

c. Profits remitted by the foreign branch of an Indian company to the parent.

d. Deposits in NRE accounts and FCNR accounts.

e. None of the above.

21. The different forms of trading blocks are

a. Free trade area

b. Customs union

c. Common market

d. Economic union

e. All of the above.

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22. The effects of trade barriers are a. Inefficient production by local producers b. The consumption of a high priced imported good will be reduced c. Tariffs generate revenue for the government d. All of the above e. Both (a) and (b) above. 23. TRIPs stands for a. Trade Related Aspects of Intellectual Property Rights b. Trade Review of Intellectual Property Rights c. Trade Review of Intelligent Property Rights d. Trade Related Aspects of Intellectual Policy e. None of the above. 24. Which of the following is an international cartel? a. OPEC b. UNCTAD c. NAFTA d. ECM e. None of the above. 25. ITC(HS) refers to a. Import Trade Control (Harmonized System) b. International Trade Control (Harmonized System) c. International Trade Control (Harmonic System) d. Indian Trade Classification (Harmonized System) e. Indian Trade Classification (Harmonic System). 26. Identify the incorrect statement. a. A confirmed letter of credit has the guarantee of not only the opening bank but also

the confirming bank. b. Only irrevocable letters of credit can be confirmed. c. The confirming bank will add its confirmation only if requested by the opening bank. d. A confirmed letter of credit is slightly costlier than other forms of LCs. e. Confirming banks are usually located in the country of the buyer. 27. When the goods are delivered to the shipping company for transportation, at first a

temporary receipt is issued by the shipping company. This receipt is known as a. Bill of lading b. Mate’s receipt c. Seaway bill d. Freight receipt e. Liner way bill. 28. Banks have to extend a minimum of _____ % of net bank credit to the export sector. a. 5 b. 7 c. 10 d. 12 e. 15.

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29. Proposals for export on elongated credit terms should be submitted in ____________ to the regional office of the Reserve Bank of India.

a. Form A2 b. Form ECB1 c. Form ENC d. Form ECT e. Form XOS. 30. Applications connected to advance remittance in respect of imports into India should be

made in a. Form ECB b. Form A1 c. Form A4 d. Form ECB1 e. Form ECB2.

Part B: Problems (50 Points) Solve all the problems. Points are indicated against each problem. 1. As a dealer in the bank, you observed the following quotes in the market. Rs./$ 42.18 42.60

Rs./£ 68.59 69.96 Rs./Euro 46.25 47.17

Compute the cross rates for $/£ and $/Euro. (6 points)

2. A corporate treasurer is trying to hedge the foreign currency risk associated with a loan of face value $1,000,000. Interest is payable semi-annually on the loan at the rate of 8% p.a. The principal will be repaid after 2 years. Since forward contracts are available only for a maximum period of 6 months, the treasurer has decided to use a roll over forward cover. If the loan is availed of on 1/1/98 and interest payments begin from 1/7/98, work out the effective cost of the loan. Assume that the exchange rates on the dates of roll over of the forward contract are as follows:

Date Exchange rates (Rs./$) Spot 6 months

1/1/1998 41.00/41.50 41.40/41.90 1/7/1998 41.45/41.95 42.00/42.50 1/1/1999 42.15/42.70 42.50/43.10 1/7/1999 42.45/43.00 43.15/43.70 1/1/2000 43.10/43.70 43.60/44.20

(12 points) 3. Assume that you are free to borrow/lend in any market and that active spot and forward

markets are accessible to all parties in Rupee against any currency. The market rates are as under:

Rs./DM spot 20.98 21.39 3-m forward 21.82 22.62 3-m interest rates Rs. 17.50% 18.50% DM 5.75% 6.25%

Verify whether an opportunity for covered interest arbitrage exists. (8 points)

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4. An US based MNC typically has the following transactions among its subsidiaries every month.

Y = UK parent pays US subsidiary £ 1,000,000

Y = US subsidiary pays UK parent £ 800,000

Y = UK parent pays German subsidiary £ 500,000

Y = German subsidiary pays UK parent £ 500,000

Y = US subsidiary pays German subsidiary £ 1,000,000

Y = German subsidiary pays US subsidiary £ 800,000 The following are the average spot rates during the month: DM/£ : 2.00/2.05 DM/$ : 1.80/1.82 How much can the MNC save by netting the transactions?

(8 points) 5. A German subsidiary of an US based MNC has to mobilize working capital for the next

12 months. It has the following options: Loan from German bank : @6%

Loan from US parent : @5% Loan from Swiss bank : @2%

Banks in Germany charge an additional 0.5% towards loan servicing. Loans from outside Germany attract withholding tax of 10% on interest paid. If the interest rates given above are market determined, examine which loan is the most attractive.

(10 points) 6. Bank ‘B’ which is the negotiating bank under an irrevocable letter of credit receives a bill

of lading from its customer. The bill of lading bears a printed clause that the carriers have a right to transship the goods although the underlying letter of credit prohibits transhipments. Can Bank B accept the following bill, keeping in view the provisions of UCP 500.

(6 points)

Part C: Applied Theory (20 Points) Answer the following questions. Points are indicated against each question. 1. The Hong Kong dollar has remained at 7.78 to the dollar for the past 15 years, barring

minor variations. This has been so despite huge inflows and outflows of capital in Hong Kong’s open economy. Explain how the Hong Kong dollar could have remained steady even as currencies of relatively closed economies such as India have been far more volatile.

(6 points) 2. Almost a year after the Asian currency crisis began, the following were the short-term

interest rates prevailing in different countries in the last week of May, 1998. Indonesia : 45.50% Thailand : 21.00% S. Korea : 17.70% Philippines : 14.43% Malaysia : 11.04% Hong Kong : 8.05% Taiwan : 7.15% Singapore : 6.50%

a. Explain the reasons for the wide divergence in interest rates across the countries. b. Explain the linkage between the strength of a currency and interest rate.

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c. According to interest parity principle, when interest rates are relatively high for a currency it should depreciate and vice versa. Yet, central banks often raise interest rates to prop up a currency. Explain how the two positions are consistent.

d. Why do you think the Indian Rupee did not depreciate significantly when other Asian currencies were tumbling?

(9 points) 3. ‘X’ wants to import certain items falling in the negative list of imports. Given the fact that

every importer in India is required to possess a valid import license, you are required to explain in detail to ‘X’ about the usage of an import license as well as the various categories of import licenses.

(5 points)

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Paper II Part D: Case Study (50 Points)

Read the case carefully and answer the following questions. 1. Is VUK subject to exchange risk? How, if at all, do your analysis and conclusions differ

from those of Ms. Ronningen? (8 points)

2. If the product prices are indicative of the inflation levels in US and UK, verify whether relative purchasing power parity is holding good over the periods 1974-1979 and 1978-1983.

(16 points) 3. What is the nominal and real depreciation of British Pound?

(8 points) 4. Should Vulkan refund the pound debt it used for the acquisition of BMC and replace it with

dollar financing? Why or why not? What criteria are you using to reach your decision? (6 points)

5. The losses incurred by the company are due to transaction exposure and operating exposure as well. Explain the term transaction exposure and operating exposure and justify whether you agree with the above statement.

(12 points) British Materials Corporation

In January, 1981, Vulkan Inc., a US firm relatively new to international business acquired British Materials Corp., or BMC an English firm. BMC operated two detinning plants in England, one in Manchester and the other in Brimingham, and a scrap collection depot just outside of London. Detinning involves the separation and recovery of tin and detinned steel from tinplate scrap. The principal sources of tinplate scrap are the waste cuttings and stampings from the manufacture of articles made from tinplate trimmings and rejects from steel companies that manufacture tinplate. Both the steel and the tin recovered in this process are high-quality, high-purity premium metals. BMC was the only detinning company operating in the United Kingdom and had established clear domination of the industrial tinplate scrap market. At the time of its acquisition, approximately 80% of BMC’s scrap supply was provided by 39 tinplate fabricators, the largest of which provided nearly half of BMC’s scrap. BMC did not buy the scrap supplied to it by these firms. Rather, it had signed contracts with them to process their scrap for a fee. These contracts all had similar provisions. They were cost-plus, and they prescribed a profit to BMC equal to 15% of the prices BMC received for the detinned steel and the recovered tin. Costs covered by the contracts included all variable costs as well as an agreed upon amount for fixed costs excluding depreciation and financing charges. The management of Vulkan felt that the fixed-cost recovery provisions were adequate to cover projected out-of-pocket fixed costs. The remaining 20% of BMC’s tinplate scrap requirement was met through open market purchases. Detinned steel recovered by BMC was sold primarily to British Steel, with the remainder exported to companies in Western Europe. During 1974-1976, only 2% of BMC’s detinned steel sales revenue arose from foreign sales, whereas 33% of its 1980 sales revenue came from export sales. Most of the tin recovered is sold to various firms in the market areas surrounding the detinning plants. These firms convert the tin into inorganic tin chemicals consumed by the glass, plating, and chemical industries. The acquisition of BMC was effected through Vulkan’s newly formed United Kingdom subsidiary, Vulkan UK or VUK, which purchased all of the outstanding common and preference shares of BMC. Subsequently, BMC and its primary subsidiaries were liquidated into VUK. As it considered the alternatives for funding this acquisition a paramount concern of Vulkan was the possible foreign exchange exposure associated with the sterling revenues and costs generated by

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VUK. On the basis of 1980s proportions of pound sterling and US dollar-denominated sales, and assuming that sterling prices were invariant to exchange rate changes, Vulkan tested the sensitivity of VUK’s income and debt-service capacity to likely changes in the dollar-sterling exchange rate. These analysis tended to indicate that dollar-denominated earnings and cash flows were sensitive to exchange rate fluctuations. In addition, Thomas Alan, Vulkan’s financial vice-president, consulted with several investment and commercial bankers. A typical opinion is the one from Diane Ronningen, the partner in charge of international finance at the investment banking firm of Ronningen and Simnowitz (see Exhibit I). To minimize the economic gains and losses on its investment in BMC resulting from fluctuations in the rate of exchange between the US dollar and the pound sterling, Vulkan concluded that the acquisition should be funded entirely in pounds sterling. This decision was based on the following factors: • All BMC’s assets would be denominated in pounds sterling; • The high probability that most, if not all, of BMC’s future revenue and costs would be

denominated in pounds sterling or would be determined on a pound sterling-equivalent basi;

• Vulkan’s projected income and debt-service sensitivity analysis; • UK and US tax laws and UK corporate law; • The advice of Vulkan’s investment and commercial banks. Accordingly, in January, 1981, Vulkan and VUK borrowed £2,355,000 and £1,137,000, respectively, for 10 years on a floating-rate basis (LIBOR plus a margin) to fund part of the purchase of all the outstanding common and preference shares of BMC. The balance of the purchase price was funded by VUK’s borrowing under a sterling overdraft facility and its issuance of short-term sterling notes. VUK’s obligations were not guaranteed by Vulkan. On the date of these borrowings, the exchange rate was $2,4060:£1.00. It should be emphasized that Vulkan decided to finance its acquisition of BMC with sterling debt to hedge against the effects of unanticipated exchange rate changes, not to profit from the possibility that sterling would devalue by more than the amount already reflected in the sterling:dollar interest rate differential. Pursuing the latter objective would have constituted currency speculation, not hedging. And it was an article of faith among Vulkan’s management that its comparative advantage lay in production and marketing, not in currency speculation. During April, 1983, the average US dollar:pound sterling exchange rate was $1.5362. On the basis of quarterly exchange rates between 1981:1 and 1983:1, the nominal or actual, sterling depreciation against the dollar was 33.6%. In real or inflation-adjusted terms, using the implicit price indices in both countries to measure inflation, sterling depreciated 31.0%. This significant and rapid depreciation of the pound sterling in both nominal and real terms raised the question: Had the sterling borrowing to finance the acquisition of BMC provided an effective hedge of the economic foreign exchange exposure believed to be inherent in its operations? Vulkan’s management accordingly decided to re-examine its original conclusion that the acquisition of BMC created a `long’ pound sterling exposure. Although Ms. Ronningen’s reasoning still seemed persuasive, Mr. Alan has decided to call in an independent consultant, Robert Daniels, for a second opinion of the advisability of funding VUK with pound debt. Mr. Daniels, who is noted for his expertise in the area of currency risk management, requested all available data on BMC’s past operations. Thomas Alan managed to assemble operating data for BMC from the first quarter of 1974 through the first quarter of 1983. Due to unusual transactions that occurred during the second quarter of 1981, he decided to exclude these data. In addition, Mr. Alan included the average exchange rate (dollars:pound), as well as some price data on detinned steel, for each quarter. These data are contained in Exhibit II. Now it was up to Mr. Daniels to interpret these data and come to some conclusion concerning the extent to which VUK was subject to exchange risk. His opinion would have a major impact on whether Vulkan would maintain its pound sterling debt or refund this debt and replace it with dollar financing.

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Exhibit I: Opinion on BMC’s Exchange Risk January 05, 1981

Mr. Thomas Alan Vice-President – Finance Vulkan, Inc. 30 Golden Triangle Pittsburgh, Pennsylvania 15217

Dear Tom:

Following our recent conversations, I am writing to give you our thoughts on the appropriate currency Vulkan should use for financing the acquisition of British Materials Corp. (BMC). You have asked specifically that we review alternatives in pounds sterling, US dollars, Deutsche marks, and Swiss francs. We believe that financing the acquisition of BMC with sterling or a sterling equivalent makes the most financial and business sense. It is sterling revenues and income which BMC generates in its daily operations and sterling which Vulkan would then have available to service any debt used for the acquisition. If BMC were a substantial exporter or competed in the United Kingdom against firms which set their prices on a dollar base (e.g. the UK computer industry, North Sea oil, etc.) the appropriate currency might be dollars. Since this is not the case, a financing in dollars places an unnecessary foreign exchange exposure burden on Vulkan. Vulkan’s primary business is not currency speculation. Since neither you nor we know the future movements of the sterling exchange rate over the next few years and since sterling has been one of the most volatile and least predictable currencies in the world recently, incurring such an exchange risk would, in our opinion, be ill-advised. Borrowing on the Deutsche mark or Swiss franc markets on an unhedged basis to fund the acquisition makes even less sense for Vulkan since you have no natural exposure in either of these currencies. On a hedged basis, the cost would theoretically be similar to those for the dollar borrowing alternative. I hope this letter clarifies our recommendations. Please don’t hesitate to call if you have questions. Best regards. Sincerely, Diane M. Ronningen Senior Partner Ronningen & Simnowitz

Exhibit II: Operating Data for BMC 1972-1983

Year: Quarter

Exchange Rate1

£Cash flow

(BIT)2

£Cash flow

(BDIT)3

Home Price4

Export Price5

Average Price6

72:1 2.599 – – – – – 72:2 2.599 – – – – – 72:3 2.445 – – – – – 72:4 2.364 – – – – – 73:1 2.420 – – – – – 73:2 2.530 – – – – – 73:3 2.480 – – – – – 73:4 2.379 – – – – – 74:1 2.279 127.000 51.000 21.190 25.860 21.930 74:2 2.397 186.000 142.000 28.020 36.280 28.920 74:3 2.350 –11.000 –57.000 34.040 – 34.040 74:4 2.330 220.000 171.000 39.120 51.500 39.570

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Year: Quarter

Exchange Rate1

£Cash flow

(BIT)2

£Cash flow

(BDIT)3

Home Price4

Export Price5

Average Price6

75:1 2.391 325.000 280.000 40.740 – 40.740 75:2 2.325 392.000 345.000 36.720 38.400 36.750 75:3 2.129 235.000 175.000 35.160 29.990 35.030 75:4 2.043 354.000 305.000 33.610 30.140 33.430 76:1 2.000 32.000 –10.000 39.010 – 39.010 76:2 1.807 693.000 648.000 48.010 – 48.010 76:3 1.767 416.000 363.000 40.490 – 40.490 76:4 1.651 207.000 154.000 39.300 – 39.300 77:1 1.714 65.000 40.000 36.290 – 36.290 77:2 1.719 –54.000 –146.000 35.050 28.180 33.350 77:3 1.735 417.000 365.000 32.250 26.410 30.410 77:4 1.815 688.000 638.000 29.600 22.460 27.040 78:1 1.927 53.000 2.000 29.240 21.900 28.020 78:2 1.835 597.000 539.000 33.360 30.610 32.830 78:3 1.932 401.000 342.000 38.830 35.760 38.250 78:4 1.984 800.000 728.000 45.230 42.210 44.690 79:1 2.016 –35.000 –94.000 57.800 65.380 58.350 79:2 2.080 616.000 553.000 59.580 53.420 58.530 79:3 2.232 760.000 693.000 60.310 47.400 58.420 79:4 2.159 829.000 760.000 51.890 47.390 50.450 80:1 2.254 186.000 109.000 53.750 51.410 52.770 80:2 2.285 379.000 299.000 46.870 46.360 46.640 80:3 2.381 120.000 27.000 35.290 36.190 35.870 80:4 2.386 –141.000 –246.000 30.910 31.280 31.120 81:1 2.310 838.000 803.000 34.620 33.310 34.180 81:2 2.081 – – 35.130 39.270 35.990 81:3 1.837 332.000 274.000 35.920 38.930 36.600 81:4 1.884 545.000 477.000 39.720 35.530 39.210 82:1 1.887 552.000 496.000 47.880 40.320 46.150 82:2 1.780 177.000 116.000 42.260 45.620 42.920 82:3 1.725 5.000 –60.000 41.740 44.720 42.360 82:4 1.650 370.000 297.000 35.310 28.880 36.180 83:1 1.534 –57.000 –171.000 36.140 37.920 36.500

1 Average spot exchange rate during the quarter (US dollars/British pounds).

2 Cash flow equals income before interest and taxes plus depreciation plus or minus changes in working capital.

3 Same as in note 2 but without depreciation.

4 Average sales price in UK in £/ton.

5 Average export sales price in £/ton.

6 Volume weighted, average total sales price in £/ton.

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Part E: Caselets (50 Points)

Caselet 1 Read the caselet carefully and answer the following questions. 1. A Central Bank is concerned with the domestic value of the currency. How is it linked to

the external value of the currency? (6 points)

2. The caselet advocates that FDI is better than FII. Do you agree? Justify. (4 points)

Last month the Group of Seven came out with a series of initiatives to lay the groundwork for an improved international financial system. The objective is to mitigate the possibilities of the kind of crisis many countries in Latin America and, more recently in East Asia, have suffered from. The proposals include: • Stronger supervision of creditor institutions like investment and commercial banks, hedge

fund, etc. • Greater transparency on the part of the IMF as also debtor nations’ financial systems. • A new contingency finance mechanism for the IMF to channel short-term funds to basically

sound economies which may suffer from the `contagion’ disease. • Caution about capital market liberalization. On the last point, one remains unclear whether the G7 supports strong regulation of cross-border flows of short-term capital. The case for free capital movements, which the IMF has been advocating strongly, rests on several grounds. The first of course is that controls on capital movement inhibit the freedom of the investor to invest his money in the manner he thinks fit. But, at the basic level, the imposition of direct tax itself is a draft by the state on the earnings of its citizens, and should, therefore, be equally questionable. The state’s right, indeed sometimes duty, to regulate the manner in which an individual can use his assets is a fact of modern governance. The issue is not so much one of principle as of whether the regulation promotes general good. The second argument favoring free movement of capital is that it will seek opportunities where returns are highest and put the world’s savings to the most efficient use. In theory, this argument is of course true. But is it equally true in the real world where investors and lenders are often driven by the herd instinct rather than by rational analysis? The reason for such behavior is simple. The risk-reward relationship for the decision makers is heavily weighted in favor of following the herd. If ten others are making money in, say, Mongolia, and you choose not to go and make lesser returns at least in the short-term, you are open to question. On the other hand, if you follow them and end up losing money along with them, the decision maker is rarely blamed. His losses get accepted and condoned since these have been incurred along with many others. No wonder, therefore, that following the herd, whether while going in or retreating, is the norm, and a Warren Buffett kind of investor, totally unconcerned about short-term returns, is an exception. In reality `funds seeking the best returns’ argument is at best a hope, at worse a myth. The third argument against any restrictions on capital movements is that they tend do be evaded. True. Yet, to my mind, this is the weakest of the arguments favoring free capital movement. A parallel would be that since thefts occur despite laws making them illegal, theft should be made legal. The fact that there would be a certain amount of evasion of capital controls is not a conclusively persuasive argument for their removal. Given the herd instinct, several countries have experienced larger inflows of capital than the economy can use to finance its deficit on current account. Anything in other words, will be lent back to the countries of the currencies in which the reserves are held. Before the capital flight from mid-1997 onwards, East Asian capital inflows were roughly double the deficit on the current account. Thus, only half the money that came in was productively used for investments in the real economy.

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The purists will of course argue that when there are excess capital inflows, central banks should refrain from appreciation of domestic currency, thereby creating larger deficits on the current account. This might be neat logic, but the first corollary is that when the reversal takes place the exchange rate should be allowed to go were it will. The second corollary is that the central bank should be completely unconcerned about the external value of its currency. I find it difficult to swallow this argument. For one thing, no central bank even in the floating rate era has completely neglected its exchange rate. Secondly, if one accepts that one of the central bank’s primary responsibilities is to maintain the domestic value of the currency – i.e. price stability – I find it difficult to accept that it should allow the external value to go where it will. Undue currency appreciation would surely lead to an uncompetitive domestic industry and large scale unemployment. A sharp fall, on the other hand, would be inflationary. Neither is a very desirable outcome. Domestic monetary policy can of course cure the latter but only at the cost of savage deflation as is currently being experienced in East Asia. To me at least, the risk-reward relationship of unfettered short-term capital movement does not seem all that attractive. Surely, there is a distinction between short-term money coming in the expectation of currency appreciation (and, if fulfilled on a significant scale, capable of destroying jobs) and a Ford or a Sony bringing in money to finance a factory creating jobs? China has shown that a country can enjoy the benefits of the later without permitting unfettered cross-border capital flows.

Caselet 2 Read the caselet carefully and answer the following questions. 1. Borrowing in Pesos to fund the local operations was expensive though it would be helpful

for hedging, the report said. Does it mean that the company had to necessarily have exchange exposure? Justify.

(8 points) 2. The devaluation of the Peso had both the effects of increasing and decreasing the profits.

Explain how this was possible. (8 points)

3. If the company was able to foresee the devaluation in Peso by 50%, what could it have done to enhance its profits?

(6 points) In a matter of less than a decade, General Electric’s rationale for a joint venture to manufacture appliances in Mexico changed several times (as the following excerpt explains). In GE’s case the company was fortunate that new developments gave further support for the original choice. Our major appliance (white goods) business had mainly domestic focus for many years. In the mid-1980s, GE Appliances decided to enter the North American gas range business through a Mexican joint venture with a local partner. They built a plant in Mexico to serve both the export market and eventually, what they foresaw (correctly, as it turns out) was a growing Mexican market for modern domestic appliances. Their initial foreign exchange concern was a 1982-style devaluation and de facto confiscation of Peso financial assets. The solution had two principal elements: one was an offshore sales company to minimize locally-held assets to the extent possible, the other was careful management of working capital and cash flow exposure to maintain a balanced position. These are classic strategies in devaluation-prone currencies where hedging instruments are either unavailable or prohibitively expensive. The strategy worked well throughout the 1980s, but within two years, the environment has changed. First of all the local Mexican market for major appliances (including refrigeration and home laundry products, which the joint venture also supplies) has expanded and GE Appliances is well-positioned to take advantage of the increased local demand. The result, of course, is that we now have more peso assets on the books. Also, financing these assets by borrowing in local currency – a classic hedging technique – remains stubbornly expensive. The business did a lot of homework on the Mexican economic situation and on forecasting cash flows and income statements by currency. Their assessment of the former and their analysis of cash flows and

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expected returns in the business led them to a greater degree of comfort with an increased level of Mexican asset exposure. The strategy is working well, and GE Appliances is very enthusiastic about the second stage, as it were, of their Mexican investment. Less than two years after this item was written, Mexico experienced a serious financial crisis. Between December, 1994 and March, 1995 the peso lost almost half its foreign exchange value. A strategy of having Mexican asset exposure meant resulting translation or transaction losses; peso assets such as peso accounts receivable, became worth half their previous value when converted into dollars. However, to the extent that Mexican facilities produced for the US market, the peso devaluation meant increased profitability. The net result of the asset versus operating exposures is difficult to discern. Nevertheless, the scale of the 1994-95 peso crisis helps reinforce the importance of maintaining close scrutiny of foreign direct investments.

Caselet 3 Read the caselet carefully and answer the following questions. 1. The article mentions that devaluation can be an ineffective weapon while attempting to

reduce the current account deficit. However, common sense tells us that devaluation of a currency should make the country’s exports cheaper, imports more expensive and thus narrow the external deficit. Explain how the two positions can be reconciled.

(9 points) 2. PPP states that relative inflation rates should determine the exchange rate between two

currencies. On the other hand, the findings of the study reported in the article indicate that exchange rate movements can determine the relative inflation rates. Which view do you support and why?

(9 points) America’s current account deficit, though, is more persistent: indeed, it seems to be widening again. If this trend continues, American firms and politicians are likely to blame it on the dollar’s rise against the Yen over the past year, and to review their demands for a cheaper dollar. Yet the experience of the past decade or so suggests that devaluation is an ineffective weapon against America’s external deficit. After narrowing a bit last year, the country’s current account deficit, which stood at $30 billion in the fourth quarter of 1995, hit $39 billion in the second quarter of this year. In July, America had its biggest monthly trade deficit since 1987. On current trends the current account deficit for 1996 as a whole is likely to hit $150 billion roughly the same as in the past two years, and not much below its peak of $166 billion in 1987. (Relative to GDP, the deficit has shrunk a bit.) The dollar’s slide over the past decade or so has failed to dent the deficit. And what a slide: from ¥270 in 1982 to ¥80 in April, 1995. Since then, however, the dollar has rebounded to around ¥110. American manufacturers moan that this is 38% above its low point, but by most measures the dollar is still cheap against the Yen. Moreover, in trade-weighted terms the currency has risen by only 9% leaving it 40% below its peak in 1985. Until last year American governments had often tried to talk the Yen up and to jawbone the Bank of Japan into supporting its currency with high interest rates in the hope that this would trim both Japan’s surplus and America’s deficit. The policy has been a failure: a study by Ronald Mckinnon, Renichi Ohno and Kazuko Shirono explains why. Traditional exchange rate theory says that in the long run, currencies will move towards their Purchasing Power Parity (PPP) – the rate that leaves an identical basket of goods and services costing the same in two countries. The original version of this theory says that exchange rates adjust in line with inflation differences. Thus, if Japan had a lower inflation rate than America, this would lead to a rise in the Yen. Japan’s experience, however, suggests that causation also runs the other way from exchange rate movements to relative price levels.

Model Question Paper 1 Suggested Answers

Paper I Part A: Basic Concepts

1. (d) Net foreign investments = Exports – imports, this equation says that the balance on the current account must be equal to the net capital outflow, that is, any foreign exchange earned abroad must either be spent on imports or exchanged for claims against foreigners. A current account deficit indicates that a nation is a net capital importer.

2. (d) Interest rates, exchange rates, prices of financial assets, all of them change quite frequently in response to the various changes taking place in the financial markets all over the world.

3. (e) Portfolio investment by foreign institutional investors, and repayments by the government of foreign currency debts are recorded in the capital account section of the BoP.

4. (c) Under a currency board system, a country decreases its money supply of its home currency when it is depreciating so that the demand for the home currency increases leading to an appreciation.

5. (c) To overcome the international liquidity problem a new reserve asset was created by IMF in 1967, namely SDR – Statutory Drawing Rights.

6. (e) Germany’s central bank has built up a high level of credibility for fighting inflation. 7. (d) Let the exchange rate of currency A be 100A/B. This means 1A = 0.01B.

After depreciation of currency A by 50% the exchange rate will be 1A = 0.015B. Hence B = 66.667 a depreciation of 33%.

8. (a) SF/$ – 1.5/1.52, FF/$ – 5.8/5.9 (FF/SF)bid/ask = (FF/$)bid/ask x 1/(SF/$)ask/bid = 3.82/3.93 9. (d) According to the PPP the percentage change in the spot rate A/B equals the difference

in the inflation rates divided by 1 plus the interest rate in country B

= 0.08 0.031.03− = 4.85% (app) 4.9%

10. (a) As the interest rate differential is higher than the forward premium invest in currency with higher rate of interest. Hence borrow Dollars and invest in Sterling.

11. (b) rA = rB + B

( )F A / B S(A / B)SC(A / B)

−⎡ ⎤⎢ ⎥⎣ ⎦

where ( )A / B S(A / B)

S(A / B)−⎡ ⎤

⎢ ⎥⎣ ⎦

is forward premium or

discount. 0.06 = r⇒ BB – 0.05 r⇒ B = 11%. B

12. (b) When interest rate parity holds good then the forward premium/discount between two currencies will be equal to the difference in the interest rates on the two currencies.

13. (c) According to Fisher effect when interest rate parity and relative purchasing parity hold good then real interest rates are approximately equal to the difference between nominal interest rates and inflation rates.

14. (e) The important principles of product life cycle theory are (i) new products are developed as a result of technological innovations; (ii) trade patterns are determined by the market structure and the phase in a new product’s life.

15. (e) All the alternatives given are reasons for the imposition of trade barriers. 16. (d) Imitation gap theory given by Posner considers the possibility of trade between two

countries having similar factor endowments and consumer tastes. According to this theory improvement in trade is a continuous process and the resulting inventions and innovations in the existing products give rise to trade between such countries.

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17. (d) America has comparative advantage in food production over all the other countries. Hence it may or may not import food.

18. (b) The authorized dealers have to operate within the rules, regulations and guidelines issued by the Foreign Exchange Dealers Association of India (FEDAI). Only the bid-ask spreads are subject to the caps by FEDAI.

19. (d) Goods from one country to another due to bilateral agreement does not mean an international transfer. Therefore only statements (a) and (c) are correct.

20. (d) Deposits in NRI accounts and FCNR accounts is a capital account item in the Indian Balance of Payments statement.

21. (e) All the above are different forms of trading blocks differing in respect of the degree of economic co-operation between member countries.

22. (d) All the alternatives given are effects of trade barriers on the economy.

23. (a) The acronym TRIPS stands for Trade Related Aspects of Intellectual Property Rights.

24. (a) OPEC is an international cartel.

25. (d) ITC(HS) refers to Indian Trade Classification (Harmonized System).

26. (e) Confirming banks are usually located in the country of the supplier (i.e. the exporter).

27. (b) The temporary receipt issued by the shipping company when goods are delivered for transportation is the mate’s receipt.

28. (d) Banks have to extend a minimum of 12% of net bank credit to the export sector.

29. (d) Proposals for export on elongated credit terms should be submitted in Form ECT through the exporters banks to the concerned regional office of the Reserve Bank for consideration.

30. (b) Applications connected with import remittances including advance remittances must be made in Form A1.

Part B: Problems

1. Cross rates for $/£:

($/£)bid = ($/Rs.)bid x (Rs./£)bid = ask

1(Rs./$)

x (Rs./£)bid = 68.5942.60

= 1.6101

($/£)ask = ($/Rs.)ask x (Rs./£)ask = ask

1(Rs./$)

x (Rs./£)ask = 69.9642.18

= 1.6586

Cross rates for $/Euro:

($/Euro)bid = ($/Rs.)bid x (Rs./Euro)bid =ask

1(Rs./$)

x (Rs./Euro)bid =46.2542.60

= 1.0857

($/Euro)ask = ($/Rs.)ask x (Rs./Euro)ask = ask

1(Rs./$)

x (Rs./Euro)ask = 47.1742.18

= 1.1183

2. Inflows today : Rs.(1,000,000) (41.00) = Rs.41,000,000 Installment payments I – $40,000 II – $40,000 III – $40,000 IV – $40,000 Principal repayment – $1,000,000 Total exposure = $1,160,000

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Date Cash flows (Rs.)

1.1.98 +41,000,000

1.7.98 –(1,160,000) (41.90) + (1,120,000) (41.45) = –Rs.2,180,000

1.1.99 –(1,120,000) (42.50) + (1,080,000) (42.15) = –Rs.2,078,000

1.7.99 –(1,080,000) (43.10) + (1,040,000) (42.45) = –Rs.2,400,000

1.1.2000 –(1,040,000) (43.70) = –Rs.45,448,000 IRR is the value of ‘r’ in the following equation:

41,000,000 = 2 32,180,000 2,078,000 2,400,000 45, 448,000+

1+ r/2 (1+ r/2) (1+ r/2) (1+ r/2)+ + 4

r = 13% 3.

Spot rate (Rs./DM) 20.98 21.39

3 months forward 21.82 22.62

3 months Rupee interest rate (%) 17.5000 18.5000

3 months DM interest rate (%) 5.7500 6.2500

Option I

Borrow Rs.21.39 at 18.5%.

Convert Rs.21.39 into DM at the spot rate.

Invest DM @5.75% for 3 months. After three months, we get

1 + 14

x 0.0575 = DM 1.014375

Amount required to repay the Rupee borrowing:

21.39 (1 + 14

x 0.185) = 22.38

Convert DM invested in forward market to get Rs.21.82 x 1.014375 = 22.13

The amount received from buying DM spot, investing in 3 months DM deposit and selling DM forward is less than the amount required to repay the Rupee borrowing. Therefore, there is no possibility of arbitrage.

Option II

Borrow DM at 6.25% for 3 months.

Sell the DM in the spot market at Rs.20.98.

Amount to be paid on DM borrowing after three months = [1 + 14

x (0.0625)] = DM 1.015625

Invest Rs.20.98 at 17.5% for three months to get 20.98 [1 + 0.25(0.175)] = Rs.21.90

Buy DM forward to get = 21.9022.62

= DM0.9682

As the DM that can be purchased with the Rupee inflows are lower than the DM liability, there is no scope for arbitrage.

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4. $/£ 1.0989/1.1389 DM/£ 2.00/2.05 DM/$ 1.80/1.82 UK–US

Without netting Inflow = (1,000,000) (1.0989) = $ 1,098,900

Outflow = (800,000) (1.1389) = $ 911,120

Net inflow = = $ 187,780

With netting Net inflow = (200,000) (1.0989) = $219,780

Benefit due to netting = $ 32,000 =

UK–Germany

Without netting Inflow = DM (500,000) (2.00) = DM 1,000,000

Outflow = DM (500,000) (2.05) = DM 1,025,000

Net outflow = DM 25,000

With netting Net outflow = Nil

Benefit due to netting = DM 25,000

US–Germany

Without netting Inflow = (1,000,000) (2.00) = DM 2,000,000

Outflow = (800,000) (2.05) = DM 1,640,000

Net inflow = DM 360,000

With netting Net inflow = (200,000) (2.00) = DM 400,000

Benefit = DM 40,000

5. Loan in Germany

Cost = 6 + 0.5 = 6.5%

Loan from US Bank

Effective rate of interest = 51 0.1−

= 5.56

Premium on USD = 1.061.05

– 1 = 0.0095 = 0.95%

Net Cost = 5.56 + 0.95 = 6.51%

Loan from Swiss Bank

Effective rate of interest = 21 0.1−

= 2.22

Premium on SF = 1.061.02

– 1 = 0.0392 = 3.92%

Net cost = 2.22 + 3.92 = 6.14%

So, Swiss loan is the best.

6. Bank B can accept the bill of lading, because as per Article 23(d)(ii) of UCPDC 500, even if the credit prohibits transhipment, banks will accept a bill of lading which incorporates clauses stating that the carrier reserves the right to tranship.

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Part C: Applied Theory 1. Hong Kong follows the currency board system which is similar to the erstwhile gold

standard which prevailed in the early part of the 20th century. Under the system, the Hong Kong Monetary Authority increases domestic money supply when dollars flow in and vice versa. Because of this mechanism, the demand supply balance between Hong Kong Dollars and US Dollars is maintained at a parity level of 7.78, leaving aside minor variations. Suppose, there is a downward pressure on HK $. The Monetary Authority would contract money supply thereby allowing interest rates to go up. This would once again attract investors back into Hong Kong’s currency. When the HK $ tends to appreciate, the policy measure used would be to expand money supply and lower interest rate.

2. a. The differences in interest rates reflect the differences in degrees to which the countries have been affected by the currency crisis. Countries worst effected by the currency crisis have had to steeply hike their interest rates not only to stop further slide of the domestic currency but also to control the resulting inflation.

b. A strong currency is likely to appreciate in the near term. As such, interest rate would be relatively low to ensure that returns are equalized across currencies. Another way of arguing is that a strong currency needs to pay only a small interest rate to attract investors.

A weak currency is expected to depreciate. As such, high interest rate is the compensation which prospective investors would be looking for.

c. When interest rates are raised, the most likely phenomenon would be investors attempting to park surplus funds in that currency. This would mean buying the currency as a result of which it would appreciate. Since investors would cover their risk, they would presumably sell the currency forward. As a result, the forward discount will adjust. Thus, the currency will appreciate in the spot market but trade at a forward discount so that arbitrage profits are ruled out. What has been explained is the general case.

In some cases, central banks may raise interest rates to curb inflation. If the markets are not convinced that the hike is adequate, the currency may actually be driven down even after the hike the interest rate is announced.

d. There are several restrictions on trading in India. The RBI has a strangle hold on the market. Free repatriation of foreign capital is not allowed in India. As such, the rupee did not really face the full fury of the storm in East Asia.

3. Import license means a license granted specifically for import of goods which are subject to import control. Items which require a license can be imported only by an actual user, unless the actual user condition is specifically dispensed with by the licensing authority.

The Export-Import Policy defines “Actual User” as an actual user who may be either industrial or non-industrial user. “Actual User (Industrial)” is defined as “a person who utilizes the imported goods for manufacturing in his own unit or manufacturing for his own use in another unit including a jobbing unit.” “Actual User (Non-Industrial)” is defined as “a person who utilizes the imported goods for his own use in

i. any commercial establishment carrying on any business, trade, or profession; or ii. any laboratory, Scientific or Research and Development (R&D) institution,

university of other educational institution or hospital; or iii. any service industry. Every license has a validity period which is specified therein. For example, the validity of

the Export Promotion Capital Goods license (EPCG) is 24 months. Only those items or category of items mentioned on the license can be imported under that license. A license is issued subject to the provisions of the policy applicable as on date of issue of the license. Every license bears the security seal of the office of issue as well as the signature of the issuing authority. As per the present rules import licenses issued under various provisions of the policy indicate the value in Indian rupees and in foreign currency at the exchange rate prevailing on the date of issue of the license.

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Categories of Licenses There are different categories of licenses. Regular License: These are licenses issued for the import of goods which fall under the

normal import policy. These can be issued to any body entitled for issuance as per the policy provision.

Advance License: Advance licenses are issued under the duty exemption scheme. Under advance licenses, duty free imports of inputs are permitted on fulfillment of value addition and export obligation within a certain time-frame. Such licenses (other than those for deemed exports) are exempted from payment of basic customs duty, surcharge, additional customs duty, anti dumping duty and safeguard duty, if any.

Under a value based advance license, any of the inputs specified in the license may be imported within the total CIF value indicated for those inputs, except inputs specified as sensitive items. Under such a license, both the quantity and the FOB value of the exports to be achieved shall be specified. It shall be obligatory on the part of the license holder to achieve both the quantity and FOB value of the exports specified in the license.

In case of quantity based license, each item of inputs for import will be restricted in terms of quantity (or value where restrictions cannot be put in quantity terms).

The exim policy 1997-2002 has done away with value based advance licenses. However, quantity based advance licenses will continue to remain in force. Quantity based advance licenses indicate the individual item, along with quantity and the aggregate CIF value of imports.

Licenses with Export Obligations Certain licenses are issued with a rider, like ‘export obligation’ which means importers of

capital goods are required to export to a place outside India, a certain proportion of goods manufactured by the use of imported capital goods. In case of importers rendering services, export obligation means receiving payments in freely convertible foreign currency for services, rendered through the use of such capital goods. License where export obligation is imposed, indicates value of export obligation both in free convertible currency and Indian Rupees equivalent thereof at the exchange rate prevailing on the date of issue of the license. It also indicates exchange rate used for arriving at the rupee value of license. Value indicated on import licenses is always for CIF (Cost, Insurance and Freight) value of goods authorized to be imported.

Special Import License A Special Import License (SIL) may be used to import, among other items, certain

consumer goods. The SIL is like an import permit and is traded in the market, at a premium on its value. It is issued to Indian exporters as an export incentive, and its value is tied to export earnings. SIL licenses are freely transferable and thus can be easily procured in the market by any prospective importer. The Special Import License shall be valid for import of items appearing in the ITC(HS) classification of Export and Import items.

Import licenses are issued in duplicate. One copy is marked for “Customs purposes” and has to be presented to the customs authorities at the time of clearance of goods. The other copy is marked for “Exchange control purposes” and has to be presented by the importer to the authorized dealer while opening a Letter of Credit (LC) or making payment for import of goods.

Transferability of Licenses After the fulfillment of export obligation and other conditions laid down, the holder of a

transferable license may transfer it to a third party. However, a request for endorsement of transferability should be made to the licensing authority within 36 months of the date of issuance of license. When the import license is so endorsed, the license holder may transfer the license in full in case he has not made any imports or where imports have already been made, the license may be transferred in part excluding the value and quantity of imports already made or the materials or the balance already imported.

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Issue of duplicate license, increase in the C.I.F value or any other amendments will not be permitted once the endorsement of transferability is made on the license.

The license transferred will be valid for the balance period of its validity or six months from the date of endorsement whichever is later.

Endorsement of Import License Where a license is transferable, the fact of transferability will be indicated on the body of

the license. In such case the license holder may effect part or full transfer of the license to other eligible importers in conformation with the various provisions of the policy.

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Paper II Part D: Case Study

1. Exchange risk can result from transaction, translation and operating exposures. In the case of VUK transaction and translation exposures are not significant. This is because most of the revenues and costs are denominated in pound sterling equivalent basis. Even though 33 percent of its sales revenue came from export sales, these exports are to companies located in the Western Europe. The likelihood of these exports being invoiced in sterling or in currencies closely related to sterling is more. On the other hand, currently all the assets and liabilities of VUK are sterling denominated. Therefore, VUK’s exposure to transaction and translation risks is limited.

On account of operating exposure, VUK is not subjected to exchange risk. VUK has clear domination in the industrial tin plate scrap market. There is no competition either in domestic or external market. So maximum percent of raw material is processed on cost-plus basis and most of the revenues and costs are sterling denominated. Therefore, VUK is exposed to minimal operating exposure.

The conclusions of Ms. Ronningen still hold good. Nothing substantial has happened in the last two years so as to warrant a change in stand.

2. Average prices: 1974-1979

Year Home (UK) Export (US)

1974 (21.19+ 28.02+34.04 +39.12)4

= 30.5925 (25.86 +36.28+51.5)3

= 37.8800

1979 (57.80 +59.58+ 60.31+51.89)4

= 57.3950 (65.38+53.42+ 47.00+ 47.39)4

= 53.2975

Inflation assuming 1974 price level to be the base year is Price level in1979 1 x100Price level in1974⎡ ⎤

−⎢ ⎥⎣ ⎦

∴ InflationUK = 57.3950 130.5925⎡ ⎤−⎢ ⎥⎣ ⎦

x 100 = 87.61%

∴ InflationUK = 53.2975 137.8800⎡ ⎤−⎢ ⎥⎣ ⎦

x 100 = 40.70%

Relative purchasing power parity says that S~ ($/£) = ~ ~

US UK~

UK

P P(1+ P )

−

Where S~ is the percentage change in the spot rate, P~ is the inflation.

S∴ ~ ($/£) = 0.4070 0.8761(1 0.8761)

−+

= –0.2500 = –25.00%

If the Relative Purchasing Power Parity holds good, then pound sterling should depreciate by 25% in the given period.

The average exchange rates in 1974 is (2.279 2.397 2.350 2.330)4

+ + + = 2.3390

In 1979 the average exchange rate is (2.016 2.080 2.232 2.159)4

+ + + = 2.1218

Actual depreciation of £ during the period is ∴(2.3390 2.1218)

2.3390− x 100 = 9.29%

Therefore, RPPP does not hold good for the period 1974-79 since the depreciation of £ implied by RPPP is not equal to the real depreciation.

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Average prices: 1978-1983 Year Home (UK) Export (US) 1978 (29.24 33.36 38.83 45.23)

4+ + + = 36.6650 (21.90 30.61 35.76 42.21)

4+ + + = 32.62

1983 36.14000 37.9200 Inflation 36.1400 36.6650 x100

36.6650−⎡ ⎤

⎢ ⎥⎣ ⎦= –1.43% 37.9200 32.62 x100

32.62−⎡

⎢⎣ ⎦⎤⎥ = 16.25%

Percentage change implied by RPPP is 0.1625 ( 0.0143)1 ( 0.0143)

− −+ −

= 17.94%

RPPP indicates appreciation of £ by 17.94% during the period. ∴

Average exchange rate for the year 1978 is (1.927 1.835 1.932 1.984)4

+ + + = 1.9195

Exchange rate in 1983 is 1.534.

Percentage change in actual exchange rate is ∴(1.5340 1.9195)

1.9195− = –0.2008 = –20.08%

That is the £ depreciated by 20.08%. Hence the RPPP does not hold good during 1978-83 also. 3. No period is mentioned in the question to compute depreciation of £. We will use first

quarters of 1974 and 1983 for this purpose. The 1974 exchange rate is 2.279 (first quarter) and in 1983 the exchange rate is 1.534.

Nominal depreciation of £ is = ∴(2.279 1.534)

2.279− = 0.3269 = 32.69%

Real exchange rate, R($/£) = S($/£)~

UK~

US

PP

Where S($/£) is the spot exchange rate.

P~UK for the period is (36.140 21.190)

21.190− = 0.7055 = 70.55%

P~US for the period is (37.920 25.860)

25.860− = 0.4664 = 46.64%

Real exchange rate in 1983 is 1.534 x 1.70551.4664

= 1.7841

Real depreciation of £ is (2.279 1.7841)2.271− = 21.72%

Therefore, for the period 1974-83, nominal depreciation of £ is 32.69% and real depreciation is 21.72%.

4. While deciding about replacing pound debt with dollar debt, we need to consider cost of borrowing in both the currencies. These costs consist of interest costs and costs associated with unanticipated movement in the exchange rate. Though historical exchange rates are available, no information regarding interest rates is given so that we can forecast the exchange rates in future.

It may be tempting to replace the pound debt since the pound has depreciated substantially and Vulkan need to fork out less dollars now. But, what if the interest in the US is much higher than UK? Or if the pound is expected to depreciate further?

Therefore, we need to consider all the relevant factors while deciding about replacing the debt. If the rate of interest is not considered and the decision is to be based on the depreciation of pound, it is advisable to hold the pound debt since pound is a weak currency going by the trend in the recent past and Vulkan can benefit by holding its liabilities in a weak currency.

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5. Transaction exposure is the measure of sensitivity of home currency value of assets and liabilities which are denominated in foreign currency, to unanticipated changes in exchange rates, when assets or liabilities are liquidated.

Operating exposure arises due to the effect of exchange rate changes on a firm’s future cash flows from operations. Neither the prices nor the quantities of outputs and inputs are fixed and all are subject to change when exchange rates change. As a result, the value of the firm calculated in terms of future cash flows is influenced by exchange rates.

No, the statement is not agreeable. VUK has little operating exposure because of its dominance in the market. This ensures immunity of cash flows from exchange rate fluctuations. All inputs are acquired domestically and there is a threat of exchange rate fluctuations increasing the cost of inputs. In the same way, exchange rate fluctuations do not effect the price or quantity sold in the domestic market because of its near monopoly position in the market. Therefore, operating exposure is not the cause for losses.

Year/quarter Exchange rate Cash flow (BIT)77/2 1.719 –54.000 79/1 2.016 –35.000 80/4 2.386 –141.000 83/1 1.534 –57.000

Transaction exposure can lead to a loss when the foreign exchange rate movement is unfavorable at the time of settlement of a liability or an asset.

For VUK, there are no foreign currency liabilities. Foreign currency assets can arise in the form of receivables. If home currency appreciates substantially by the time of realization of foreign currency assets, this can lead to loss in home currency. But from the above data, we do not find any relation between the exchange rate and cash losses for VUK. Hence, we can conclude that the losses are not caused by the transaction exposure.

Perhaps we may have to look at other factors like cost of production, efficiency, etc. for the cause of loss.

Part E: Caselets Caselet 1

1. The domestic value of a currency and external value are closely related and it is not possible to deal with one without influencing the other. Any central bank should take care of the external value of the currency as well because:

a. A strong domestic currency may make exports uncompetitive, as the foreign currency price of domestic production moves up.

b. A strong domestic currency may also result in foreign investments slowing down, as investors get fewer units of domestic currency for each unit of foreign currency.

c. Slowdown of exports and low foreign capital inflows will result in slowing down of industrial activity and unemployment.

d. A weak domestic currency makes imports expensive and foreign debt difficult to service. Imports become expensive because, for the same price in foreign currency, more amount of domestic currency will have to be paid. The domestic currency value of foreign currency borrowing will also increase and servicing the borrowing will call for more amount of domestic currency. Both these can have a telling effect on the domestic economy.

e. A sharp fall in the value of the currency leads to high inflation which is difficult to tackle through monetary measures. Tight monetary policies like high interest rates and higher reserve requirements push up the cost of funds and cause a decline in industrial production.

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2. Yes, FDI is better because it is a. Long-term and does not cause severe currency fluctuations and excessive liquidity. b. Aimed at investment and not speculation. c. Creates jobs and promotes development of the domestic industry through technology

transfers. d. Exports may increase, as MNCs choose the country as a production base. e. Increased industrialization, higher exports and increase in the number of jobs

lead to higher growth in the economy as a whole. f. FDI is not volatile as is the case of FII.

Caselet 2 1. No, it was not necessary to have exchange exposure. The company faced exchange

exposure because some of its assets are denominated in Pesos and borrowing in Pesos is expensive. If borrowing in Pesos was not expensive the company would borrow an amount equal to its Peso denominated assets and avoid foreign exchange exposure altogether. Even after ruling out the alternative of borrowing in Pesos, it is not necessary to have exposure. The company might borrow in any other currency in its wisdom and the company may use other hedging instruments (forwards, futures, etc.) to hedge its exposure.

2. GE Appliances was using its facilities in Mexico to produce for sale in the domestic (Mexican) market and for the American market. The cost of production was denominated in Peso. When Peso was devalued, the dollar value of the proceeds from profits in the Mexican market decreased. However, the devaluation made the goods produced in Mexico cheaper in dollar terms and hence helped in increasing its sales.

3. If it could be foreseen that the Peso would depreciate: a. The company could lead the transfer of profits from the Mexican company. b. The company could lag investments or payments denominated in Peso. c. Borrowings could be made in Peso for deployment in US as the cost of funds would

come down. The borrowings could be repaid after the devaluation of Peso.

Caselet 3 1. Strong currencies can make exports uncompetitive. However, appreciating currencies can

also have the following effects: a. Imports will become cheaper. This can facilitate lower pricing of exportable goods,

which use importable inputs. Cheaper imports may also significantly lower the rate of inflation making exports more competitive.

b. Appreciating currencies can boost imports and reduce domestic spending in the short run. In the long run, slow GDP growth may also reduce imports.

c. Many goods are traded for reasons other than price. If quality, trend image and reliability are the important considerations, the exchange rate

will have little impact on the current account deficit. Manufacturers such as Toyota continued to export cars to USA even as the Yen appreciated from 360 to a dollar at the end of the second world war to as low as 90 in 1995.

2. Exchange rate movements as explained above can be the cause of inflation/deflation. Weak currencies add to inflation while appreciating currencies have a deflationary impact. Having said that, if countries follow loose monetary policies which lead to rapid expansion of money supply and consequent inflation, they may well find their exports becoming uncompetitive especially if the competition is on the basis of price. This would lead to a trade deficit, consequent depreciation of the currency and restoration of the trade balance.

Model Question Paper 2 Time: 3 Hours Total Points: 200

Paper I Part A: Basic Concepts (30 Points)

Answer all the questions. Each question carries one point. 1. Fisher open condition says that the a. Real rate of exchange should be equal across different countries b. Nominal rate of exchange should be equal across different countries c. Real rate of interest should be equal across different countries d. Nominal rate of interest should be equal across different countries e. Rate of inflation should be equal across different countries. 2. A borrower will prefer to borrow in a currency B instead of borrowing in currency A, when

a. n B

A

F (B/A) (1+i )>S(A/B)

(1+i )

b. n B

A

F (A/B) (1+i )>S(A/B)

(1+i )

c. n A

B

F (A/B) (1+i )>S(A/B)

(1+i )

d. n A

B

F (A/B) (1+i )<S(A/B)

(1+i )

e. n B

A

(A/B) (1+i )<S(A/B)

(1+i )F

3. If interest parity holds and the transaction costs are zero, covered foreign financing will result in an effective borrowing rate that is a. Less than the domestic interest rate b. Greater than the domestic interest rate c. Equal to the domestic interest rate d. Greater than the domestic interest rate if the forward rate exhibits a premium and

less than the domestic interest rate if the forward rate exhibits a discount e. None of the above.

4. The immediate impact of devaluation is reflected in a. Transaction exposure b. Translation exposure c. Economic exposure d. Operating exposure e. None of the above.

5. Exchange rate overshooting is explained by a. Triffin Paradox b. Dornbusch Sticky-Price theory c. Efficient market theory d. Marshall-Lerner condition e. None of the above.

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6. Activation of blocked funds will a. Reduce the initial capital cost b. Increase the initial capital cost c. Increase the tax to be paid in domestic country d. Increase the tax to be paid in foreign country e. Both (a) and (c) above.

7. You invest Rs.10 million on the New York Stock Exchange. If the returns obtained are 20% and the exchange rate moves from Rs.38/$ to Rs.39/$ during the year, what is the effective return on the investment?

a. 20% b. 21% c. 22% d. 23% e. 24%. 8. The benefit from centralized cash management comes in the form of a. Reduced transaction costs b. Reduced time to enter into contract c. Netting d. Leading e. Lagging. 9. The assumptions of law of one price are

a. Free movement of goods b. No transportation costs c. No transaction costs d. No tariffs e. All of the above.

10. The reasons for PPP not holding good are a. Constraints on movement of commodities b. Price index construction c. Non-tariff barriers d. All of the above e. Both (b) and (c) above.

11. The extent to which the value of a firm stands exposed to exchange rate movements is a. Transaction exposure b. Translation exposure c. Accounting exposure d. Operating exposure e. Both (b) and (c) above.

12. The price elasticity of demand is dependent on a. Degree of competition b. Location of competitors c. Degree of product differentiation d. All of the above e. Both (a) and (c) above.

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13. _________ approach assumes that the Purchasing Power Parity holds good.

a. Monetary

b. Demand-supply

c. Portfolio balance

d. Asset

e. None of the above.

14. A transaction in which an investor seeks to protect a position is known as

a. Hedging

b. Speculation

c. Arbitration

d. All of the above

e. None of the above.

15. Foreign Exchange exposure is defined as

a. Variance of the domestic currency value of an asset, liability or operating income that is attributable to unanticipated changes in exchange rates

b. Sensitivity of changes in the real domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates

c. Sensitivity of changes in the nominal domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates

d. Sensitivity of changes in the real foreign currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates

e. Sensitivity of changes in the real domestic currency value of assets, liabilities, or operating incomes to anticipated changes in exchange rates.

16. Which of the following is not a suitable strategy to hedge economic exposure?

a. Plant location.

b. Pricing of the product.

c. Market selection.

d. Product mix.

e. Currency swap.

17. Which of the following statements is false?

a. Offsetting a long position in one currency with a short position in the same currency is known as ‘netting’.

b. Risk arising from an exposure in one currency can be reduced with an exposure in another currency.

c. A firm can offset a long position in a currency with a short position in the same currency.

d. If the exchange rate movements of two currencies are negatively correlated, then a firm can offset the risk arising from a long position in one currency with a short position in other currency.

e. If the currency movements are negatively correlated, then long positions in both the currencies will give rise to risk which is less than the risk arising from a long position in any one currency.

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18. A speculator buys US dollar at 43.50 and expects to make a profit by keeping open position for one month. He expects that

a. The spot ask rate after one month will be less than the current spot bid rate

b. The spot bid rate after one month will be less than the current spot ask rate

c. The spot ask rate after one month will be more than the current spot ask rate

d. The spot bid rate after one month will be less than the current spot bid rate

e. The spot bid rate after one month will be more than the current spot ask rate.

19. The host country’s Governments offers a loan equivalent to Rs.10 million at zero interest. The loan involves bullet repayment at the end of 5 years. If the competitive rate of borrowing in the home country is 10%, the benefit due to the loan is

a. 0

b. Rs.9 million

c. Rs.10 million

d. Rs.3.79 million

e. None of the above.

20. _______ requires various marketing, production and financial management strategies to cope with the risks.

a. Transaction exposure

b. Accounting exposure

c. Translation exposure

d. Economic exposure

e. Both (b) and (c) above.

21. Association of South East Asian Nations (ASEAN) is an example of

a. Free trade area

b. Customs union

c. Common market

d. Economic union

e. None of the above.

22. The objectives of GATT were

a. Reduction or elimination of trade barriers

b. Incorporation of the most favored nation principle

c. The principle of reciprocity

d. Countries should not take unilateral action against each other

e. All of the above.

23. A letter of credit where a bank other than the issuing bank undertakes to pay is known as

a. Irrevocable LC

b. Confirmed LC

c. Revocable LC

d. Back-to-back LC

e. Anticipatory LC.

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24. Which of the following is not an example of deemed exports? a. Supplies made in India to World Bank/IDA – aided projects against international

competitive bidding. b. Supplies to free trade zones/100 percent export oriented units. c. Sales to foreign shipping companies. d. Supplies to ONGC and Oil India Ltd. for off-shore and on-shore drilling operations. e. Software exports which are not in physical form.

25. When the payment due on a draft is made upon the presentation of the draft, it is a a. Clean draft b. Payment draft c. Sight draft d. Acceptance draft e. Documentary draft.

26. Which of the following L/Cs is the safest for the exporter? a. Revocable, confirmed L/C b. Irrevocable, unconfirmed L/C c. Irrevocable, confirmed L/C d. Revocable L/C e. None of the above.

27. As per the EMU, the currency of each member country could fluctuate between the wide _____ band to the narrow ______ up to August 1993. a. 4%, 2% b. 4.5%, 2.5% c. 6%, 2.25% d. 6.5%, 2.5% e. 6.25%, 2.25%

28. Canalized goods in relation to imports refers to those goods which a. Can be imported freely b. Can be imported only by certain agencies c. Cannot be imported d. Fall under the restricted category of imports e. Can be imported using a special import license.

29. Anticipatory credit a. Is a credit where advance payment is made at the pre-shipment stage b. May be a red clause letter of credit or a green clause letter of credit c. Is widely used in international trade d. Both (a) and (b) above e. All of (a), (b) and (c) above.

30. Export proceeds of goods (other than deferred payment terms for project and service exports) are normally required to be realized a. On the due date for payment b. Within six months from the date of shipment of goods c. Within 15 months from the date of shipment of goods d. On the due date for payment or within 6 months from the date of shipment of goods

whichever is earlier e. On the due date for payment or within 15 months from the date of shipment

whichever is later.

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Part B: Problems (50 Points) Solve all the problems. Points are indicated against each problem. 1. You are a banker. A client has approached you for a quote to purchase DM 1,000,000. The

client will be receiving the amount sometime during the third month. You collect the following information:

Bombay : (Rs./$) Spot : 42.50/43.002-month forward : 43.00/43.603-month forward : 43.60/44.20Singapore : (DM/$) Spot : 1.68/1.692-month forward : 1.69/1.703-month forward : 1.71/1.72

What rate (Rs./DM) should you quote to the customer? (8 points)

2. Interest rates for three months in US and Canada are as follows: Borrow Invest US $ 9% 8% Canada $ 10.5% 9.5%

Can $ / $ spot 1.5612 1.5632 3-m forward 1.5655 1.5675

Advise the currency in which borrowing and lending for 3 months needs to be done for a US company.

(8 points) 3. During a year the price of British gilts (face value £ 100) raised from £ 102 to £ 106 while

paying a coupon of £ 9. At the same time, the exchange rate moved from $/£ 1.76 to $/£ 1.62. What is the total return to an investor in US who invested in the above security?

(9 points) 4. During a year the price of British gilts (face value £ 100) raised from £ 102 to £ 106 while

paying a coupon of £ 9. At the same time, the exchange rate moved from $/£ 1.43 to $/£ 1.34. What is the total return to an investor in US who invested in the above security?

(10 points) 5. You were to import an equipment for your project and you have a choice to invoice in the

following currencies: Invoice value £ 100000 DM 290000 FFr 917000 Spot rate 67.50/90 23.25/40 7.05/15 1-m Forward rate 25/40 10/15 20/25 2-m Forward rate 50/90 – – 1-m Interest rate 6.00 4.00 4.50 2-m Interest rate 6.25 4.25 4.75

You have the option to pay at the end of 1st month or 2nd month along with interest at the applicable rates. However, the pay-out at the end of 2nd month has to be made in Euro and actual pay-out depends on how the rates are fixed with Euro. If the Rs./Euro is 39, after 2 months, compute the limits for DM/Euro and FFr/Euro rates that will make invoicing in DM and FFr a better choice than £. Which currency do you select if you prefer to pay at the end of first month?

(8 points)

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6. Bank ‘B’ has entered into an agreement with one of its customers on 15th November, for a forward purchase contract of DM 5000, delivery 1st March at the rate of Rs.20.96 per DM, covering itself by a forward sale at the rate of Rs.20.98. On 15th December, the customer requests the bank to purchase a bill for DM 5000 under this contract. Calculate the amount that would be paid to the customer assuming the following rates in the interbank market on 15th December. Spot : Rs./DM 20.925/20.93 Delivery March : 21.47/21.4775 Interest on outlay of funds at 16% and inflow of funds at 12%.

(7 points)

Part C: Applied Theory (20 Points)

Answer the following questions. Points are indicated against each question. 1. Brazil experienced devaluation of its currency and the coffee prices declined in India. What

is the exposure which the Indian business experienced? Explain the three types of exchange exposure.

(7 points)

2. If the common central bank manages the monetary policy of the EMU, what could be the disadvantages to individual countries?

(7 points)

3. X Limited, an export unit, is interested in participating in a trade fair conducted in Dubai. Your friend who works in this organization and who is likely to represent his company in this trade fair, approaches you for information on the exchange control regulations relating to participation by exporters in trade fairs abroad. Elucidate

(6 points)

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Paper II

Part D: Case Study (50 Points) Read the case carefully and answer the following questions. 1. What are the various factors which determine the strength or weakness of a currency?

(10 points) 2. The Euro-zone has been registering a current account surplus for sometime now while the

US has been running up a deficit. Yet, the dollar is stronger. Why could this be so? (6 points)

3. Explain how structural reforms in the Euro-zone can influence the eurodollar exchange rate. (8 points)

4. Calculate the depreciation of the euro against the dollar during the four quarters of 1999. (Hint: Exchange rates at the beginning and end of the quarter may be used.)

(8 points) 5. Based on the interest rate parity, calculate the expected appreciation or depreciation of Euro

against dollar during the four quarters of 1999. Compare with the actual rates and comment. (8 points)

6. a. The US inflation rate during 1999 was 2.7%. If the Purchasing Power Parity holds good for dollar and euro, then what should be the inflation level in the euro area to justify the appreciation or depreciation of euro during 1999.

b. In June 1999, what will be the expected 3-month eurodollar interest rate after three months?

(5 + 5 = 10 points) On January 27, 2000, the Euro plunged to its lowest level, ever against the Dollar, breaching the parity level of $1 per Euro. The fall was only a continuation of trend that had started after a brief period of promise at the beginning of 2000. As the Euro plunged, press reports indicated that the European Central Bank (ECB), the Central Bank for the 11 countries in the Euro zone (Germany, France, Spain, Italy, Belgium, Netherlands, Luxembourg, Portugal, Australia, Finland, Ireland) was probably more concerned than it acknowledged in public statements. Given below is a detailed analysis of the problems facing the Euro and a study of the various options before the ECB. As the euro plunged to new record lows on Friday, Williem Buiter, the arch euro enthusiast on the Bank of England’s monetary policy committee, was characteristically dismissive. “It is the non-story of the decade,” he said, “of interest only to chartists.” But, not for the first time, Mr. Buiter was in the minority. When European finance ministers gather in Brussels this morning, their discussions will be overshadowed by a problem that has until now been mostly political, but is growing in economic significance. Over the past three years, the weakness of the euro’s predecessor currencies and then of the euro itself has been an unmixed blessing. Europe has been enjoying a classic export-led recovery. But the euro’s latest collapse has taken it into increasingly alarming territory for the Continent’s leaders. And though every one agrees that the euro is too low, no one can see what might stop it going even lower. For the time being, euro-zone businesses are making hay. It is no coincidence, for example, that Airbus for the first time last year claimed the majority share of the passenger jet market, winning 55 percent of new orders worldwide, and beating Boeing into second place.

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Last year, too, US drivers went crazy for German cars. As Norbert Walter, chief economist of Deutsche Bank in Frankfurt, puts it: “The German luxury car-makers are enjoying a luxurious life.” Mr Walter is forecasting 3 percent GDP growth for Germany this year, and 3.25 percent for the euro-zone. If those forecasts are wrong, he thinks, it will be because they are too low. At the World Economic Forum in Davos, Ferdinand Piech, the head of Volkswagen, made no secret of his delight at the current situation. With a strong dollar, an even stronger yen, and a weak euro he could not think of a better combination of exchange rates, he said. It is always possible, however, to have too much of a good thing. In Davos, officials of the European Central Bank did their best, under enormous pressure not to comment about the euro’s decline. Bitter experience has taught them that anything they say is likely to be taken by the markets as an excuse to push the euro lower. But they are becoming increasingly concerned. When Ernst Welteke, the president of the Bundesbank who sits on the ECB’s Council, said in Davos that the euro was “being watched very closely by the ECB”, the markets took little notice. But his insistence that “no central bank in the world can neglect the development of the exchange rate” is a clear signal that the Bundesbank is getting worried. Euro-zone inflation is set to go through the ECB’s 2 percent target soon. With oil at $30 a barrel, and the German engineering union IG Metall demanding a 5.5 percent pay rise, the fall of the euro is creating an inflationary threat which can no longer be ignored in Germany. Like the German government, the Bundesbank has been arguing for the ECB to hold rates down. Now it seems to be changing its mind. And where the Bundesbank goes, the ECB will follow. There is a growing expectation that euro-zone interest rates could be raised as soon as the next Council meeting on Thursday. If not, they will go up soon after. But the euro’s fall has been barely checked by all the recent news about the growing vigor of Europe’s economy. Changing expectations about interest movements will probably make little difference either. Above all, the irresistible force driving the euro lower has been the flow of investment. “Europeans have been so in love with the US, especially with high-tech `new economy’ assets, that Europe has been a massive net exporter of capital,” says Kit Juckes, chief currency strategist with NatWest Global Financial Markets. Although the euro-zone’s trade balance has been in modest surplus, while that of the US is in spectacular deficit, direct and portfolio investment has been pouring out of the euro-zone and into the US, making all attempts to turn the euro around dismally ineffectual. Europe’s leaders describe it as a problem of perception; a “psychological” one, according to Mr. Welteke. Investors, they think are failing to appreciate Europe’s true potential. As Christian Sautter, France’s finance minister, said at the weekend: “The euro is a young currency, and it has a very good foundation. But may be there is a lack of visibility regarding our macroeconomic policy and our stability policy.” But for many investors, the problem is not so much European governments’ macroeconomic policies, as their structural policies. European governments are unquestionably committed to structural reform. Some of their proposals will deliver substantial benefits to investors. Germany’ planned reform of corporate taxation, for example, will add 7-8 percent to earnings in single year. Mr Walter points out that economies like France, the Netherlands and even Germany are on the whole much less overregulated now than they were a decade ago. But compared with the record-breaking strength and dynamism of the US economy, the Continent still seems sluggish. Wim Duisenberg, the ECB’s president, admitted last night: “What we desperately need in Europe is structural reform ... and when it happens it is a very slow process.” European leaders are looking for something to give that process fresh impetus. Tony Blair, Britain’s prime minister, said on Friday that European Union’s Lisbon summit in March should “mark a definitive turning point towards the reform agenda, retaining the values of the European

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social model but changing their application radically for the modern world”. If it does, it is possible that the currency markets will take it as a turning point for the euro too. Some analysts think it will not now take much more for perceptions to shift. Week after week, euro-zone companies are reporting strong trading performances. The last week alone has brought good sales and earnings reports from the high-tech companies Siemens, SAP and Cap Gemini. “The time will come when the world is no longer in love with US assets, and has overcome its prejudice against everything not Anglo-Saxon”, says Mr Juckes. Victory over the next seven days for the UK’s Vodafone AirTouch in its battle for control of Mannesmann, the German telecommunications group, could be another cue for a change of heart among investors. When the mood of the markets shifts, a steady progression in one direction can turn into a stampede in another. “When the markets realize that there is potential for a strong upswing of the growth rate in the euro area, we will see there is a very great potential for an upswing in the euro,” says Mr Welteke. Almost nobody disputes that the euro is fundamentally undervalued, and so, as Wim Duisenberg puts it, “It has a potential to increase in value”. The trouble is that Europe’s leaders have been saying it for month after month, and it has still not yet happened. Some say it is time for deeds, not words. Euro-enthusiasts like Robert Mundell, who won the Nobel Prize for Economics last year, and Fred Bergsten of the Washington-based Institute for International Economics, have been urging concerted G7 intervention on the foreign exchange markets to revive the euro. The idea has some appeal. Larry Summers, the US Treasury secretary, may have said on Friday, “a strong dollar is in our national interest”, but it is no secret that the US is worried about the decline of the competitive position, and would like to stop the euro falling. But no one is optimistic about the prospects for intervention succeeding. History shows it can work, if a currency is near a turning point. But Canute like attempts to change the direction of markets are generally seen as a waste of time and money. Eventually, the tide will turn. The animal spirits of investors will tell them that the euro has gone as low as it can go. The question is, how long will it take and how much lower will it have to go before the turning point is reached. And as Mr. Juckes puts it: “There’s no science in that.”

Date USD/EUR Eurodollar Interest Rates Euro Interest Rates 3-month

4/1/99 1.1874 3-month 6-month 01/1999 3.13

1/2/99 1.1303 01/1999 4.88 4.88 02/1999 3.09

1/3/99 1.0891 02/1999 4.86 4.92 03/1999 3.07

1/4/99 1.0780 03/1999 4.88 4.96 04/1999 2.71

3/5/99 1.0570 04/1999 4.87 4.94 05/1999 2.62

1/6/99 1.0446 05/1999 4.90 5.00 06/1999 2.66

2/7/99 1.0248 06/1999 5.09 5.27 07/1999 2.68

3/8/99 1.0680 07/1999 5.21 5.53 08/1999 2.70

1/9/99 1.0583 08/1999 5.36 5.78 09/1999 2.73

1/10/99 1.0717 09/1999 5.48 5.87 10/1999 3.37

1/11/99 1.0495 10/1999 6.09 6.02 11/1999 3.45

1/12/99 1.0068 11/1999 5.67 5.93 12/1999 3.45

4/1/2000 1.0311 12/1999 6.06 6.07 01/2000 3.35

01/2000 5.90 5.96

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Part E: Caselets (50 Points) Caselet 1

Read the caselet carefully and answer the following questions. 1. Explain why heavy capital inflows must lead to a tight monetary policy.

(5 points) 2. How does a tight monetary policy affect the competitiveness of exports?

(5 points) 3. Explain why prudent management of capital inflows is important.

(5 points) 4. Critically examine Chile’s approach to management of capital inflows.

(5 points) Chile’s Experience with Capital Controls

The recent developments in Asia have renewed the debate on the usefulness and effectiveness of capital controls. A number of economists have advocated throwing sand in the wheels of international markets to inhibit volatile, short-term capital flows. This view stems from the belief that massive inflows of foreign capital, mainly in the form of short-term portfolio investment and bank loans, have proved to be too unstable and unpredictable to be a major source of external financing for emerging markets. Thus, in contrast to earlier periods, where the focus was on using capital controls to limit capital flight, the current proposals have examined the use of controls to alter the volume and composition of capital inflows. In this context, Chile’s controls have been viewed by some observers as the type of instrument that can be used to manage short-term inflows. In the early 1990s, Chile experienced a surge in capital inflows that created a conflict between the authorities’ internal and external objectives; the problem was how to maintain a tight monetary policy without hindering Chilean export competitiveness. In 1991, the Central Bank attempted to resolve this dilemma by imposing a one year unremunerated reserve requirement on foreign loans. 10% of the inflows had to be effectively deposited in a non-interest bearing bank account. The Chilean Government also stipulated that bonds issued abroad by Chilean companies must have an average maturity of at least 4 years.

Caselet 2 Read the caselet carefully and answer the following questions. 1. When a country adopts a Currency Board, it loses all flexibility with regard to exchange

rates. For example, it would not be able to devalue the currency as a short-term measure to boost exports. Yet, countries like Hong Kong have adopted the Currency Board. Explain the justification for a Currency Board and the type of countries for which it may be best suited.

(7 points) 2. Till a few years back, India followed a fixed exchange rate system. Explain how this

arrangement differed from a Currency Board. (6 points)

A wave of currency depreciation has swept through East Asia, from Thailand to Taiwan. Only the Hong Kong Dollar has clung on to its peg to the American greenback. Hong Kong is also the only economy in the region to operate a currency board. In the past week, speculators have attacked the Hong Kong dollar and the stock market has swing wildly. Will the currency board prove more durable than other Asian exchange rate pegs? That question matters elsewhere. Although the trend in emerging economies is towards more flexible exchange rate mechanisms, several countries including Argentina, Bulgaria, Estonia and Lithuania have introduced currency boards in recent years. But as a recent IMF paper points out, currency boards have costly drawbacks as well as benefits. A country that introduces a currency board commits itself to converting its domestic currency on demand at a fixed exchange rate. The Argentine Peso, for instance, has been convertible into one American Dollar since the board was introduced in 1983. To make this commitment credible, the currency board holds reserves of foreign currency (or gold or some other liquid asset) equal at the fixed rate of exchange to at least 100% of the domestic currency issued. Unlike a conventional Central bank which can print money at will, a currency board issues domestic notes and coins only when there are foreign exchange reserves to back it. Under a

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strict currency board regime, interest rates adjust automatically. If investors want to switch out of domestic currency into, say, dollars (as they have been doing in Hong Kong) then the supply of domestic currency will automatically shrink. This will cause interest rates to rise, eventually it becomes attractive for investors to hold the local currency again.

Caselet 3 Read the caselet carefully and answer the following questions. 1. Developed countries seem to be in favor of putting various restrictions on free trade even as

developing countries like India are talking of further trade liberalization. Explain the reasons behind this peculier turn of events.

(7 points) 2. Critically analyze the statement: “Trade is about greater competition, which weakens the

power of vested interests. It is about greater opportunity for millions rather than privileges for the few.”

(5 points) 3. The article mentions that if further trade liberalization fails to take place, it is the

developing countries which will suffer. However, the fact is that many of India’s politicians remain deeply cynical about the gains from free trade. Reconcile the two positions.

(5 points) As the dust has settled and the tear gas has dispersed, a new parlour game has taken hold people are vying to decide who won, and who lost, from the failure of the World Trade Organization’s meeting in Seattle last weekend. Did the protestors whether greens, trade unions or ‘anarchists’ win? Did Bill Clinton or Mike Moore (the head of the WTO), or big business lose? As the game is played one group representing more than 5 billion of the world’s 6 billion people, sits bemused and befuddled, more or less ignored just as in Seattle. These 5 billion live in the developing countries, and include the poorest of the world’s poor. They are the real losers from this whole sorry episode. Those who wish to claim to have been the winners now also claim that last weekend marked the high point of globalization in general and freer trade in particular. On this view, globalization will now at least be halted, but preferably even be forced into reverse. The battle to prevent this from happing needs now to begin. But as that fight takes place, it is as well to be clear about who would stand to lose most if globalization really were to be pushed sharply backwards-or, indeed, simply if further liberalization fails to take place. It is the developing countries. In other words, the poor. Few of the protesters think this way. Many seem to believe that they are on the poor’s side-against big, multinational conglomerates, against exploiters, against polluters. Even the trade unions, mainly American, who lobbied successfully to pursue President Clinton to press for labor standards to become more closely tied to trade, might well argue that their dearest wish is to help the Indian child whose picture is on our cover they want to export America’s rules that protect workers against exploitation in various forms, including rules forbidding child labor. Nobly, just as they wish to spread democracy and human rights around the globe, so they wish to share their labor values with others.

Swallow, if you can, any scepticism about whether John Sweeney, head of the AFL-CIO union federation, really does have this aim in mind. Ask yourself, first of all, what the developing countries, gathered in Seattle, thought of this. They hated the idea. Partly, no doubt, because they don’t like things being foisted upon them. But also because they don’t think this in their interests. In some cases, it might be right to dismiss that view: the interests of a government, and the elites may well not be the same as the interests of a country’s citizens. But it is not right to dismiss it in all, or in most cases. Think above all of India, home of our cover child. The world’s biggest democracy, for four decades it pursued policies of socialist anti-globalization, shutting out trade and foreign investment

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as best it could. To put it mildly, this did its hundreds of millions of poor no good at all. Finally, in the past decade it has begun to embrace globalization, gradually opening itself up to the world. Finally, its economic growth rate, and with it the welfare and prospects of the poor, has begun to pick up. The process has barely begun, but hopes are high. So India’s ministers troop off to Seattle to discuss further trade liberalization. What are they told? By some, that they are making a big mistake to want to liberalize at all. By others, that they should do so only while imposing labor rules that make their factories less viable. Oh and by the way, the United States will not budge on its protection for textiles and on its use of anti-dumping laws, and the European Union wants to carry on keeping out foreign farm products. The Indians could be forgiven for being disillusioned. They thought, after all, that they were trying to emulate the West. And what is surprising is that this has followed two years in which the world-for which read, the developing world-had passed a stiff test of its faith in open markets. The financial crash in East Asia in 1997 and the ensuring troubles in Eastern Europe and Latin America might well have begun a backlash against globalization. Remarkably, it didn’t. The real question, it seems, is whether that backlash is going to begin in the rich, developed countries of North America and Western Europe. If it does so, it will be a tragedy. Neither trade, nor globalization in general, would be sufficient to give that Indian child a better life. Above all she needs education, and health, and much else. But without trade, and the faster growth it can bring, she is unlikely to get any of it. Tying trade to rules that forbid her from working will not help her either: that way lies greater poverty, not a better education. Free trade, like freedom in general, is not a panacea. It is not likely to bring better welfare on its own. But also, it is not likely simply to enrich multinationals and destroy the planet. Trade is about greater competition, which weakens the power of vested interests. It is about greater opportunity for millions rather than privileges for the few. It is about more countries joining the handful – Japan, South Korea, Singapore and a few more-that this century have closed the gap on the West and transformed the lives of their people. Ten years ago, when the fall of the Berlin wall signalled the failure of communism and other forms of autarkic central planning, it looked as if a new chance had arrived for the 5 billion poor to join the world economy and improve their lives. That chance remains. It must not be thrown away, amid the debris of Seattle.

Model Question Paper 2

Suggested Answers Paper I

Part A: Basic Concepts 1. (c) Fisher open condition states that the nominal interest rates minus the expected inflation

rates, is equal to the interest rate differential i.e., real interest rates are equal across different countries.

2. (e) According to the interest rate parity, an investor will prefer to invest in currency denominated in foreign currency rather than in home currency when the domestic currency interest rate is less than the foreign currency interest rate plus the forward premium as it would fetch higher return. Because

Borrow in currency ‘B’ if S(A/B) > B

A

F(A / B) (1 r )

(1 r )

+

+

Borrowing in currency ‘A’ if S(A/B) < F(A/B) B

A

1 r

(1 r )

+

+

3. (c) If interest rate parity holds good and the transaction costs are zero then the cost of money i.e., the cost of borrowing money or the rate of return on financial investments, when adjusted for foreign exchange risk, is equal across different currencies. Hence the effective borrowing rate will be equal to the domestic interest rate.

4. (a) Transaction exposure is the exposure that arises from foreign currency denominated transactions which an entity is committed to complete. It arises from contractual, foreign currency, future cash flows. Hence an immediate impact of devaluation is reflected in transaction exposure.

5. (b) Dornbusch Sticky-Price Theory explains the phenomenon of overshooting of exchange rates i.e., exchange rates changing more than required by a change in the economic variable and later coming back to the new equilibrium.

6. (a) If the blocked funds are activated and invested in a new project, the initial outlay for the new project stands reduced accordingly.

7. (d) Amount invested is Rs.10 million. As the exchange rate is Rs.38/$ amount invested in $ will be 26315$. The returns obtained were 20%.

Hence the total returns = 31578 which is 26315 + 20% of 26315 or Rs.1231542 million.

Hence the effective return will be 23% approximately, which is 231542/10,00,000.

8. (c) The benefit of centralized cash management in a large MNC comes in the form of netting whereby the receivables are netted out against payables and the net cash flows are settled among the group subsidiaries.

9. (e) The law of one price states that the price levels in different countries determine the exchange rates of these countries. It is based on all the above assumptions.

10. (d) All the alternatives given are reasons for PPP not holding good.

11. (d) Operating exposure is defined by Alan Shapiro as “the extent to which the value of a firm stands exposed to exchange rate movements, the firm’s value being measured by the present value of its expected cash flows. It is the result of economic consequences of exchange rate movements on the value of the firm.”

12. (d) The price elasticity of demand is dependent on all the reasons given.

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13. (a) The monetary approach assumes that PPP holds good, i.e., an increase in the price level results in the depreciation of a country’s currency and vice-versa.

14. (a) Hedging involves taking a position in the forex or the money market which cancels out the outstanding position.

15. (b) Foreign exchange exposure is defined as the sensitivity of changes in the real domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates.

16. (e) Currency swap is not a suitable technique for hedging economic exposure as it cannot be managed by using traditional hedging techniques due to the unpredictability of the changes in the cash flows.

17. (d) If the exchange rate movements of two currencies are negatively correlated, then a firm cannot offset the risk arising from a long position in one currency with a short position in the same currency.

18. (e) Only when the spot bid rate after one month is more than the current bid rate the speculator will benefit from the open position.

19. (d) Amount of loan = Rs.10 million

Amount to be repaid at the end of 5 years = 10,00,000/(1.10)5 = 6.21 million

Benefit due to loan = 10 – 6.21 = 3.79 million.

20. (d) Economic exposure cannot be managed by the traditional hedging techniques due to the unpredictability of the changes in the cash flows. Hence it requires various marketing, production and financial management strategies to cope with the risks.

21. (a) ASEAN is an organization for economic, political, social and cultural co-operation among its members. It is an example a free trade area.

22. (e) The GATT charter aimed at improving standard of living through substantial reduction of tariffs and the elimination of discriminatory treatment in international commerce i.e., free and fair trade. All the alternatives given are objectives of GATT.

23. (b) A letter of credit that is confirmed or guaranteed by a bank in addition to the issuing bank, is referred to as a confirmed letter of credit.

24. (e) Deemed exports occur in case of specified transactions within India, which result in foreign exchange earnings. Software exports cannot be considered as deemed exports.

25. (c) A draft is an unconditional order in writing-usually signed by the exporter (seller) and addressed to the importer (buyer) or the importer’s agent-ordering the importer to pay on demand, or at a fixed or determinable future date, the amount specified on its face value. Sight drafts must be paid on presentation or else dishonored.

26. (c) An irrevocable and confirmed letter of credit is the safest for the exporter because it cannot be cancelled by the issuing bank without the consent of the beneficiary and it is guaranteed by a bank in addition to the issuing bank.

27. (c) As per the exchange rate mechanism established by the European Council, the currency of each country could fluctuate between the wide 6% band to the narrow 2.25% up to August, 1993.

28. (b) Canalized goods are those goods which can be imported only by certain agencies.

29. (d) Under anticipatory credit, payment is made to the exporter at the preshipment stage in anticipation of export of goods and submission of bills at a later stage. Anticipatory credit may be a red clause letter of credit or a green clause letter of credit. As of now, anticipatory credits are outdated and are very rarely used.

30. (d) Normally, export proceeds are to be realized on the due date for payment or within 6 months from the date of shipment of goods whichever is earlier.

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Part B: Problems 1. Bank has to purchase DM 1,000,000 Cover transaction will be to sell DM 1,000,000 ⇒ 2-month forward ⇒ DM 1.70 = $1

3-month forward DM 1.72 = $1 2-month forward $1 = 43.00 3-month forward $1 = 43.60

⇒⇒⇒

2-month forward cross rate = 43.00/1.70 = DM 25.29 3-month forward cross rate = 43.60/1.72 = DM 25.35 The bank will quck the more adverse rate of DM 25.29 minus the margin applicable. If the

margin is 25%, the rate quoted will be 25.29 (1 – 0.0025) = Rs.25.23/DM. 2. Investment in US $ will yield for every dollar invested, (1 + 0.25 x 0.08) = $1.02

Investment made in Can $ will yield 1.56121.5675

x [1 + 0.25 (0.095)] = $1.0196

That is, buy Can $ 1.5612 for each US $, invest the Can $ at 9.5% and sell the proceeds forward for US $.

Since the return from investment made in Canada is less than that made in US, it is advisable to invest in US $.

If borrowing is made in US $, one has to repay for each dollar. (1 + 0.25 x 0.09) = $1.0225 Borrowing in Canadian dollar implies that for each US $ required, 1.5632 Can $ need to be

borrowed. Liability in Can $ = 1.5632 (1 + 0.25 x 0.105) = Can $ 1.6042 If converted to $, at forward rate it becomes 1.6042/1.5655 = $ 1.0247 As the outflow in $ when lower, if borrowing is made in Can $, the firm should borrow in

Can $. 3. Assume the investor had $ 1000

He gets $1,0001.76

= £ 568.18

He can invest in 568.18102

= 5.57 securities

Coupon income = 5.57 x 9 = £50.13 Capital gains = 5.57 (106 – 102) = £22.28 Total inflow on liquidation = £ 568.18 + 50.23 + 22.28 = £ 640.69

Inflow in $ = 640.69 x 1.62 = $ 1037.92

Return = 10 = 3.79% 37.92 1,000 x1001,000

−

4. Assume the investor had $1000

He gets $1,0001.43

= £ 699.30

He can invest in 699.30102

= 6.86 securities

Coupon income = 6.86 x 9 = £61.74 Capital gains = 6.86 (106 – 102) = £27.44 Total inflow on liquidation = £ (699.30 + 61.74 + 27.44) = £ 788.48 Inflow in $ = 788.489 x 1.34 = $1056.56

Return = 1056.56 1,000 x1001,000

− = 5.66%

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5. Currency Amount Payable

After – m After2 – m Outflow in Rs. after 1-m

£ 100,500 101,042 1,00,500 x 68.30 = 6,864,150 DM 290,967 292,054 2,90,967 x 23.55 = 6,852,273 FFr 920,439 924,260 9,20,439 x 7.40 = 6,811,249

FFr is the best currency for making payment at the end of the first month.

Outflow in Rs. if payment is made in £ after two months:

1,01,042 x (67.90 + 0.90) = Rs.6,951,690.

Value of the outflow in Euro = 6,951,69038

= 182939.21

Break even DM/Euro rate = 2,92,0541,82,939.21

= 1.596

Break even FFr/Euro rate = 9,24,2601,82,939.21

= 5.052

Hence, payment in DM and FFr will be better choice if the DM/Euro and FFr/Euro rates are less than the break even rates.

6. On 15th December, the bank will purchase DM 5000 at Rs.20.96/DM and sell DM at the market buying rate of 20.925. The outlay of funds involved will be as under:

The bank buys DM at Rs.20.96

The bank sells DM at Rs.20.925

Outlay of funds Rs.0.035 per DM.

Outlay of funds for DM 5000 is Rs.175

Interest on outlay of funds of Rs.175 for 76 days (i.e. from 15th December to 1st March) at 16% p.a. is Rs.6.

The bank also enters into a forward purchase of DM, delivery 1st March at the market selling rate of 21.4775.

Hence, swap loss/gain will be as under:

The bank sells DM to the market at Rs.20.925.

The bank buys DM from the market at Rs.21.4775.

Swap loss per mark is Rs.0.5525.

Swap loss for DM 5,000 is Rs.2762.5.

Charges for early delivery:

Swap loss Rs.2762.5

Interest on outlay of funds Rs. 6

Flat Charge Rs.100

Rs.2868.5

The customers account will be credited with Rs.104800 and his account will be debited with early delivery charges of Rs.2868.5.

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Part C: Applied Theory 1. The decline of coffee prices in India as a result of devaluation of the Brazilian currency is

an example of operating exposure. The three types of exchange rate exposure are Transaction Exposure This is a measure of the sensitivity of the home currency value of assets and liabilities

which are denominated in foreign currency, to unanticipated changes in exchange rates, when the assets or liabilities are liquidated.

Transaction exposure can arise in three ways: a. A currency has to be converted in order to make or receive payment for goods and

services; or b. A currency has to be converted to repay a loan or make an interest payment (or, conversely,

receive a repayment or an interest payment); or c. A currency has to be converted to make a dividend payment.

Translation Exposure Also called Accounting Exposure, is the exposure on assets and liabilities appearing in the balance sheet but yet to be liquidated. Translation risk is the related measure of variability. The key difference between transaction and translation exposure is that the former involves actual movement of cash while the latter 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 arises when a parent multinational company is required to consolidate a foreign subsidiary’s financial statements with its own after translating the subsidiary’s statements from its functional currency into the parent’s home currency. Thus suppose an Indian company has a UK subsidiary. At the beginning of the parent’s financial year the subsidiary has real estate, inventories and cash valued at, respectively, £1,000,000, £200,000 and £150,000. The spot rate is Rs.47 per pound sterling. By the close of the financial year, these have changed to £1,200,000, £205,000 and £160,000 respectively. However, during the year, there has been a drastic depreciation of the pound to Rs.44. If the parent is required to translate the subsidiary’s balance sheet from pound sterling into rupees at the current exchange rate, it has `suffered’ a translation loss. 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 the subsidiary’s liabilities. Operating Exposure Unanticipated exchange rate changes not only affect assets and liabilities but have significant impact on future cash flows from operations. Operating Exposure is a measure of the sensitivity of future cash flows and profits of a firm to unanticipated exchange rate changes. Consider a firm which is involved in producing goods for export and/or import substitutes. It may also import a part of its raw materials, components, etc. A change in exchange rate(s) gives rise to a number of concerns for such a firm: • What will be the effect on sales volume 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 price to the foreign customers following an appreciation of the foreign currency; a firm which produces import substitutes may contemplate an increase in its domestic currency price to its domestic customers without hurting its sales.

• Since a part of the inputs are imported, material costs will increase following a depreciation of the home currency.

• Labor costs may also increase if cost of living increases and wages have to be raised. • Interest costs on working capital may rise if in response to a depreciation the authorities

resort to monetary tightening. In general, an exchange rate change will affect both future revenues as well as operating costs and hence the operating income. The net effect depends upon the complex interaction of exchange rate changes, relative inflation rates at home and abroad, price elasticities of export and import demand and supply and so forth. Operating exposure and the related risk are extremely difficult to analyze, estimate and hedge against.

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2. The following are the major disadvantages to individual countries if the monetary policy is managed by the EMU: a. Recession: Suppose one of the countries is facing recession and wants to increase

the investment by increasing money supply and bringing interest rates down. It will not be able to do so as money supply is controlled by the EMU.

b. Inflation: Again, as they do not have any control on the money supply, individual countries will not be able to increase or decrease inflation on their own. If the level of inflation decided by the EMU does not match the economic condition of the individual countries, they can only request the EMU for a change in policy and cannot do anything on their own.

c. Unemployment: Unemployment can be reduced by generating employment opportunities, which in turn are dependent on creation of investment. For stimulating investment, money supply and interest rates have to be altered. Once again, individual countries will have to wait for the Union to act and will not be able to do anything to improve the situation on their own. This may have political consequences.

d. If the Union is running a deficit, individual countries will not be able to alter this by planning their trade and will have to suffer until things are set right by the Union.

e. Fiscal Problems: Populist policies such as subsidies give rise to deficits in the long run. They may also result in crowding out of private investment. There are certain monetary tools with which these problems can be overcome. Lack of control over monetary policy will, again, mean that member countries will have to wait until the EMU acts.

3. Indian exporters intending to participate in Trade Fairs conducted abroad, have to make an application to the authorized dealer giving necessary particulars. Foreign exchange will be released by the AD after scrutinizing the application, provided the exporter agrees to give a proper account of the expenditure incurred for the above purpose. Exporters may also open temporary foreign currency accounts abroad for depositing the foreign exchange obtained on sale of goods at the trade fairs. The foreign currency account will be closed, once the fair ends and any balance in that account will be repatriated back to India through normal banking channels. Details of the transactions entered and the sale of goods (duly certified by the exporter’s banker) will have to be made to the RBI. In addition documentary proof as to reimport of goods unsold will have to be furnished within 15 days from the close of the exhibition/fair.

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Paper II Part D: Case Study

1. FACTORS DETERMING STRENGTH OR WEAKNESS OF A CURRENCY

Interest Rates

Interest rates are important determinants of the exchange rates. In case interest rates are market determined their impact on exchange rates will be high rather than when they are regulated. Secondly, the long-term trend in interest rates – rising, declining, stable etc. have a direct effect on the exchange rate.

Balance of Payments

If the BoP of an economy is positive, it reflects growth, competitiveness and such an economy is likely to have a strong currency. An economy with current account deficit is likely to have a relatively weaker currency.

Growth Rate of Economy

The growth of an economy consistently adds strength to the currency. Growth in turn is related to several other factors such as, exports, GDP, per capita income, etc. This adds further to the strength of the currency.

Inflation

Moderate inflation is desirable for the growth of an economy. However, it should be maintained within acceptable levels. Deflation may spell doom for an economy and currency will loose strength. Again inflation directly determines the appreciation/depreciation of the home currency vis-á-vis the foreign currency.

Forex Reserves

Depleting forex reserves adds downward pressure on the home currency while comfortable forex reserves add strength to the currency.

Other Factors

• Government policies and regulatory environment

• Political stability

• Demographics of the economy

• Government debt/borrowings

• Policies of the central bank

• Literacy, unemployment, etc.

• Type of economy – agrarian, industrial, etc.

• Global competitiveness in trade

• Fiscal deficit.

2. A current account surplus indicates that a country has net trade surplus in its balance of payments. A surplus in balance of payments means that the inflow of foreign currencies is higher than that of outflows. When a country runs a current account surplus, the demand for its currency increases. As a result the domestic currency tends to appreciate against the foreign currencies. But this has not been the case for euro.

While a favorable BoP has positive impact on the strength of a currency, the US dollar stands on a different footing. The strength of a dollar is maintained because of capital inflows which US economy attracts. These are high because of free market economy model which US evolved and demonstrated its intention to remain so. Central Banks all over the world keep most of their forex reserves denominated in US dollar.

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The US economy is running through a deficit and high level of inflation, and the US dollar is appreciating against euro. This may be due to the perceptions about the US economy and European economies. Though Euro-Zone has been registering a current account surplus but the prospects of those economies compared to the US economy are not very stable as yet. US economy has proved its worth, whereas most of the countries under euro were languishing in the recent past. Also euro is a very young currency. Till now most of the world’s trade is denominated in dollar, so replacing dollar with euro as a vehicle currency will take sometime, which will increase the demand for euro. Also it is doubtful whether euro-zone countries can together work in such a way to keep euro stronger. These are the possible reasons for euro depreciating against dollar.

3. There are many structural reforms required in the Euro-Zone to influence the euro dollar exchange rate. The most prominent among those is the labor market reforms. In US the labor market is very flexible. There are no restrictions for companies to reduce their labor force when required. As a result US companies can keep their products competitive when the market for a product is falling or when there is a recession in the economy. But the same is not the case for Euro-Zone countries. In those countries retrenching labor force is not easy. So unless those countries reform the labor markets, these economies cannot weather the shocks of the recessionary period. So if these perceptions about the countries are not changed, the possibility of influencing eurodollar exchange rate is remote.

To keep a country’s currency strong vis-á-vis other foreign currencies it is required to follow a focussed monetary policy. The credibility of European Central Bank to follow such a monetary policy is yet to be established.

4.

Quarter Opening Closing Quarterly (depreciation)/appreciation (%)

1st 1.1874 1.0780 (9.21) 2nd 1.0780 1.0248 (4.94) 3rd 1.0248 1.0717 4.58 4th 1.0717 1.0311 (3.79)

5. 1st Quarter

F($/Euro) = $

Euro

r1+ r

1+x S($/Euro) =

0.04881+4 x 1.1874

0.03131+4

= 1.1925. 1.0780← Actual rate

2nd Quarter

F($/Euro)

0.04871+4 x 1.07802711+4

0.0= 1.08378. 1.0248← Actual rate

3rd Quarter

F($/Euro)

0.05211+4 x 1.0248

0.02681+4

= 1.03123. 1.0717← Actual rate

4th Quarter

F($/Euro)

0.05211+4 x 1.0717

0.03371+4

= 1.07892. 1.0311← Actual rate.

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Quarter Expected (depreciation) / appreciation (%)

Actual (depreciation) / appreciation (%)

1st 0.42 1.1925 1.18741.1874

−⎡ ⎤⎢ ⎥⎣ ⎦

0.42%

2nd 0.53 1.08378 1.07801.0780

−⎡ ⎤⎢ ⎥⎣ ⎦

0.53%

3rd 0.62 1.03123 1.02481.0248

−⎡ ⎤⎢ ⎥⎣ ⎦

0.62%

4th 0.67 1.07892 1.07171.0717

−⎡ ⎤⎢ ⎥⎣ ⎦

0.67%

Comments:

Ist quarter:

As per Interest Rate Parity, Euro should have appreciated 0.42% against dollar, but Euro has actually depreciated 9.21% against dollar.

IInd quarter:

As per Interest Rate Parity, Euro should have appreciated 0.53% against dollar, but Euro has actually depreciated 4.94% against dollar.

IIIrd quarter:

As per Interest Rate Parity, Euro should have appreciated 0.62% against dollar, but Euro has actually appreciated 4.58% against dollar.

IVth quarter:

As per Interest Rate Parity, Euro should have appreciated 0.67% against dollar, but Euro has actually depreciated 3.79% against dollar.

6. a. IUS = 2.7%

IEu = Inflation in Euro Area

Op. $/Euro = 1.1874

Cl. $/Euro = 1.0311

Eu

Eu

0.027 I1.0311 1.18741.1874 1 I

−−=

+

or, – 0.1316 = (0.027 – X)/(1 + X)

or, – 0.1316 – 0.1316 X = 0.027 – X or, 0.8684X = 0.1586 or, x = 0.1826 = 18.26% → Inflation level in the Euro area.

b. 0.0509 i 0.0527(1 )(1 ) (1 )4 4 2

+ + = +

(1.012725) (1 + i/4) = (1.02635) ⇒

1 + i/4 = 1.0134538 ⇒

⇒ i = 0.053815 = 5.3815%.

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Part E: Caselets

Caselet 1 1. i. When there are heavy capital inflows, the money supply in the economy will

increase. Higher money supply will give rise to inflationary pressures. Higher inflation will reduce domestic savings and investments and makes exports expensive and the volume of exports comes down (assuming the domestic currency is not devalued).

ii. Too much of liquidity in the economy leads to speculative investments in financial assets and real estate and gives birth to bubbles.

iii. With higher liquidity domestic interest rates fall. Lower interest rates lead local investors to risky investments to enhance their returns.

iv. A lower interest rate scenario can also lead to low savings followed by low investment which can lead to recession in the long run.

2. If the monetary policy is tight, that means the money supply is low and hence interest rates are high. High interest rates lead to higher cost of capital for firms, which push up the cost of production, assuming that the value of the home currency does not fall due to the higher interest rates.

3. If a developing country wants to enhance its rate of industrial growth and employment generation, it will have to depend on foreign capital, as developing countries generally do not have enough capital to meet such requirements. But, foreign capital inflows do not bring in just higher investments and employment. They also create problems of excess liquidity investments in areas thought profitable by foreign companies than those desired by the country, booms and busts in stock market, forex markets and real estate markets when the inflows are heavy and when they are withdrawn and also allegations of a sell out to foreign nationals. But, restricting capital inflows will mean, for a developing country, slowdown of growth. Therefore, capital inflows have to be managed well to ensure that the gains are not offset by the losses.

4. a. The likely benefits from Chile’s approach are i. The stipulation of a one-year deposit will ensure that only medium or long-

term investments will come in. ii. The stipulation of a minimum maturity for funds raised by Chilean

companies from overseas markets also prevents hot money from flowing in. b. The likely losses are i. Capital inflows will slowdown – both because the rate of return required to

be earned from investments in Chile will be high and the confidence of the foreign investors will suffer.

ii. The cost of funds for Chilean companies will go up • because companies will have to borrow 10% more than their actual

requirement • rate of interest increases with increase in the amount borrowed.

Caselet 2 1. The basic advantage of a Currency Board is that, by making a country’s monetary policy

subservient to a Central Bank that is independent and has a good track record in inflation control, the country’s inflation could itself be kept under check.

Removal of discretionary powers relating to money supply means that there will be little scope for political interference. This is especially relevant in emerging economies.

Linking the domestic currency to dollars or some other hard currency makes it more credible and valuable.

The Currency Board can be managed easily as rules are clearly defined unlike a conventional Central Bank where experienced and wise economists are needed to reform

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monetary policies in response to the changing economic scenario. Even such wise men find themselves helpless during times of economic crises.

The predictability and rule based nature of a Currency Board are its main advantages. Open economies for whom a significant proportion of income is generated by international

trade need to insulate themselves from forex fluctuations. Violent currency fluctuations will tend to affect all segments of the economy. As such, the fixed exchange rate mechanism is valuable for countries such as Hong Kong which is a very small open economy.

2. In a Currency Board, the fixed exchange rate is maintained by adjusting the domestic money supply in response to inflows and outflows of foreign capital. This selling pressure on the domestic currency would lead to outflow of foreign capital, contraction of domestic money supply and hike in interest rates. Buying pressures on the other hand could mean inflow of foreign capital, expansion of money supply and lowering of interest rates.

In the case of India, the fixed exchange rate was maintained by a virtual ban on trading and outflow of capital. So, the parity was maintained artificially by not allowing the market mechanism to function than by strict monetary discipline, the essential characteristic of a Currency Board.

Caselet 3 1. The World Trade Organization’s meeting in Seattle failed miserably because both the

developing and developed countries were against each others views for more free trade practices. Developing countries want more access to the market of the developed countries without putting any restrictions to the present practices. Whereas developed countries are of the view that developing countries should be given more access to their markets when they improve their labor standards and other practices. These developed countries are against the practices followed by those developing countries to produce goods for exports in their countries like cheap labor or child labor and inadequate sanitation facilities in the working place etc. To improve the standard of living of these laborers it is necessary to relate the standards of labor with trade. The reason behind such a view for developed countries is naturally that by using cheap labor these countries can produce goods at cheaper prices and if all the markets become free then more jobs will be taken away by these exporters thus creating more unemployment. Whereas the developing countries were against this view because their competitiveness lies in using cheap labors. Because of such clash of views WTO’s meeting for more free trade was not successful.

2. Due to trade the most benefitted class is the general consumers. The international trade takes place because one country may be more efficient in producing a particular good than another country, that is it reduces the cost of that particular good to consumers. Now if trade restrictions like export quota, anti-dumping duty are imposed – they are done to protect some particular class of producers from the international competition due to their inability to produce goods at a cheaper price. By this the cost to the consumers increases, thus resulting in a higher outflow for their consumption which directly goes to the exchequer of those producers, thus servicing their interests without addressing the requirement of the consumers. So free trade will force these producers to face open competition, thus reducing the possibility of manipulating the prices to their benefit.

3. The liberalized trade benefits the developing countries by providing access to the developed markets where demand is high. The developing countries enjoy cost competitiveness because of the cheap labor costs. Hence if trade liberalization takes place these economies will be benefitted. The free economy will also help them in strengthning the quality/productivity in view of the competing products. If the economy experiences a growth as a consequence it is in the interest of the developing countries. However, the logical view essentially tries to highlight the adverse consequences. The free trade resulting in imports is likely to adversely affect the domestic industry if sufficient protection and time are not provided for the domestic industry to cope with.

In developing countries like us the labor standards are to be improved which will make our product less competitive in the international market. Also banning the child labor is a big blow to the economy. In this scenario ban on child labor for free trade can only make the

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life of those children and their families more difficult. So it is necessary to have free access to markets of the developed countries but not at the cost of our huge labor force.

Model Question Paper 3 Time: 3 Hours Total Points: 200

Paper I

Part A: Basic Concepts (30 Points)

Answer all the questions. Each question carries one point. 1. The spot rate is Rs.35/$. If the dollar appreciates by 5%, the depreciation of the rupee

a. Is equal to 5%

b. Is less than 5%

c. Is more than 5%

d. Cannot be determined

e. None of the above.

2. __________ are underwritten and have a maturity of up to one year.

a. Note issuance facilities

b. Medium-term notes

c. Commercial paper

d. ADRs

e. None of the above.

3. __________ is a private arrangement between lending banks and a borrower.

a. Club loan

b. Multiple component facility

c. Syndicated Euro credit

d. All of the above

e. Both (a) and (c) above.

4. Shibosai bond is a bond

a. Denominated in ¥ and issued outside Japan

b. Denominate in a currency other than ¥ and issued in Japan

c. Denominated in Japanese ¥ and issued under private placement in Japan

d. Denominated in ¥ and issued by a overseas corporate to the public in Japan

e. None of the above.

5. In the APV method, the discount rate used for calculating the value of a concessional loan is

a. The risk-free interest rate in the home country

b. The risk-free interest rate in the host country

c. The competitive borrowing rate in the home country

d. The competitive borrowing rate in the host country

e. None of the above.

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6. International Asset Pricing Model is based on the premise that a. International capital markets are perfectly integrated b. Purchasing Power Parity holds good c. International capital markets are not perfectly integrated d. Both (a) and (b) above e. Both (b) and (c) above.

7. The Bundesbank announces a sudden, unexpected hike in the German interest rates. What do you think is likely to happen? a. The dollar will appreciate against the Mark. b. The dollar will depreciate against the Mark. c. The dollar will appreciate against the rupee. d. The mark will depreciate against the rupee. e. There will be no change in exchange rates.

8. A Samurai Bond is a Yen denominated bond issued by a. Japanese resident to non-resident investor b. A non-resident in Japanese market c. Japanese resident in international market d. Both (a) and (b) above e. All of the above.

9. The cost of production is as follows

Wheat Rice USA x y India 3x 5y

Then the following statement is most appropriate. a. US should export rice and wheat. b. US should export only rice and keep wheat for domestic consumption. c. US should export only wheat and keep rice for domestic consumption. d. US should export wheat and import rice. e. US should export rice and import wheat.

10. The key issue in international cash management is a. Giving sufficient independence to individual subsidiaries b. Centralizing and minimizing independence of subsidiaries c. Deciding whether hedging is required or not d. Striking the right balance between decentralization and centralization e. None of the above.

11. The observed rates on a particular day in New York are F. Fr/£ : 8.8800; DM/$ : 1.5380; $/£ : 1.7122

Then F. Fr/DM = ? a. 5.1863 b. 5.1860 c. 3.3721 d. 3.3525 e. 5.1870.

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12. The functional currency of a firm can be best defined as a. The currency in which the firm prepares its financial statements b. The currency of the primary economic environment in which the firm operates c. The currency in which the firm reports its financial performance to the international

shareholder d. The currency of that country where the parent firm is situated e. None of the above.

13. A bank has to quote a forward rate for purchase of dollars. Delivery option is second month. Given the following quotes in the interbank market, what is the rate the bank should quote?

Spot : 35.50/35.751 month forward : 20/30 2 month forward : 25/35 a. 35.50

b. 35.70

c. 35.75

d. 36.05

e. 36.10

14. A company sells its exports receivables to a firm that takes responsibility for collecting payment from the importer. It has used

a. Accounts receivable financing

b. Factoring

c. Forfaiting

d. Letter of credit

e. None of the above.

15. If the forward rate is 35.75/36.00 and the relevant swap points are 10/15, what is the spot rate?

a. 35.85/36.15.

b. 35.60/36.10.

c. 35.65/35.85.

d. 35.90/36.10.

e. None of the above.

16. In the context of balance of payments reserve assets include

a. Assets denominated in foreign currencies

b. Special drawing rights

c. Gold with RBI

d. All of the above

e. Both (b) and (c) above.

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17. Foreign Exchange Risk is defined as

a. Variance in the value of assets and liabilities and operating income due to unanticipated changes in exchange rates

b. Variance in the operating income due to expected changes in exchange rates

c. Variance in the operating income, value of the assets and liabilities due to unfavorable movement of exchange rates

d. The possibility of loss a firm may sustain due to changes in the exchange rates

e. The actual and potential loss suffered due to changes in exchange rates.

18. If the spot rates are Rs./$ : 35.50/90 and SFr/$ : 1.4955/62 then the implied Rs./SFr rates will be (Round off to nearest two decimals).

a. 23.74/23.99

b. 23.73/24.01

c. 23.73/23.99

d. 23.74/24.01

e. None of the above.

19. If the spot rate is Rs./$ 35.50/90 and if swap points for 3m forward are 30/50, then the forward rate is

a. 35.20/35.40

b. 35.80/36.40

c. 36.00/36.20

d. 35.20/36.40

e. 35.00/35.40

20. According to AS-II, a transaction in a foreign currency should be translated at the _______ as on the date of the transaction.

a. 1 month forward rate

b. 3 month forward rate

c. Spot rate

d. Inflation adjusted rate

e. Rate depending on case by case basis.

21. European Union is an example of

a. Free trade area

b. Customs union

c. Common market

d. Economic union

e. None of the above.

22. The exceptions to the basic principles of WTO are

a. BOP problems

b. Tariff problems

c. Dumping

d. Regional groupings

e. All of the above.

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23. The incentives provided to Indian exporters by the government of India are

a. Cash incentives for certain exports

b. Tax concessions

c. Infrastructure facilities

d. All of the above

e. Both (a) and (b) above.

24. A letter of credit which is opened with another letter of credit as the security is known as

a. Back-to-back letter of credit

b. Revocable letter of credit

c. Revolving letter of credit

d. Transferable letter of credit

e. Deferred payment letter of credit.

25. A letter of credit is

a. A short-term credit by a bank to an importer

b. A guarantee to honor the bills of an exporter drawn within stipulated terms

c. A guarantee by a bank to discount all the bills of an exporter

d. A short-term credit by the bank to an exporter against a confirmed order

e. Both (b) and (c) above.

26. The acronym UCPDC is related to foreign trade where

a. Credit is extended on open account

b. Sales are undertaken through consignment

c. Factoring is involved

d. Letter of Credit is involved

e. Not related to foreign trade.

27. The validity of the EPCG license is

a. 6 months

b. 12 months

c. 15 months

d. 18 months

e. 24 months.

28. Exporters of Gem and Jewellery are eligible to import their inputs by obtaining

a. Special Import Licenses

b. Advance Licenses

c. Replenishment Licenses

d. Diamond Imprest Licenses

e. Both (c) and (d) above.

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29. Which of the following is not a valid condition with regard to opening of an import letter of credit? a. In case of goods falling in the negative list, the importer is required to submit the

exchange control copy of the import license to the authorized dealer. b. The import license should be valid for shipment at least up to the last shipment date

requested for in the letter of credit application. c. Payment in respect of goods imported from Nepal or Bhutan should be made in

rupees, and such an LC should be treated as a domestic LC. d. Remittance in case of imports on cash basis should be made within a period of six

months from the date of shipment. e. If the beneficiary is from an ACU country, the LC should necessarily be

denominated in US dollars. 30. Pre-shipment Credit in Foreign Currency (PCFC)

a. Is made available to cover only imported inputs of the exported goods b. Is available only for exports on deferred payment basis c. Can be extended in one convertible currency in respect of an export order invoiced

in another convertible currency d. Is made available to the exporter with an intention of providing finance at

internationally competitive rates e. Both (c) and (d) above.

Part B: Problems (50 Points)

Solve all the problems. Points are indicated against each problem. 1. A German subsidiary of an US based MNC has to mobilize working capital for the next 12

months. It has the following options: Loan from German bank : @5% Loan from US parent : @4% Loan from Swiss bank : @3%

Banks in Germany charge an additional 0.25% towards loan servicing. Loans from outside Germany attract withholding tax of 8% on interest paid. If the interest rates given above are market determined, examine which loan is the most attractive.

(9 points) 2. Fill the blanks in the following table.

Country USD AUD GBP CAD FRF DEM U.S. — 1.9865 0.6241 1.4727 6.2657 1.8682 Australia — 0.4127 0.9739 3.7341 1.2354 Britain 1.6023 2.4230 — 2.2313 10.0395 Canada 0.6790 1.0268 — 4.7513 1.2686 France 0.1596 0.0996 — 0.2982 Germany 0.5353 0.8094 0.3164 0.7883 —

(5 points) 3. The current market quotes are as under:

Rs./Euro Spot 49.50/65 Rs. interest rate Euro Interest Rate1-m forward 49.20/40 1-month 9.00% 9.50% 3.50% 3.75% 2-m forward 49.00/25 2-month 9.75% 10.25% 4.00% 4.25%

Verify whether there is any scope for covered interest arbitrage. What should be the amount of money to be borrowed to make risk-free gains of Euro 25,000 if there is scope for arbitrage.

(10 points)

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4. Interest rates for three months in US and Canada are as follows: Borrow Invest US $ 9% 8% Canada $ 10.5% 9.5%

Can $/$ spot 1.235 1.240 3m forward 1.255 1.260

Advise the currency in which borrowing and lending for 3 months needs to be done for a US company.

(9 points) 5. A bank agreed at the request of an exporter for a 2m forward contract based on the

following rates: Rs./$ Spot 42.50/55 1m forward 20/28 2m forward 35/40 The exporter requested for the cancelation of the forward contract at the end of one month

and delivered US$ 10,00,000. If the forward rates are the unbiased estimates of spot rates compute the cash flow to the exporter.

(10 points) 6. Bank B has entered into a 3-month forward purchase contract for Sw Frcs 15,000 with ‘A’

at the rate of Rs.28.25. After two months, `A’ approaches Bank B and requests for cancellation of the contract. On this date, the rates prevailing are Spot Rs./CHF 28.30/28.35 1-month forward 28.45/28.52 (All merchant rates)

What is the loss/gain to the customer on cancellation? (7 points)

Part C: Applied Theory (20 Points)

Answer the following questions. Points are indicated against each question. 1. Many economists have argued that our country needs a strong domestic financial system

before capital account convertibility is introduced. Explain the linkage between the health of a country’s financial system and its ability to deal with heavy inflows and outflows of capital.

(9 points) 2. What do you think are the other areas which may eventually have a common regulatory

framework? Justify. (6 points)

3. Documentary credits, though of comparatively recent origin, have contributed enormously to the growth of international trade worldwide. In light of this, briefly explain the operation of a letter of credit.

(5 points)

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Paper II Part D: Case Study (50 Points)

Read the case carefully and answer the following questions. 1. Comment on the financial viability of the project.

(20 points)

2. What are the different circumstances in which nominal all-equity discount rate and real all-equity discount rate should be used for discounting the cash flows? Explain the rationale behind it.

(9 points)

3. Comment on the financial viability of the project if the firm is sure about being able to absorb the tax benefits arising out of depreciation and increased borrowing capacity.

(7 points)

4. Explain the concept of exchange risk and how it affects an international project.

(6 points)

5. How can the financing structure of a project be used to overcome repatriation restrictions? What are the additional benefits of such maneuvers?

(8 points)

Krutika Designers Ltd. is an Indian company engaged in designing shirts for an international shirt manufacturer. Its operations are currently restricted to designing shirts for the Indian market. The firm is interested in extending its operations to the European markets, but is restricted by its lack of knowledge about the latest fashions and trends prevailing there. Hence, the firm has decided to open an office in Finland for establishing a network in Europe that will give the firm access to the needed information. The firm feels that it does not have the capability of sustaining itself in the foreign markets in the long-term, and will be able to generate additional revenue from these activities only for the next 5 years. After that, the Finnish office will have to be closed down.

The firm anticipates an initial investment of Rs.14 million. The project is expected to generate the following cash flows over the 5 years period.

Year Cash flow (Finnish Marks)

1 10,00,000

2 20,00,000

3 50,00,000

4 50,00,000

5 30,00,000 These cash flows are expressed in terms of today’s money.

The firm can claim depreciation in India according to the Straight Line Method. The salvage value from the project is expected to be nil.

The Finnish Government does not provide any incentives for foreign investments. However, currently it is making an attempt to have better economic ties with India. Hence, it has decided to extend a loan of 50,000 marks to Krutika Designers. The loan will be at a concessional interest rate of 7%. The loan is to be repaid in 5 equal annual installments which will include the interest payments.

The project will generate additional borrowing capacity of Rs.5 million for the firm. However, as the firm does not have any firm contract with the international shirt manufacturer, its domestic

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revenues are expected to be very volatile. Therefore, there is no surety that the firm will be able to absorb the tax benefits arising out of depreciation and additional borrowing capacity.

The firm does not intend to indulge in any illegal money transfers.

The current spot rate for the Finnish Mark is Rs.7.25/FM. The inflation rates in India and Finland for the next 5 years are expected to be 8% and 3% respectively. The exchange rate is expected to move in tandem with the inflation rates.

Indian tax rate is 35%, while Finnish tax rate is 40%. India and Finland have entered into a tax treaty whereby the earnings of the residents of one country are taxable in that country only.

In India, the nominal risk-free interest rate is 11%. The same is 6% in Finland. The Indian nominal interest rate (including risk-premium) is 15%, while that in Finland is 9%. The nominal all-equity rate in India is 18%.

Part E: Caselets (50 Points)

Caselet 1 Read the caselet carefully and answer the following questions. 1. Explain the linkage between the strength of a currency and the flexibility of an economy.

(5 points)

2. One of the major gaps in India’s economic reforms program is the absence of an exit policy. Explain the importance of exit policy in the context of the move towards capital account convertibility.

(5 points)

3. Reliance on external funds for domestic economic growth appears to be a reason for the crisis in Asian countries. Does it mean that ‘Self-Reliance’ and ‘Swadeshi’ are the right approaches for stable economic growth? Explain.

(5 points)

The Flexible Tiger

Asia’s string of financial crisis has exposed the fact that the fast growth of many companies has depended critically on easy money. Many factors have been held responsible for the Asian currency crisis – ready availability of bank loans at attractive interest rates, fixed exchange rates, heavy foreign debt burden, poor banking regulation, etc. When crisis came and the easy money dried up, debt-leaden companies were quickly mired in financial trouble. Their restructuring will entail redundancies and plant closures which will make the economic situation all the more serious.

One of Asia’s so called Tigers, however, has fared far better than the rest. While Korea and South-East Asia are struggling, Taiwan has so far escaped with a small currency devaluation and a relatively modest decline in share prices. There are various reasons to explain the relatively strong performance of Taiwan. One explanation offered is the light foreign debt burden. Taiwan is also credited with better banking regulations than generally found in other Asian countries. A more interesting explanation reported in ‘The Economist’ is the flexibility of the Taiwanese economy. In this context, some experts have pointed out that in Taiwan, it is easy for new companies to enter and old ones to fail. In 1991, 40% of Taiwan’s chemical output came from firms that did not exist in 1986. About 33% of the value of Taiwan’s plastics production and half its output of fabricated metal products were also attributable to firms less than five years old. New companies often establish their business by forcing old timers out. Firms that had accounted for 58% of Taiwan’s chemical production in 1981 had left the business in 1991. Roughly 80% of the firms that

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manufactured clothing, metal products, textiles and plastics in 1981 either closed or changed lines of business over the next decade.

Caselet 2 Read the caselet carefully and answer the following questions.

1. The article mentions that markets for goods and services usually operate with a reasonable amount of predictability. On the other hand, financial markets are characterized by bubbles and crashes. Explain why this may be so.

(7 points)

2. Consider a country which is attracting heavy capital inflows. What steps should it take to ensure that economic stability is maintained and maximum benefits can be generated?

(7 points)

3. Consider a country like India. Explain with reasons whether you advocate free flow of capital.

(7 points)

Among economists, support for the free movement of money is an article of faith. Give free trade, the argument goes, the free flow of capital across borders can increase economic efficiency. Savings will flow to the most productive investment opportunities, regardless of their location; greater competition will create more nimble financial systems in every country; and vigilant investors will provide a healthy discipline for profligate governments. But, as the political, social and economic costs of East Asia’s financial crisis becomes clearer, a revisionist chorus is gaining voice. Perhaps, it is now argued, international capital mobility brings more costs than benefits.

In the current issue of Foreign Affairs, Jagdish Bhagwati, a respected trade theorist from Columbia University argues that “the claims of enormous benefits from free capital mobility are not persuasive”. In another recent essay Dani Rodrik, a Harvard University trade specialist, says of capital mobility: “We have no evidence that it will solve any of our problems, and some reason to think that it may make them worse.” Both are deeply skeptical of the idea that the International Monetary Fund should prod countries to liberalize capital shows. They use two broad lines of argument: that the theoretical case for capital mobility is much weaker than the case for free trade; and that there are few signs of the benefits of free capital flows but abundant evidence of the costs.

Superficially, the theory supporting free trade in widgets and free trade in money seems similar. In both cases, economic theory assumes that markets function efficiently and rationally, based on perfect information. In neither case does reality live up to theory. The markets for many goods and services are far from textbook perfect. But in financial markets, the failures are much more acute.

As Mr. Rodrik points out, markets for goods and services usually more in a reasonably predictable way. In financial markets, in contrast, bubbles and crashes are endemic.

The revisionists’ other approach is to question the evidence of the benefits of capital mobility. Mr. Bhagwati points out that proponents have failed to estimate the size of the gains capital mobility is purported to have brought. He provides anecdotal evidence that the benefits might not be so big after all. China and Japan, he points out, enjoyed remarkable growth without allowing free capital flows, as did Western Europe after the second world war.

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Caselet 3 Read the caselet carefully and answer the following questions. 1. Explain the advantages and disadvantages of counter-trade.

(4 points) 2. What are the different forms of counter-trade?

(4 points) 3. What are the skills and resources necessary to succeed in counter-trade?

(6 points) Marc Rich & Co. Recreates the Soviet Union’s Supply System

In 1992, Marc Rich & Co., a giant Swiss-based commodity trader, engineered a remarkable $100 million deal involving enterprises and governments in five newly independent countries. This deal essentially pieced together shattered supply links that Moscow controlled when the U.S.S.R. was one giant planned economy.

Here’s how the deal worked. Marc Rich bought 70,000 tons of raw sugar from Brazil on the open market. The sugar was shipped to Ukraine, where through a “tolling contract,” it was processed at a local refinery. After paying one sugar refinery with part of the sugar, Marc Rich sent 30,000 tons of refined sugar east to several huge Siberian oil refineries, which need sugar for their vast workforces.

Strapped for hard currency, the oil refineries paid instead with oil products, much of it low-grade A-76 gasoline, which has few export markets. But one market is Mongolia, with which Marc Rich has long traded. The company shipped 130,000 tons of copper concentrate. The company sent most of that back across the border to Kazakhstan, where it was refined into copper metal. Then the metal was shipped westward to a Baltic seaport and out to the world market where, several months after the deal began, Marc Rich earned a hard currency profit.

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Model Question Paper 3 Suggested Answers

Paper I Part A: Basic Concepts

1. (a) The direct quote for Rs. is 35/$. When the dollar appreciates by 5% the rate changes to Rs.36.75/$ i.e., 1.05 x 35. Hence the depreciation of rupee is equal to 5%.

2. (a) A note issuance facility is a medium-term legally binding commitment under which a borrower can issue short-term paper, of up to one year.

3. (a) The club loan is a private arrangement between lending banks and borrower. When the loan amounts are small and the parties are familiar with each other lending banks form a club and advance loan, hence the name of club loan.

4. (c) Shibosai bonds are privately placed bonds issued in the Japanese markets. Shibosai bonds are offered to a different market segment that consists of institutional investors, including banks.

5. (c) As the nominal foreign currency interest would have had to be paid in the absence of concessionary loan, that rate should be used as the discount rate for calculating the present value of repayments of concessional loan.

6. (c) International Asset Pricing Model is based on the premise that the international capital markets are not perfectly integrated.

7. (b) A high interest rate would increase the demand for domestic currency. Hence the Dollar would depreciate against Mark.

8. (b) Samurai bonds are bonds issued by non- Japanese borrowers in the domestic Japanese markets.

9. (e) According to the theory of comparative advantage, each country should produce that good, in which it has a comparative advantage. Hence US should export rice in which it has a comparative advantage over India and import wheat.

10. (d) Striking the right balance between decentralization and centralization is the key issue in International cash management

11. (c) F Fr/P: 8.8800 $/P = 1.7122 F Fr/$ = F Fr/P x 1/($/P) F Fr/$ = 5.1863 DM/$ : 1.5380 F Fr/DM = F Fr/$ x 1/(DM/$) F Fr/DM = 3.3721 12. (b) Functional currency is the currency of primary economic environment in which the

affiliate generates and expends cash. 13. (b) Since the delivery option can take place any time during the second month, the bank

will base its quote on the more adverse of the one month and two month forward rates, as it has to buy dollars. Hence, the one month forward bid rate (35.70) will be the quote which is obtained by adding the swap points to the spot rate when the swap points are in low/high order.

14. (b) Firms with substantial export business and companies too small to afford a foreign credit and collections department can turn to a factor. Factors buy a company’s receivables at a discount, thereby accelerating their conversion into cash.

15. (c) The spot rate can be obtained by deducting the swap points from the forward rate when the swap points are in low/high order. Hence, the spot rate is 35.65/35.85.

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16. (d) Official reserves include gold, reserves of convertible foreign currencies, SDR’s and balances with IMF which are the means of international payment which are acquired or lost during the period for which the BoP account is constructed.

17. (a) According to Maurice D Levi, foreign exchange risk as the variance of the domestic currency value of assets, liabilities or operating income that is attributable to unanticipated changes in exchange rates.

18. (b) Spot rate Rs./$ = 35.50/35.90 Spot rate SFr/$ = 1.4955/1.4962 (Rs./SFr)bid = (Rs./$)bid x 1/(SFr/$)ask (Rs./SFr)ask = (Rs./$)ask x 1/(SFr/$)bid = 23.726/24.005 (app.) = 23.73/24.01 19. (b) The forward rate is obtained by adding the swap points 30/50 to the spot rate when the

swap points are in low/high order. Hence the forward rate is 35.80/36.40. 20. (c) According to the accounting standard - II prescribed by the ICAI which deals with the

reporting of foreign currency transactions, a transaction in a foreign currency should be translated at the spot rate as on the date of the transaction.

21. (d) With a common central bank created in 1998, the European union is now a economic union.

22. (e) Certain concessions were allowed for countries facing peculiar problems or for some special situations. All the alternatives given are exceptions to the basic principles of WTO.

23. (d) All the alternatives given are incentives provided to the Indian exporters by the Government of India.

24. (a) A back-to-back credit or a counterveiling credit is a letter of credit which is opened with another letter of credit as the security. The letter of credit acting as the security is known as the overriding or principal credit.

25. (b) A letter of credit is defined as an arrangement by means of which a bank acting at the request of a customer, undertakes to pay a third party a predetermined amount by a given date, according to agreed stipulations and against presentation of stipulated documents.

26. (d) Uniform Customs and Practices for Documentary Credits (UCPDC) is related to foreign trade where letter of credit is involved.

27. (e) The Export Promotion Capital Goods license (EPCG) is valid for a period of 24 months. 28. (e) Exporters of Gem and Jewelry are eligible to import their inputs by obtaining

Replenishment Licenses and Diamond Imprest Licenses. 29. (e) If the beneficiary is from an ACU country, the LC should be denominated in ACU

dollar which is equivalent value-wise to one US dollar. 30. (e) Pre-shipment Credit in Foreign Currency (PCFC) can be extended in one convertible

currency in respect of an export order invoiced in another convertible currency. It is made available to the exporter with an intention of providing finance at internationally competitive rates.

Part B: Problems 1. Loan in Germany Cost = 6 + 0.25 = 6.25% Loan from US Bank

Effective rate of interest = 4% 4.351 0.8

=−

Premium on USD = 1.05 1 0.96%1.04

− =

Net Cost = 4.35 + 0.96 = 5.31%

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Loan from Swiss Bank

Effective rate of interest = 3 3.261 0.8

=−

Premium on SF = 1.05 11.03

− = 0.019%

Net cost = 3.26 + 1.9 = 5.16% So, Swiss loan is the best.

2. a. AUDUSD

= 1.9865 (given)

USD 1 0.5031AUD 1.9865

= =

b. FRF 3.7341 (given)AUD

=

AUD 1 0.2678FRF 3.7341

= =

c. CAD 2.2313 (given)GBP

=

GBP 1 0.4482CAD 2.2313

= =

d. FRF 4.7513 (given)CAD

=

CAD 1 0.2105FRF 4.7513

= =

e. DEM 0.2982(given)FRF

=

FRF 1 3.3535DEm 0.2982

= =

f. GBP 0.3164(given)DEM

=

DEM 1 3.1606GBP 0.3164

= =

3. 1-month: Borrow Rs. and invest in Euro:

Borrow Rs.49.65

Buy one Euro

Invest one Euro to get 0.0351 1.002912

⎛ ⎞+ =⎜ ⎟⎝ ⎠

Euro

Sell 1.0029 Euro forward to get (Rs.1.0029 x 49.20) = Rs.49.34

Amount repayable = Rs.49.65 0.095112

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.50.04

As the amount received is lower than the amount repayable, no arbitrage is possible.

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Borrow Euro and Invest in Rs.: Borrow one Euro Sell the Euro to get Rs.49.50

Invest Rs.49.50 to get Rs.49.50 0.09112

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.49.87

Sell Rs.49.87 forward to get 49.8749.40

⎛ ⎞⎜ ⎟⎝ ⎠

= 1.0095 Euro.

Repay 0.0375112

⎛ ⎞+⎜ ⎟⎝ ⎠

Euro = 1.0031 Euro.

As the Euro received is more than the Euro required to repay the loan, there is an opportunity for arbitrage.

Profit for every Euro borrowed: 1.0095 – 1.0031 = 0.0064 Euro

Number of Euro to be borrowed for a profit of Euro 25,000 = 25,0000.0064

= Euro 3,906,250

2-months: Borrow Rs. and invest in Euro Borrow Rs.49.65 Buy one Euro

Invest the Euro to get 0.0416

⎛ ⎞+⎜ ⎟⎝ ⎠

Euro = 1.0067 Euro. Sell 1.0067 Euro forward to get Rs.(1.0067 x 49.00) = Rs.49.33

Repay Rs.49.65 x 0.102516

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.50.50

As the amount received is less than the amount to be repaid, there is no arbitrage opportunity.

Borrow Euro and invest in Rupees Borrow one Euro Sell spot for Rs.49.50

Invest Rs.49.50 to get Rs.49.50 0.097516

⎛ ⎞+⎜ ⎟⎝ ⎠

= Rs.50.30

Repay 0.042516

⎛ ⎞+⎜ ⎟⎝ ⎠

Euro = 1.0071 Euro

Sell Rs.50.30 forward to get Euro 50.3049.25

⎛ ⎞⎜ ⎟⎝ ⎠

= 1.0213 Euro

As the amount received in Euro is higher than the Euro payable, there is possibility of arbitrage profit.

The profit = (1.0213 – 1.0071) Euro = 0.0142 Euro

Number of Euros to be borrowed for making profit of Euro 25,000 = 25,0000.0142

= Euro

1,760,563 4. Investment in US $ will yield for every dollar invested, (1 + 0.25 x 0.08) = $1.02 Investment made in Can $ will yield

1.2351.260

x [1 + 0.25 (0.095)] = $1.003438

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That is, buy Can $ 1.235 for each US $, invest the Can $ at 9.5% and sell the proceeds forward for US $.

Since the return from investment made in Canada is less than that made in US, it is advisable to invest in US $.

If borrowing is made in US $, one has to repay for each dollar. (1 + 0.25 x 0.09) = $1.0225 Borrowing in Canadian dollar implies that for each US $ required, 1.240 Can $ need to be

borrowed. Liability in Can $ = 1.24 (1 + 0.25 x 0.105) = Can $ 1.27255 If converted to $, at forward rate it becomes 1.27255/1.2550 = $ 1.01398 As the outflow in $ is lower, if borrowing is made in Can $, the firm should borrow in Can $. 5. Rs./$ spot: 42.50/55 1m forward: 20/28 2m forward: 35/40 Forward contract for two months booked at Rs.42.85 spot rate on the day of cancelation is

the same as the one-month forward rate on the day of booking the contract. That is, 42.70/42.83.

The bank sells to the customer one-month forward and buys one-month forward to cover itself. The one-month forward rate on the day of cancellation is 42.85/42.95.

Bank recovers from the customer (42.95 – 42.85) x 1,000,000 = Rs.1,00,000. Cash flow to the customer = 42.70 x 1,000,000 – 1,00,000 = Rs.42,600,000 6. Bank B will cover the exposure by entering into a 3-month forward sale of Sw Frcs 15000

to the market. However, because of early cancelation, the contract will be canceled at the 1-month forward selling rate for Sw Frcs which is 28.52.

The bank buys Sw Frcs at 28.25 The bank sells Sw Frcs at 28.52 Net amount payable per Sw Frc by customer on cancellation is 0.27 Cancellation charges payable by the customer: Exchange difference 4050 Flat charge for cancellation 100 Total charges 4150

Part C: Applied Theory 1. Inflow of foreign capital is generally in two forms: long-term investments such as funding of

industrial projects and short-term investments, such as portfolio investments in financial assets. When capital account convertibility is introduced, the inflows are likely to be mostly short-

term. The reason lies in the political risk perception of the foreign investors. That is, a long-term investment can be made in a foreign country only if it is reasonably certain that the country remains investment-worthy in the long run. Since that is difficult to judge and the outlook is not very positive for India, the inflows will be short-term.

Another reason that makes short-term investments attractive is that they start generating returns almost immediately, contrary to long-term investments, which have long gestation periods. Short-term capital is generally very volatile. They are withdrawn at the first sight of a crisis. Thus, the characteristic feature of short-term capital flows is that both inflow as well as the outflow will be very quick.

The inflows being immediate increase the money supply immediately. The financial system of the country should be able to absorb this. If not, excessive money supply will lead to inflation. And, high demand for the local currency may lead to its appreciation, affecting exports. Sudden inflows of huge amounts of capital may push up the prices of financial assets creating aberrations in the markets.

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When short-term investments are withdrawn, they cause a sharp fall in the market values of financial assets. Heavy demand for foreign currencies will result in a sharp fall in exchange rate of the local currency. If these two should not happen, the markets for financial assets should be strong enough to absorb such volatility in capital flows. In case the economy as such is not in a position to withstand, the reserve position of the Central Bank should be strong enough to launch a defense of the currency.

Foreign Capital Inflows can affect the health of the financial system if the following mistakes are committed:

i. Lending for non-productive uses such as consumption loans. Such loans do not increase the income of the borrower and the risk is higher.

ii. Directed lending at lower rates. iii. Lending to individuals who are not creditworthy. iv. Lending heavily to real estate sector. v. Investments are allowed through secondary markets. Though there is nothing wrong per se in lending for consumption or lending to real estate

sector, problems arise when the amount lent becomes excessive. Outflow of foreign capital precipitates a banking crisis if the above mistakes are committed, because banks become weak in the long run and will not be in a position to withstand withdrawal of capital.

2. After the currency union, it is expected that there will be greater movement of goods, labor and capital across the member countries enhancing the allocational efficiency of their economies. If the movement of these three becomes as free as expected, then, over a period of, say, half a decade, the regulatory norms in these countries will become uniform. Why should it be so? When movement across the countries is freely allowed, goods, labor as well as capital will move to the place where they find the conditions most congenial, forcing other countries also to change the conditions. More specifically, uniformity in regulations may be seen in the following areas:

a. Quality Specifications and Consumer Grievances: Movement of goods can take place freely only if the regulations regarding the quantities in which packaging can be made, the containers in which packaging has to be made, and the minimum quality standards, regulations regarding their movement and stocking are similar. Similarly, uniform norms regarding the minimum quality of food grains will evolve.

b. Financial Markets: If in one of the countries dividends paid to foreign investors are taxed at 10% and in another country there is no tax, companies desirous of raising capital from different countries will prefer the latter country. There is also a likelihood of uniform entry norms for both residents and non-residents to raise capital.

c. Credit Rating: If companies raising capital are allowed to make issue in any country of the Union as they please, they will naturally choose the country in which the credit rating norms are least strict. As companies flock to countries with less strict norms, the remaining countries may also relax their norms to attract the companies or pressurize the other countries to tighten their norms. Thus, over a period of time, the credit rating norms in the entire region may become uniform.

d. Environmental Regulations: If environmental regulations in different countries are not similar, firms will choose the countries where they are most lax. But then, those countries may attract hazardous industries and may want to tighten the regulations. Similarly, the countries which do not attract industries may want to relax their regulations. Ultimately, the regulations of all the countries will become similar.

Apart from the above, there can be many other areas in the real sector and financial sector where uniformity is expected.

3. In order to make payment to the overseas supplier, the buyer of goods approaches his bank for opening a letter of credit in favor of the supplier.

After considering the request of the buyer and fulfillment of the necessary formalities, the issuing bank (i.e. the buyer’s bank) opens the letter of credit in favor of the supplier.

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The letter of credit is transmitted to the advising bank (usually an intermediary bank located in supplier’s country) with a request to advise the credit to the beneficiary. After being satisfied with the authenticity of the credit, the advising bank advises the credit to the beneficiary (i.e. the supplier).

The beneficiary verifies the letter of credit and checks for any discrepancies vis-à-vis the sale contract. If any discrepancies are noticed, the buyer is asked to incorporate the necessary changes/amendments to the LC. The supplier then proceeds to ship the goods.

Shipment of goods is followed by submission of necessary documents by the supplier to the negotiating bank in order to obtain payment for the goods. The negotiating bank, upon receipt of commercial documents and the bill of lading from the exporter, scrutinizes the documents in relation to the LC and if found to be in order, negotiates the bill and makes payment to the supplier.

The negotiating bank then claims reimbursement from the issuing bank by mailing the documents to it or any other bank authorized for the said purpose.

The commercial invoice and other documents are presented by the issuing bank to the buyer of goods, who on receipt of the same checks the documents and accepts/pays the bill. On acceptance/payment, the shipping documents covering the goods purchased are handed over to him.

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Paper II Part D: Case Study

1. C0 = Rs.14 million The expected spot rates for next five years:

*1S = 7.25 x 1.0485 = Rs.7.60/FM

*2S = 7.60 x 1.0485 = Rs.7.97/FM

*3S = 7.97 x 1.4805 = Rs.8.36/FM

*5S = 8.36 x 1.4805 = Rs.8.76/FM

*6S = 8.76 x 1.4805 = Rs.9.19/FM

Cash flows adjusted for rise in price levels:

*1C = FM 10,00,000 x 1.03 = FM 10,30,000

*2C = FM 20,00,000 x (1.03)2 = FM 21,21,800

*3C = FM 50,00,000 x (1.03)3 = FM 54,63,635

*4C = FM 50,00,000 x (1.03)4 = FM 56,27,544

*5C = FM 30,00,000 x (1.03)5 = FM 34,77,822

T = 35% in India and 40% in Finland

Dt = Rs.14million5

= Rs.2.8 million

ke = 18% kd = 15% B0 = Rs.5 million r = 15% kb = 15%

CL0 = FM 50,000

Rt = (7%,5)

50,000 50,000 FM 12,195PVIFA 4.1

= =

kc = 9%

* *n n n nt t 0 t

0 0 0t t t tt 1 t 1 t 1 t 1e d b c

(S C )(1 T) D T r B T RAPV C S CL

(1 k ) (1 k ) (1 k ) (1 k )= = = =

⎡ ⎤−= − + Σ + Σ + Σ + − Σ⎢ ⎥

+ + + +⎢ ⎥⎣ ⎦

= –140,00,000 +

1 2 3(7.60 x10,30,000)(0.60) (7.97 x 21, 21,800)(0.60) (8.36 x 54,63,635)(0.60)

(1.18) (1.18) (1.18)

⎡ ⎤+ +⎢ ⎥

⎣ ⎦

4 5(8.76 x 56, 27,544)(0.60) (9.19 x 34,77,822) (0.60)

(1.18) (1.18)

⎡ ⎤+ +⎢ ⎥⎣ ⎦

+ [28,00,000 x 0.35 x PVIFA(15%, 5)] + [0.15 x 50,00,000 x 0.35 x PVIFA(15%, 5)] + 7.25 [50,000 – (12,195 x PVIFA(9%, 5))]

= Rs.[–140,00,000 + 515,03,333 + 3284960 + 8,79,900 + 18,571] = Rs.41686764 As the APV of the project is positive, the project is financially viable.

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Alternative Method 1: C0 = Rs.14 million

ke = ⎥⎦⎤

⎢⎣⎡ −1

08.118.1 x 100 = 9.26%

Since cash flows are expressed in real terms i.e. todays prices, all equity real rate is used to discount the cash flows)

n n n n0 t t 0 t

0 0 0t t t tt 1 t 1 t 1 t 1e d b c

(s C )(1 T) D T rB T RAPV C S CL

(1 k ) (1 k ) (1 k ) (1 k )= = = =

⎡ ⎤−= − + + + + −⎢ ⎥

+ + + +⎢ ⎥⎣ ⎦∑ ∑ ∑ ∑

= –140,00,000 +

2 3(7.25 10,00,000)(0.60) (7.25 20,00,000)(0.60) (7.25 50,00,000)(0.60)

(1.0926) (1.0926) (1.0926)x x x⎡ ⎤

+ +⎢ ⎥⎣ ⎦

4 5(7.25 50,00,000)(0.60) (7.25 30,00,000)(0.60)

(1.0926) (1.0926)x x⎡ ⎤

+ +⎢ ⎥⎣ ⎦

+ [28,00,000 x 0.35 x PVIFA(15%, 5)] + [0.15 x 50,00,000 x 0.35 x PVIFA(15%, 5)] + 7.25 [50,000 – (12,195 x PVIFA(9%, 5))]

= Rs.[–140,00,000 + 515,87,787 + 3284960 + 8,79,900 + 18,571] = Rs.41771218 As the APV of the project is positive, the project is financially viable. 2. Nominal all-equity discount rate should be used in the following circumstances: a. for discounting contractual cash flows b. for discounting non-contractual cash flows expressed in nominal terms c. for discounting non-contractual real cash flows if they have been converted into

nominal terms. Real all-equity discount rate should be used for discounting non-contractual real cash

flows, when such cash flows have not been converted into nominal terms. The rationale is to discount the nominal flows with the nominal rates and real flows with

real rates, and thus avoid a mismatch between the cash flows and the discount rates. 3. In this case, the discount rate used for calculating the present value of the tax shields on

depreciation and interest would be the domestic nominal risk-free interest rate, i.e 11%. Hence, the present value of tax shields would be (28,00,000 x 0.35 x PVIFA(11%,5) + (0.15 x 50,00,000 x 0.35 x PVIFA(11%,5))

= 36,21,979 + 9,70,173 = Rs.45,92,152 Hence, APV = Rs.4,17,71,218 – 32,84,960 + 8,79,900 + 4592152 = Rs.4,21,98,510 The project continues to be financially viable. Note: APV is value computed through alternative approach. 4. Foreign exchange risk may be defined as the variance in the domestic currency values of

assets, liabilities and operating incomes attributable to unanticipated changes in exchange rates. Two things have to be noted in this definition. One, risk may arise due to variability of incomes, assets and liabilities. Two, it is only the variance that is caused by unanticipated changes that adds to risk, as variance from anticipated changes can be eliminated through hedging.

Krutika Designers Ltd. may face exchange risk due to its international project. If it is making supplies to the Finland office, denominated in Finland marks, it will have transaction risk. Similarly, if there are outstanding receivables and payables between the two, translation risk will arise. Translation risk may also arise due to other assets and liabilities of the Finland office as well, if KDL chooses to consolidate its accounts. Operating risk any how will exist, as it cannot be eliminated.

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5. An overseas project can be funded solely through equity investments, or through a mixture of equity and debt. In cases where there are restrictions on repatriation of profits and repayment of capital, part of the project can be funded through loans from the parent company to the foreign subsidiary. Generally, there are fewer restrictions on payment of interest and repayment of loans than on profit repatriation. Also, interest payments are tax deductible for the subsidiary whereas dividend payments are not (for the parent company both are taxable). There is another tax incentive involved as repayment of loans is non-taxable in the hands of the parent company, whereas funds transferred and dividends are. This way, repatriation restrictions can be maneuvered around, along with getting additional tax advantages, by extension of loans to the subsidiary by the parent company, instead of making direct equity investments.

Part E: Caselets Caselet 1

1. If a country should be able to attract consistent capital flows, it is necessary to maintain a stable exchange rate. If the currency of the country appreciates, investors who have already brought in their money may gain, but prospective investors may lose. If the currency depreciates the existing investors lose while the prospective investors gain. While stability of exchange rate is important for attracting capital flows, the flows of capital themselves cause exchange rate fluctuations. If the flows of capital should not effect the exchange rate, the economy should be flexible enough to withstand the capital flows.

2. Foreign investors bring in their capital with a view to earn better profits on their investment than in their home country. They invest freely if they are reasonably sure that they will be able to take back their principal and profits when they want. If there are restrictions on repatriation of profits and the original investment, investments will be hard to come by. The introduction of capital account convertibility is a step in the direction of providing this facility to exit. However, even if CAC is present, there will continue to be some restrictions in selected areas.

3. The reason for the Asian crisis lies, not in use of foreign capital but in the mismatch of the maturities of the sources and uses and in pumping borrowed funds into unproductive areas. If funds are raised through 14-day bills and invested in infrastructure projects, a payments crisis will naturally have to be faced. Again, if funds borrowed from foreigners are used for day-to-day running of the administration, how can the loan be repaid? Therefore, it can be said that foreign funds are desirable as long as they are invested in assets which produce enough returns to repay the loans.

Caselet 2

1. Instability in financial markets can be due to various reasons:

a. Banks offer mismatch of assets and liabilities.

b. Herd like behavior of investors can worsen volatility.

c. Asset prices often depend on investors’ expectations of how other investors will act.

d. Speed of movement is high compared to goods because capital does not have a physical existence.

International capital mobility is particularly dangerous when information is poor, domestic banking systems are weak and the Government takes an active role in allocating credit to favored borrowers. While mismanaged economies are bound to hit trouble in international capital markets, even well managed but small economies can be overpowered by the force of vast international capital flows, for the reasons mentioned above.

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2. a. Development of a strong domestic banking system. Weak banks should be closed and only those with a reasonable percentage of non-performing assets should be allowed to function.

b. Stipulation of minimum period for which foreign capital should stay within the country. This would prevent short-term flows from coming in. It is short-term capital which creates maximum volatility.

c. Make sure that foreign capital is raised only by creditworthy organization. d. Proper project appraisal to which whether the return on investment will exceed the

cost of foreign capital. This is necessary to ensure that foreign capital can be serviced without problems.

3. a. Indian banking system is weak. b. Many banks are saddled with large amounts of non-performing assets. c. Government plays an important role in credit allocation policies. d. Many enviable projects continue for political reasons. Taking all the above into account, it can be said that India is ill-prepared for CAC. Having

said that, serious reforms must be started immediately in the banking sector to move towards CAC. No economy can develop unless there is a mechanism for attracting capital flows from outside.

Caselet 3 1. The way in which the company Marc Rich & Co. handled the transaction highlights the

intricacies involved in counter-trade. First and foremost is the need to identify complementary needs of various locations. Which the purchase of sugar from the open market requires a hard currency, the refinery is paid for services, oil refineries paid for sugar, low grade gasoline has paid for in the form of copper concentrate before it was refined as copper metal for low cash. These kinds of activities require • Knowledge of complementary needs • Ability to sustain the time lag • Adequacy of profit margins

The following are the advantages and disadvantages of counter-trade. • Counter-trade facilitates trade in the case of countries which either do not have hard

currency reserves. Or may be having meager foreign currency reserves, which need to be conserved.

• Counter-trade is however far more indirect and round about as compared to settlement by money. As such, for at least one party, the cycle time which elapses before benefits are obtained, can be quite long.

• There is one aspect of counter-trade which can serve both as an advantage and as a disadvantage, i.e. the removal of transparency. When settlement is with money, there is clarity about the pricing being charged for a particular product but this is not the case especially in barter deals. Thus, members belonging to a cartel, bound by a price ceiling agreement may find it easier to pass discounts using barter or some other form of counter-trade.

2. • Barter, i.e. the exchange of one commodity for another is the simplest form of counter-trade.

• There could be variation of the barter in which a portion of the payment may be settled by money.

• There are also possibilities of the exporter receiving credit from the importer and the credit can be utilized in a third country.

• Buy-back involves supply of capital goods with an agreement by the exporter to buy-back part or whole of the resultant production.

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3. A counter-trader needs to be well connected. He should be aware of not only the political realities but also the trading opportunities across the globe.

Sound product knowledge across a range of commodities is also useful. As money often takes a long time to be realized, staying power is very important. The

counter-trader needs to have enough financial resources which may be blocked in receivables for prolonged periods of time.

Since large counter-trade deals often takes place with the direct/indirect support of Governments or Government Agencies, top level political contacts are essential for effective counter-traders.

In addition to all the above, since counter-trade often involves low value added commodities where freight costs can be significant, strengths in shipping can be very much desirable.

Model Question Paper 4 Time: 3 Hours Total Points: 200

Paper I Part A: Basic Concepts (30 Points)

Answer all the questions. Each question carries one point. 1. A letter of credit is

a. A short-term credit by a bank to an importer

b. A guarantee to honor the bills of an exporter drawn within stipulated terms

c. A guarantee by a bank to discount all the bills of an exporter

d. A short-term credit by the bank to an exporter against a confirmed order

e. Both (b) and (c) above.

2. A country is said to be living below its means if,

a. It has sustained current account surplus

b. It has sustained net surplus on current and capital account

c. It has sustained current account deficit

d. It has sustained capital account surplus

e. Its balance of trade is negative for a long period.

3. The reasons for intra industry trade taking place are

a. Transportation costs

b. Seasonal differences

c. Product differentiation

d. All of the above

e. Both (a) or (b) above.

4. For the real interest rates across the globe to be same the sufficient condition(s) is/are

a. The inflation rates across the globe must be same

b. The purchasing power parity must hold good universally

c. Interest rate parity must hold good universally

d. All of the above

e. Both (b) and (c) above.

5. Capital account monetary model is an improvement over current account monetary model. It relaxes a few assumptions of the latter. They are

i. There may be departures from PPP in the short run.

ii. The increase in domestic interest rates will always lead to depreciation of domestic currency.

iii. There is a stable demand-for-money function in each country

a. Only (i) above

b. Both (i) and (iii) above

c. Both (i) and (ii) above

d. Both (ii) and (iii) above

e. All of the above.

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6. An 8% foreign bond which pays coupons on January 1 and July 1 is traded in the secondary market where buyer pays accrued interest to seller on 30/360 basis. If it is sold on November 26, how much accrued interest would be paid by the buyer of the bond to the seller (in terms of percentage of face value)?

a. 3.24% b. 3.29% c. 1.61% d. 1.65% e. None of the above. 7. A dealer in Singapore asks for a two-month forward $-quote from another dealer in Tokyo

and strikes the deal on Wednesday, January 28. If January 29 happens to be a holiday in Singapore, the delivery date for the above deal would be

a. March, 30 b. March, 31 c. April, 2 d. April, 1 e. March, 27. Assume no other holidays in Singapore, Tokyo, London and New York except for

Saturdays and Sundays and it is not a leap year. 8. The full fledged money changers in India a. Can only buy foreign currency b. Can buy or sell foreign currency in limited amounts c. Can buy or sell foreign currency d. Can only sell foreign currency e. Can only sell foreign currency in limited amounts. 9. Which of the following statement(s) is/are true? a. The deposit rates in euro-markets are generally higher than the domestic market. b. The borrowing rates in the euro-markets are generally lower than the domestic

market. c. Euro-markets facilitate efficient allocation of funds. d. All of the above. e. Both (a) and (b) above. 10. The incentives provided to Indian exporters by the government of India are a. Cash incentives for certain exports b. Tax concessions c. Infrastructure facilities d. All of the above e. Both (a) and (b) above. 11. EXIM bank lends to foreign governments and foreign companies in the form of a. Buyer’s credit b. Lines of credit c. Rediscounting of export bills d. Both (a) and (b) above e. All of the above.

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12. An “Avalled” draft is usance or time draft a. Duly accepted by the drawees b. Under which documents are deliverable only against payment c. Under which payment is guaranteed by the drawee’s Bank d. Drawn under the protection of a letter of credit e. That is overdue. 13. Which of the following statement(s) is/are false? a. SDR transactions involve no exchange of currencies but only book entries. b. SDR is defined in terms of certain gold equivalent. c. Issue of SDRs to a member country is in proportion to its quota in the IMF. d. Both (a) and (b) above. e. None of the above. 14. In the context of balance of payments, official reserves include a. Assets denominated in foreign currencies b. Special drawing rights c. Reserve position with IMF d. Both (b) and (c) above e. All of (a), (b) and (c) above. 15. Forward rates are used as predictor of future spot rates because a. They are costless b. They are unbiased predictor of future spot rates c. They are always and easily available d. All of the above e. Both (a) and (c) above. 16. Which of the following is a form of direct intervention in the foreign exchange market? a. Increasing the rate of in interest. b. Increasing the tariffs. c. Exchanging foreign currency for domestic currency. d. Imposing quantitative restrictions on trade. e. None of the above. 17. The current exchange rate systems can best be characterized as a a. Free float b. Managed float c. Target zone arrangement d. Fixed rate system e. Hybrid system. 18. Tourism shows up in which of the accounts of BoP? a. Current account. b. Capital account. c. Merchandise account. d. Both (a) and (c) above. e. Both (b) and (c) above.

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19. The world’s largest currency trading market is

a. New York

b. Frankfurt

c. London

d. Zurich

e. Tokyo.

20. The Asian currency crisis was a result of

a. Pegged exchange rates

b. Inefficient use of funds

c. Wrong pricing of capital

d. (a), (b) and (c) above

e. Efficient use of funds.

21. The different types of non-tariff barriers to international trade are

a. Embargo

b. Export duty

c. Countervailing duty

d. Both (a) and (b) above

e. Both (b) and (c) above.

22. ______ is a person or association of persons in whose favor the letter of credit is opened.

a. Applicant

b. Issuing bank

c. Beneficiary

d. Advising bank

e. None of the above.

23. The incentives given to exporters, not in the form of actual credit, by the commercial banks are:

a. Turnkey projects incentive

b. Pre-shipment credit

c. Advance against cash incentives

d. Post-shipment credit

e. None of the above.

24. A letter of credit which cannot be canceled without the consent of the beneficiary is called

a. Confirmed letter of credit

b. Unconfirmed letter of credit

c. Revocable letter of credit

d. Irrevocable letter of credit

e. Back-to-back letter of credit.

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25. The term “Permitted Methods of Payment” refers to a. The terms of payment agreed by exporter and importer b. The terms of payment which are acceptable in the International Trade and laid down

by International Chambers of Commerce (ICC) c. The terms of payment as laid down by RBI d. The terms of payment as laid down by FEDAI e. The terms of payment as agreed by the bankers concerned. 26. An “Avalled” draft is usance or time draft

a. Duly accepted by the drawees

b. Under which documents are deliverable only against payment

c. Under which payment is guaranteed by the drawee’s Bank

d. Drawn under the protection of a letter of credit

e. That is overdue.

27. As per URC 522 a. Collections should not contain bills of exchange payable at a future date with

instructions that commercial documents are to be delivered against payment b. If a collection contains a bill of exchange payable at a future date and the collection

instruction indicates that commercial documents are to be released against payment, then documents will be released only against such payment

c. If a collection contains a bill of exchange payable at a future date and the collection instruction does not indicate anything, then commercial documents will be released only against acceptance

d. Both (a) and (b) above e. Both (b) and (c) above. 28. Usance bill is a. A bill that is payable immediately b. Also called a sight bill c. A bill that is drawn at a place outside India, but made payable in India d. A bill that is payable after a specified period of time e. Both (a) and (b) above. 29. ECGC stands for a. Export Credit Guarantee Corporation b. Export Crisis Government Corporation c. Export Credit Guarantee Company d. Exporters Credit Guarantee Company e. External Credit Guarantee Corporation. 30. In case of imports under foreign loans/credits, details about drawal and utilization of the

loan amount will have to be furnished to the Reserve Bank of India in a. Form A1 b. Form ECT c. XOS statement d. Form ECB2 e. Form ECB1.

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Part B: Problems (50 Points) Solve all the problems. Points are indicated against each problem.

1. You were to import an equipment for your project and you have a choice to invoice in the following currencies:

Invoice value £ 100000 DM 290000 FFr 917000

Spot rate 67.50/90 23.25/40 7.05/15

1-m Forward rate 25/40 10/15 20/25

2-m Forward rate 50/90 – –

1-m Interest rate 6.00 4.00 4.50

2-m Interest rate 6.25 4.25 4.75 You have the option to pay at the end of 1st month or 2nd month along with interest at the

applicable rates. However, the pay-out at the end of 2nd month has to be made in Euro and actual pay-out depends on how the rates are fixed with Euro. If the Rs./Euro is 47, after 2 months, compute the limits for DM/Euro and FFr/Euro rates that will make invoicing in DM and FFr a better choice than £. Which currency do you select if you prefer to pay at the end of first month?

(8 points) 2. The current market rates are as under:

Rs./$ – 35.10/40 $ Interest rates 6m 4.00 - 4.25 Rs. 6m 10.80 - 11.00

Work-out the limits for 6m forward rate so as to ensure that there is no scope for covered interest arbitrage. Give a quote satisfying the limits.

(7 points)

3. International Industries Ltd. (IIL), an Indian company, has a receivable of $2,000,000, maturing three months from now and a payable of £3,000,000, maturing in six months. The company has decided to hedge the two separately. The following information is available regarding the same:

Exchange Rates:

Rs./$ Spot 43.65/70

3-m forward 44.75/85

6-m forward 44.80/95

Rs./£ Spot 70.25/50

3-m forward 70.50/00

6-m forward 71.15/80 Interest Rates (%):

Rs. $ £

3-months 9.00/9.50 4.00/4.25 5.00/5.25

6-months 10.00/11.00 4.50/5.00 6.00/6.50 Advise the company on whether it should adopt a forward cover or a money market cover.

(7 points)

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4. A Service Company with 100% owned subsidiaries in four countries experiences major cash flows between these subsidiaries. The subsidiaries are located in the UK, Netherlands, Germany and Spain. The monthly cash flows are as follows:

UK pays Nfl 500,000 to Netherlands Pta 40,000,000 to Spain

Netherlands pays £ 250,000 to UK Pfa 60,000,000 to Spain DM 400,000 to Germany

Germany pays Nfl 600,000 to Netherlands Nfl 50,000,000 to Spain

Spain pays £ 200,000 to UK Nfl 400,000 to Netherlands DM 500,000 to Germany

The current exchange rates are $1 = DM 2.50 = Nfl 2.50 = 200 pta.

How, in your opinion, might this system be improved? What would be the benefits if your suggestions are implemented?

(11 points)

5. A US investor chose to invest in sensex for a period of one year. The relevant information is given below.

Size of investment ($) 20,00,000

Spot Rate 1 year ago 42.50/60

Spot rate now 43.80/90

Sensex 1 year ago 3256

Sensex now 3765

Inflation in US 5%

Inflation in India 9%

a. Compute the nominal return to the US investor.

b. Compute the real depreciation/appreciation of Rupee.

c. What should be the exchange rate if relative purchasing power parity holds good?

d. What will be the real return to an Indian investor in sensex?

(8 points)

6. Bank ‘B’ opened an irrevocable letter of credit covering import of watch spares from New Zealand. As per the terms of the LC, negotiation is restricted to United Bank of New Zealand, shipment is by parcel post and partial shipments are prohibited. Bank ‘B’ received documents under the LC from New Zealand Bank, informing that they have negotiated the documents at the request of the beneficiary. Bank ‘B’ is requested to remit the proceeds to their New York office for credit of their account with them. After scrutiny of the documents, Bank ‘B’ informs New Zealand bank that the documents are not acceptable to them on the ground that goods were dispatched in part as evidenced by 3 post parcel receipts of same date but issued from three different post offices in New Zealand. Discuss the issues involved in the context of UCPDC 500.

(9 points)

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Part C: Applied Theory (20 Points) Answer the following questions. Points are indicated against each question. 1. Almost a year after the Asian currency crisis began, the following were the short-term

interest rates prevailing in different countries in the last week of May, 1998.

Indonesia : 45.50%Thailand : 21.00%S. Korea : 17.70%Philippines : 14.43%Malaysia : 11.04%Hong Kong : 8.05%Taiwan : 7.15%Singapore : 6.50%

a. Explain the reasons for the wide divergence in interest rates across the countries.

b. Explain the linkage between the strength of a currency and interest rate.

c. According to interest parity principle, when interest rates are relatively high for a currency it should depreciate and vice versa. Yet, central banks offen raise interest rates to prop up a currency. Explain how the two positions are consistent.

d. Why do you think the Indian Rupee did not depreciate significantly when other Asian currencies were tumbling?

(9 points)

2. The Euro, a common currency for 11 countries of the European community, is expected to be launched on January 1, 1999. With the introduction of the Euro, the existing national currencies of the 11 countries will be withdrawn from circulation. The monetary policy for all the 11 countries will be managed by the European Central Bank based in Frankfurt.

a. Explain the various benefits which the 11 European countries will enjoy as a result of the Euro.

b. What could be the difficulties arising after the introduction of the Euro?

(6 points)

3. ‘X’ who has imported goods from Australia, requests his banker to open a transferable irrevocable letter of credit in favor of the exporter (not the actual supplier of goods). ‘X’ is aware that a transferable letter of credit involves certain risks. Explain as to how a transferable letter of credit differs from a back-to-back credit.

(5 points)

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Paper II Part D: Case Study (50 Points)

Read the case carefully and answer the following questions. 1. Delibirate on each of the points mentioned above and give your views on the possible

implications. 2. Work out net cash flow in Rs. at the end of 6m under the three options. i. If exchange risk exposure is covered under forward. ii. If exchange exposure is left uncovered. 3. In the given scenario, if the company is willing to take moderate risk, which option is likely

to give better results? (20 + 24 + 6 = 50 points)

South Indian Textiles is a small scale company which exports ready-made garments to European markets. The company has established regular contacts with clients abroad. Consequent to the marketing efforts, the company is now in a position to export textiles worth US $ 200000 every month. As a part of its expansion plan, the company is stepping up its production capacity and the related capital work has already progressed by 50% and it is expected to start trial production in 9 months time. The plant and machinery is being imported from West Germany at a cost of DM 1.5 million. The payment for the machinery is expected to be made 6 months hence. The current market scenario The current market rates are as below:

(Mumbai) (Singapore) Rs./$ Rs./DM DM/$

Spot 34.50/34.75 22.60-22.90 1.5065-1.5090 1-m 34.90/35.35 22.80-23.15 1.5085-1.5110 2-m 35.20/35.70 23.00-23.40 1.5100-1.5130 3-m 35.60/36.20 23.30-23.80 1.5120-1.5145 4-m 36.00/36.70 23.70-24.25 1.5140-1.5165 5-m 36.50/37.30 24.00-24.60 1.5160-1.5190 6-m 37.00/37.80 24.50-24.10 1.5175-1.5200

The interest rate scenario is as below. Rs. $ DM

1-m 18 4.00 5.50 2-m 18 4.25 5.75 3-m 18 4.50 6.00 4-m 18 5.00 6.50 5-m 18 5.25 6.75

Ms Bhargavi, Vice President (Finance) of the company is looking at the above data and is entrusted with the responsibility of managing the exchange risk and interest risk regarding the above cash flows. It is decided that the six monthly inflows commencing from 1m hence to be set apart for meeting the payable of DM 1500000. She is pursuing the following options: i. Keep the $ inflows without converting and use them to acquire DM after 6-m. ii. Convert the $ inflows to Rs. and use them to acquire DM after 6-m. iii. Convert the $ inflows to DM and use them after 6-m.

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In an attempt to choose one of the above options, she is looking into the developments in the market in the recent past.

1. The Rs./$ parity has been subject to volatility in the recent past and RBI has announced a series of measures which brought some semblance of stability to Rs./$ parity. Reports indicate that exports lobby fear slow down of exports. However, there is a divided view.

2. The RBI had to intervene rather frequently in the call market to bring stability to the call rates which have touched a high of 125% in the month of Feb. and March, 1996.

3. The slack season money policy announced by RBI provided for reduction of CRR releasing around Rs.5000 cr. to the banking system, bring some relief to the liquidity crunch.

4. Corporates have been incessantly claiming that Govt. borrowing is crowding out resulting in interest rates giving up and corporates are willing to borrow funds at rates ranging from 20%–22% for medium-term while ICD rates are ranging between 25%–30%.

5. The share of exports to Germany are increasing marginally but the significant development is that the trade is getting denominated more and more in DM. The trade deficit with Germany is also narrowing.

6. While the US $ experienced substantial depreciation against Japanese Yen, the same is not true against DM. The US economy is showing sign of recovery with US fiscal deficit employment figures showing improvement. The US interest rates are showing a declining trend.

7. Bundes Bank refused to cut the interest rate though market has been expecting for some time now that a cut is imminent.

8. International rating agencies have commented, in a couple of their recent reports on India, that the process of reforms is irreversible, irrespective of the outcome in the ensuing election.

9. A pre-election survey reported that a hung parliament is imminent but the ruling party would still form the largest block.

The actual spot rates turned out to be as under on the due dates.

Mumbai Rs./$

Rs./DM

Singapore DM/$

After 1-m 34.80/35.30 22.90/23.30 1.5090/1.5115

2-m 35.10/35.60 23.00/23.30 1.5110/1.5135

3-m 35.75/36.40 23.30/23.80 1.5130/1.5150

4-m 36.10/36.70 23.50/24.05 1.5145/1.5175

5-m 36.70/37.40 24.20/24.75 1.5165/1.5195

6-m 37.25/37.90 24.60/25.20 1.5180/1.5210 The interest rates remain unchanged.

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Part E: Caselets (50 Points) Caselet 1

Read the caselet carefully and answer the following questions. 1. It is known well in advance that the countries joining European Union will have to adhere

to the terms of the Stability and Growth Pact. If you were a dealer, what kind of positions you would have taken to make gains?

(8 points) 2. Though the share of the US in world trade is low, the trade invoiced in US$ is high. Explain

the above statement. What do you think are the reasons for selecting a currency for invoicing?

(6 points) 3. What do you think are the reasons that contribute for a strong Euro?

(6 points) Once EMU commences, it is important to make a distinction for convergence criteria for the ‘ins’ and the ‘pre-ins’. For the ‘pre-ins’ it is important to note that the Maastricht criteria will still apply to them. Moreover, the criteria for the ‘pre-ins’ will be interpreted in the same way as was done for the ‘ins’. Those who qualify for EMU (the ‘ins’) have to apply the criteria of the Stability and Growth Pact. The goal of this pact is to avoid excessive budget deficits, promote low and stable inflation, low interest rates, sustainable economic growth and high employment. Member states outside the Euro area (‘pre-ins’) must also submit convergence programs comparable to the stability programs. They are, however, not yet open to sanctions if they fail to comply with the norms. The main elements of the Pact for Stability and Growth are • Each member state will commit itself to strive for a medium-term budgetary position of

near-balance or surplus. This will allow the automatic stabilizers to work throughout the whole business cycle without breaching the reference value of the deficit (3 percent of GDP).

• A government deficit in excess of the 3 percent reference value will be considered exceptional if it is the result of an unusual event outside the control of the relevant member state (for example, a natural disaster) or if it is the result of a severe economic downturn.

• If it decides that a deficit has become excessive, the Council will make recommendations to the member state concerned. The recommendations will then have to be implemented within four months and the excessive deficit corrected within a year of being identified, other than in exceptional circumstances.

• If a member state fails to comply with successive decisions, the Council will impose sanctions, including the requirement for a non-interest bearing deposit to be placed.

• The non-interest bearing deposit will be converted into a fine after two years if the deficit continues to be excessive. The amount of the deposit or fine will comprise a fixed component equal to 0.2 percent of GDP and a variable component equal to one-tenth of the excess of the deficit over the reference value of 3 percent of GDP. There will be an upper limit of 0.5 percent of GDP for the annual amount of deposits.

Will the Euro threaten the US$ as a World Reserve/Transactional Currency? The share of total official currency holdings (percentage of total) are as in the table. Share of Total Official Currency Holdings (%)

1973 1983 1995 US$ 76.1 71.1 61.5 European Currencies 14.3 15.8 20.1 JP¥ 0.1 4.9 7.4

Although it seems that most major governments worldwide would like to diversify to some extent out of the US$, there is only a minor chance of the Euro ousting the US$ as the favored currency. The extent of the switch will also depend on the use of the Euro as a transaction currency. The share of main currencies used in international trade (percentage of world exports) is as given in the table.

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Share in International Trade (%) of Exports

1980 1992 US$ 56.4 47.6 German Mark 13.6 15.5 JP¥ 2.0 4.8

Today, the US$ is the most commonly used currency in trade invoicing. Despite the US having only a 20 percent share of world trade, the US$ was used in 48 percent of all international trade transactions. Although the Euro will play an important role in the international financial markets and as an invoicing currency in international trade in goods and services, the US$ will probably remain the most important transaction currency. The strength of the Euro will be determined by: • The credibility of the European Central Bank and the ECB’s monetary policy’s ability to

control inflation. • The budgetary and structural economic policies of the EMU countries; budgetary policy

will probably be reasonably disciplined and in any event considerably healthier than that seen in various countries in recent decades. Structural policy, affecting the operation of markets and the flexibility of the economy, is also expected to improve gradually.

• The extent to which the Euro is used as a reserve/transaction currency. The first two points will mean that the rate of inflation for the Euro will be low. Given also the increased role of the Euro as a reserve and transactional currency, it is believed that the Euro will be a structurally strong currency and nearly as strong as the DEM is now.

Caselet 2

Read the caselet carefully and answer the following questions. 1. If you are a foreign investor, would you consider India to be an attractive place for

investment? Explain with reasons. (3 points)

2. What are the short-term and long-term measures which can be introduced to boost Foreign Direct Investment in the country?

(4 points) 3. The BJP Government has announced that foreign investment will be encouraged in ‘core’

areas and discouraged in ‘non priority’ areas. Critically examine this position. (3 points)

FDI and FIPB Even without the adverse fallout from the nuclear adventures, there are clear signs that the BJP-led Government may find the going difficult in meeting the foreign direct investment target for the current year. Last year, the actual inflow was around $3.5 billion which, though higher than the $2.42 billion received in 1996, compared unfavorably with the United Front Industry Minister, Mr. Murasoli Maran’s target of $4.2 billion. This year, the new Government has pitched for an FDI flow of $6 billion which, according to the Union Industry Secretary, “will be easily achievable” because “we are still viewed as an attractive investment destination by foreign investors”. For the sake of the economy, it is to be hoped that he is right, though the actual performance in the first quarter of this calendar year suggests insurmountable obstacles ahead. According to latest indications, only $700 million flowed into the economy in the January-March period which, extrapolated, implies an annual FDI inflow of less than $3 billions – that is, even less than that achieved in 1997. True, the Vajpayee Government cannot be held responsible for this unsatisfactory performance; to blame squarely is the political uncertainty, as the three months in question were the run-up to the elections for the 12th Lok Sabha. The question is whether the new Government can make good the loss (given its target) in the remaining three quarters which is by itself a difficult task considering the actual FDI-inflow performance in the past two years. What makes the prospects bleaker is the forecast by the Institute of International Finance (without

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taking into account the impact of possible sanctions following the nuclear tests) that the FDI inflows will be at least $1.1 billions less than in 1997, or just $2.4 billions. Clearly therefore, the Government will have to take some special measures to ensure that the FDI inflow at the end of the year reaches, or comes close to the target.

Caselet 3

Read the caselet carefully and answer the following questions. 1. What are the measures that a country willing to attract FDIs should adopt?

(8 points) 2. Even after the South-East Asian crisis, prospective foreign investors view Asia in a stable

context. Discuss the reasons. (6 points)

3. After the crisis, the FDI flows to the five countries were rebounced when compared to foreign bank lending. Explain the reasons.

(6 points) In a world increasingly characterized by liberalization and globalization, firms are looking for places to invest that offer specific advantages or “created assets”, including communications infrastructure, marketing networks, and intangibles such as attitudes to wealth creation and business culture, innovative capacity, the stock of information trademarks, and goodwill. These have become critical for firms’ competitiveness and can make countries without more traditional advantage attractive locations for FDI. According to the report, FDI flows to and from Asia in 1998 are not expected to rise for the first time since 1985. They are projected to remain roughly at the same level as in 1997, when they rose by about 8 percent to an estimated $87 billions. The Asian financial crisis changed a number of the FDI determinants and raises the question of how the crisis is likely to affect FDI flows in this region. Since FDI has become the single most important source of private development financing for these countries and plays an important role in their economic growth and development, the question is relevant. Although there is a broad agreement that economic growth will be slower in 1998 and 1999 as well, the effects of the crisis are not entirely negative. For example, in the countries that were hit the hardest – Indonesia, Korea, Malaysia, the Philippines, and Thailand – firms’ costs for establishing and expanding production facilities have declined. Regulatory frameworks, which were none-too-stringent to FDI before the crisis, have become even more relaxed, facilitating the establishment and promotion of new businesses. While the report concludes that it is difficult to assess the overall impact of the crisis on FDI to and from Asia in the short and medium-terms, it states that “the fundamental features of the region as a destination for FDI remain sound”. Moreover, it adds, these may improve as countries strengthen their economies in response to the crisis. If transnational corporations take advantage of the crisis to position themselves strategically in the region, “FDI flows to Asia will continue on their upward trend without serious interruption”.

Model Question Paper 4

Suggested Answers

Paper I

Part A: Basic Concepts 1. (b) A letter of credit is defined as “an agreement by means of which a bank acting at the

request of a customer, undertakes to pay to a third party a predetermined amount by a given date, according to agreed stipulations and against presentation of stipulated documents”.

2. (a) A current account surplus indicates that a country has not been utilizing its income through proper investments.

3. (d) The phenomenon of a particular country simultaneously importing and exporting the same product is called as intra-industry trade. All the reasons given can be attributed to such trade.

4. (d) All the given conditions have to be satisfied for the real interest rates across the globe to be same.

5. (b) The capital account monetary model is an improvement over current account monetary model as it has relaxed assumptions that there may be departures from PPP in the short run and the increase in domestic interest rates will always lead to depreciation of domestic currency.

6. (a) Number of days = 30 + 30 + 30 + 30 + 26 = 146 Accrued interest = (146/360) x 0.08 = 3.24% 7. (b) The spot settlement date is the second working day from the date of contract which will

be 31st January. The delivery for the forward deal is obtained by adding the number of months to the respective spot settlement date. Hence the delivery date will be 31st March.

8. (b) Full fledged money changers in India can buy and sell foreign currencies. All service transactions are recorded in the invisibles account. The service account includes investment income (interest and dividend), tourism, financial charges (banking and insurance), and transportation expenses (shipping and air travel).

9. (e) Eurocurrency banks consists of banks called Euro banks that accept deposits and make loans in foreign currencies. The market enables the investors to hold short-term claims on commercial banks, which then act as intermediaries to transform these deposits into long-term claims on final borrowers. Statements (a) and (b) are true regarding Euro markets.

10. (e) All the alternatives given are incentives provided to the Indian exporters by the Government of India.

11. (e) Under buyers credit, credit is given to buyers abroad to enable them to import engineering goods from India on deferred payment terms. EXIM bank also extends lines of credit to overseas governments or agencies nominated by them, to enable buyers in these countries to import capital/engineering goods from India on deferred payment terms. Through rediscounting of export bills the EXIM bank lends to the Indian banks.

12. (c) Time drafts are payable at some specified future date. An “Avalled” draft is a usance or time draft under which payment is guaranteed by the drawee’s bank.

13. (b) The value of SDR is determined as a weighted average value of 5 currencies – US Dollar, Yen, Pound sterling, DM, and French Franc.

14. (e) Official reserves include gold, reserves of convertible foreign currencies, SDR’s and balances with IMF which are the means of international payment which are acquired or lost during the period for which the BoP account is constructed.

15. (d) Forward rates are used as a predictor of future spot rates because of all the given reasons.

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16. (c) Exchanging foreign currency for domestic currency is a form of direct intervention in the foreign exchange market.

17. (e) The current exchange system can be characterized as Hybrid system.

18. (a) Current account records all transactions on account of trade in goods and services and transfer payments among countries. Trade in services consists of payments and receipts on account of interest, dividend, professional services, income on assets like patents and copyrights, tourism, transport, insurance, banking and other financial services, and other factor services involving residents of two countries.

19. (c) London is the world’s largest currency trading market.

20. (b) The Asian currency crisis was a result of deployment of short-term funds in property- markets and long-term ventures. Since the funds were not being used to create any real activity, the probability of their being serviced kept coming down. Hence it is the result of inefficient use of funds.

21. (a) Embargo is a non-tariff barrier to international trade where imports from a particular country are totally banned.

22. (c) A letter of credit is defined as an arrangement by means of which a bank acting at the request of a customer, undertakes to pay a third party a predetermined amount by a given date, according to agreed stipulations and against presentation of stipulated documents. The Letter of Credit is opened in the name of the beneficiary.

23. (a) The commercial banks give Turnkey projects as incentives to the exporters. Turnkey projects are those requiring the rendering of financial services like civil construction, design, erection and commissioning of plants, supervision thereof and supply of equipment for the plant.

24. (d) An irrevocable letter of credit is one which cannot be cancelled by the issuing bank without the consent of the beneficiary.

25. (c) Exchange control has set out regulations governing permitted currencies and methods of payment to be used for settlement of financial transactions between residents and non- residents through authorized dealers. Therefore, they are the terms of payment laid down by the RBI.

26. (c) Time drafts are payable at some specified future date. An “Avalled” draft is a usance or time draft under which payment is guaranteed by the drawee’s bank.

27. (d) Alternatives (a) and (b) are valid as per article 7 of URC 522.

28. (d) Usance bill is a bill of exchange that is payable after a specified period of time.

29. (a) ECGC stands for Export Credit Guarantee Corporation.

30. (d) Details about drawal and utilization of loan amount in respect of import under foreign loans/credits should be furnished to the RBI by means of quarterly statements in Form ECB2 in duplicate.

Part B: Problems 1.

Currency Amount Payable Outflow in

Rs. after 1m

After 1m After 2m £ 100,500 101,042 1,00,500 x 68.30 = 6,864,150 DM 290,967 292,054 2,90,967 x 23.55 = 6,852,273 FFr 920,439 924,260 9,20,439 x 7.40 = 6,811,249

FFr is the best currency for making payment at the end of the first month. Outflow in Rs. if payment is made in £ after two months: 1,01,042 x (67.90 + 0.90) = Rs.6,951,690.

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Value of the outflow in Euro = 6,951,69047

= 147,908

Break even DM/Euro rate = 2,92,0541, 47,908

= 1.9746

Break even FFr/Euro rate = 9, 24, 2601, 47,908

= 6.2489

Hence, payment in DM and FFr will be better choice if the DM/Euro and FFr/Euro rates are less than the break even rates.

2.

Spot rate 35.10 35.40Interest rate 6m $ 4.00 4.25% Rs. 10.80 11.00Let the forward rate be Fb Fa

The arbitrage can be undertaken by borrowing $ and investing in Rs. or borrowing in Rs. and investing in $ and covering in the forward market.

a. Borrow Rs. and invest in $ for 6-m Borrow Rs.x for 6-m at 11% Amount payable after 6-m = Rs.x (1.055) Convert Rs.x into $ at spot rate and invest at 4.00%

Amount of $ to be received after 6-m = x (1.02)35.40

In order to ensure that there is no covered interest arbitrage

Fb x (1.02)35.40

< x (1.055)

Fb < 1.055 x 35.401.02

= Rs.36.60

In order to ensure that there is no scope for arbitrage

a

x 35.10(1.0540)F

× < x (1.02125)

3. Receivables: Forward cover: $2,000,000 x Rs.44.75/$ = Rs.895 lakh Money market cover:

Borrow 2,000,0001 0.0425 0.25x+

= 1,978,974

Convert at spot rate to 1,978,974 x 43.65 = Rs.863.82 lakh Invest the rupees for three months to get: 863.82 (1 + 0.09 x 0.25) = Rs.888.26 lakh Forward cover is better. Payables: Forward cover: 3,00,000 x Rs.71.80/£ = Rs.2154 lakh Money market cover: Invest = 2,912,622 Borrow = 2,912,622 x Rs.70.50/£ = Rs.2053.39 lakh Repay: 2053.39 x (1 + 0.11 x 0.05) = Rs.2166.34 lakh Forward cover is better.

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4. There are two ways in which the system could be improved. i. Each subsidiary could only remit/receive the net payable or receivable at the end of

every month with respect to every other subsidiary and avoid immediate payments/receipts for each and every transaction.

ii. The debtor/creditor positions could be dealt with in a centralized manner by the Head Office and all the benefits of centralized cash management could be availed of.

i. Netting out of transactions by each subsidiary. a. For the UK Subsidiary: Netherlands – Payment to be made Nfl 500,000 or £200,000. To

be received £250,000. Net position – Receive £ 50,000 or Nfl 125,000 from Netherlands subsidiary.

Spain – Payment to be made Pta 40 million or £ 200,000. To be received £200,000. Net position – Nil.

b. For the Netherlands Subsidiary: Germany – Payment to be made DM 400,000 or Nfl 400,000.

To be received Nfl 600,000. Net position – Receive Nfl 200,000 or DM 200,000 from German subsidiary.

Spain – Payment to be made Pta 60 million or Nfl 750,000. To be received Nfl 400,000. Net position – Pay Spanish subsidiary Nfl 350,000 or Pta 28 million.

c. For the German Subsidiary: Spain – Payment to be made Pta 50 million or DM 625,000.

To be received DM 500,000. Net position – Pay Spanish subsidiary DM 125,000 or Pta 10 million.

The transactions to be carried out are: Netherlands pays Pta 28 million to Spain and £ 50,000 to UK. Germany pays Pta 10 million to Spain and Nfl 200,000 to Netherlands. The benefits of this approach are avoidance of high transaction costs and reduction in the

value of cash flows exposed to foreign exchange risks which is brought about by netting of cash flows.

ii. Centralization of Receivables and Payables Management This would require that each subsidiary for every transaction with the other

subsidiaries assumes that it is dealing with the H.O. and not with the individual subsidiaries and hence debits or credits the H.O. A/c in its books. For the given transactions the H.O. A/c in the books of each of the four subsidiaries would look as follows.

£ £ Due from Netherlands 250,000 Due to Netherlands 200,000 Due from Spain 200,000 Due to Spain 200,000 450,000 400,000

At the end of the month, the UK subsidiary receives £ 50,000 from H.O.

In the books of Netherlands Subsidiary H.O. a/c Nfl Nfl Due from UK 500,000 Due to UK 625,000 Due from Germany 600,000 Due to Germany 400,000 Due from Spain 400,000 Due to Spain 750,000 1,500,000 1,775,000

At the end of the month, Netherlands subsidiary pays Nfl 275,000 to H.O.

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In the books of German Subsidiary H.O. a/c £ £ Due from Netherlands 400,000 Due to Netherlands 600,000 Due from Spain 500,000 Due to Spain 625,000 900,000 1,225,000

At the end of the month, Germany pays DM 325,000 to H.O. In the books of Spanish Subsidiary H.O. a/c

Pta Pta Due from UK 40,000,000 Due to UK 40,000,000 Due from Netherlands 60,000,000 Due to Netherlands 32,000,000 Due from Germany 50,000,000 Due to Germany 40,000,000

150,000,000 112,000,000 At the end of the month, the Spanish subsidiary receives Pta 38,000,000 from H.O. The second approach is better as for each subsidiary, exchange risk and exposure can be

avoided and the Head Office can better manage the cash position and adopt efficient strategies for managing foreign exchange risk and exposure. Also, as mentioned under the first approach, high transaction costs can be avoided.

5. a. Nominal return to the investor = $2,000,000 x 42.50 x 3,765 1 11.95%3,256 x 43.90 x 2,000,0000

− =

b. Real rate of exchange = 43.85 x 1.051.09

= 42.24.

Real appreciation of Rs. = 42.55 42.2442.55− = 0.73%

c. Exchange rate if relative purchasing power parity holds good = 42.55 x 1.09 44.171.05

=

d. Real return to Indian investor in sensex = 3,765 1x 1 6.09%3, 256 1.09

− =

6. In the given case, negotiation is restricted to United Bank of New Zealand. However, this condition has been disregarded by New Zealand Bank at the request of the beneficiary. Secondly the credit prohibits partial shipments. As per Article 40 of the UCPDC which deals with partial shipments, shipments made by post or by courier will not be regarded as partial shipments if the post receipts or certificates of posting or courier’s receipts or dispatch notes appear to have been stamped, signed or otherwise authenticated in the place from which the credit stipulates the goods are to be dispatched, and on the same date. Article 29 also confirms that banks will accept post receipts if it appears to have been stamped and dated in the place from which the credit stipulates the goods are to be dispatched. Taking these factors into consideration, it can be noticed that dispatch of goods is done from three different post offices. The issuing bank is thus entitled to treat the dispatch as partial shipments and reject the documents.

Part C: Applied Theory 1. a. The differences in interest rates reflect the differences in degrees to which the

countries have been affected by the currency crisis. Countries worst effected by the currency crisis have had to steeply hike their interest rates not only to stop further slide of the domestic currency but also to control the resulting inflation.

b. A strong currency is likely to appreciate in the near term. As such, interest rate would be relatively low to ensure that returns are equalized across currencies. Another way of arguing is that a strong currency needs to pay only a small interest rate to attract investors.

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A weak currency is expected to depreciate. As such, high interest rate is the compensation which prospective investors would be looking for.

c. When interest rates are raised, the most likely phenomenon would be investors attempting to park surplus funds in that currency. This would mean buying the currency as a result of which it would appreciate. Since investors would cover their risk, they would presumably sell the currency forward. As a result, the forward discount will adjust. Thus, the currency will appreciate in the spot market but trade at a forward discount so that arbitrage profits are ruled out. What has been explained is the general case.

In some cases, central banks may raise interest rates to curb inflation. If the markets are not convinced that the hike is adequate, the currency may actually be driven down even after the hike in interest rate is announced.

d. There are several restrictions on trading in India. The RBI has a strangle hold on the market. Free repatriation of foreign capital is not allowed in India. As such, the rupee did not really face the full fury of the storm in East Asia.

2. The benefits from a single currency are: i. Currency risk will be eliminated in transactions between the members. ii. Transaction costs will be reduced between the members. iii. Elimination of currency risk and reduction in transaction costs will increase capital

flows. iv. The currency will be more stable. v. Gains of seigniorage. vi. With the establishment of the System of Central Banks, member countries, that

could not so far influence the policies of the Bundes Bank, can have their say. vii. Movement of labor across the member countries may improve. The disadvantages likely to arise from the single currency are: i. Member countries lose their control over monetary, exchange rate and fiscal

policies. The difficulty due to the loss of control will get accentuated if, for example, a member country faces high inflation and the Union wants to follow an expansionary policy.

Similarly, if one of the member countries is facing high unemployment, it needs policies that generate more number of jobs than jobs that support a specified standard of living. If the country does not have the freedom to alter the policies, social unrest may arise. This problem may, theoretically speaking, be solved by the movement of labor from one industry to another and one country to another. But, considering that the European labor force is not very mobile, the problem may lead to differences among members before long.

ii. Conversion to Euro means maintenance of a fixed exchange rate between the present currencies by the member countries. Supporting such a fixed exchange rate calls for a considerable amount of co-ordination in the macroeconomic policies of the members, which is difficult to establish.

3. Transferable Credit: A transferable credit is one, which can be transferred (i.e. from the First Beneficiary to a Second Beneficiary). It should be noted that such credit can be transferred only once. The second beneficiary cannot in turn transfer the same to a third beneficiary. A transferable credit will be subject to the original terms and conditions of the credit, excepting the amount of credit, unit prices, percentage of insurance terms, period of validity and shipment.

According to Article 48(b) of the UCPDC, a credit will be rendered as transferable, only if it is specifically stipulated as such in the credit.

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Back-to-Back Credit: This credit is one that is opened against the security of another credit called the main credit. Under this credit, when an LC is opened by the buyer in favor of the first beneficiary (who is usually not the actual supplier or manufacturer), such a beneficiary will open another identical LC in favor of his actual supplier/manufacturer against the security of the main credit. By doing so, the first beneficiary can obtain reimbursement by presenting documents received under back-to-back credit under the main LC.

Situations where the need for back-to-back letters of credit arises are: • Where the buyer is not willing to open a transferable letter of credit; • Where the beneficiary does not want to reveal the source of supply to the buyer; • Where the actual supplier wants payment against documents for goods but the

beneficiary of credit is short of funds. Bankers may not find a back-to-back credit as safe as a transferable credit. This is because

there is likelihood that once payment is made against the documents received under the back-to-back LC, the opener of the back-to-back LC may not be able to submit the same documents under the main LC to obtain reimbursement leading to credit risk to the opening bank of the back-to-back LC. Hence, bankers should exercise due caution while opening a back-to-back letter of credit.

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Paper II Part D: Case Study

1. a. i. The RBI’s action in stabilizing the Rs./$ parity has been successful and consequently further depreciation of Rs. against US $ is not expected. Even if the exporters fears are true it may have only a short-term impact.

ii. The high call rates, while indicating liquidity crunch gives scope for arbitrage between forex market and money market and this is likely to increase the forward premia in forex market specially on US$.

iii. The improved liquidity should cool down the money market and consequently the forex market as well resulting in a reduction in the forward premia.

iv. Corporates willingness to borrow at high rates is likely to result in the above liquidity being dried up with funds among towards long-term deployment towards credit and this may bring back some tightners to the money market. This may result in forward premia being firm at higher levels if not volatile.

v. The supply of DM is expected to increase due to more trade getting denominated in DM. While the demand for DM may come down due to narrowing of trade deficit with Germany. Then DM may remain stable vis-á-vis Rs. if not depreciate.

vi. There is a general sign of US $ strengthening in spite of it getting depreciated against ¥.

vii. The limited market expectation of interest rate cut indicates market expecting DM to strengthen but Bundes Bank’s reaction may defer such appreciation for some time.

viii. The market belief that reforms are here to stay indicate a change of view for uncertainty to moderate certainty and this may continue to accelerate further FDI inflows bringing stability to Rupees in general.

ix. The survey’s outcome of ruling party forming the largest block may send a strengthening signal to the above view of reforms being irreversible and hence the Re. stability can be expected.

b.

Time Inflow US$ Interest Rate Interest Amount Total Inflow at the end of 6th m

After 1m 2,00,000 5.00 4167 2,04,167

2m 2,00,000 4.75 3167 2,03,167

3m 2,00,000 4.50 2250 2,02,250

4m 2,00,000 4.25 1417 2,01,417

5m 2,00,000 4.00 667 2,00,667

6m 2,00,000 — — 2,00,000

12,11,668

If covered in forward market $ outlay = 15,00,000 $ 9884681.5175

=

Remaining amount = 1211668 – 988468 = $223200 Rs. Equivalent at forward rate = 223200 x 37 = Rs.82,58,400

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If converted at spot rate $ outlay = 15,00,0001.5180

= $988142

Remaining amount = 1211668 – 988142 = $223526 Rs. Equivalent = 223526 x 37.25 = Rs.83,26,344 If exchange exposure is covered in forward

Time Inflow Forward Rate

DM Inflow Int. Rate Int. Amount Total Inflow

After 1m 2,00,000 1.5085 3,01,700 6.50 8171 3,09,871

2m 2,00,000 1.5100 3,02,000 6.25 6292 3,08,292

3m 2,00,000 1.5120 3,02,400 6.00 4536 3,06,936

4m 2,00,000 1.5140 3,02,800 5.75 2902 3,05,702

5m 2,00,000 1.5160 3,03,200 5.50 1390 3,04,590

6m 2,00,000 1.5175 3,03,500 — — 3,03,500

18,38,891

Remaining amount = 1838891 – 1500000 = DM 338891

Re. amount = 338891 x 24.50 = 8302830

If the exchange exposure is not covered in forward

Time Inflow Spot Rate DM Inflow Int. Rate Int. Amount Total Inflow

After 1m 2,00,000 1.5090 3,01,800 6.50 8174 3,09,974

2m 2,00,000 1.5110 3,02,200 6.25 6296 3,08,496

3m 2,00,000 1.5130 3,02,600 6.00 4539 3,07,139

4m 2,00,000 1.5145 3,02,900 5.75 2903 3,05,803

5m 2,00,000 1.5165 3,03,300 5.50 1390 3,04,690

6m 2,00,000 1.5180 3,03,600 — — 3,03,600

18,39,702

Remaining amount = 1839702 – 1500000 = DM 339702

Re. equivalent = 339702 x 24.60 = 8356669

If exchange exposure is covered in forward

Time Amt. of $ Inflow

Forward Rate

Rs. Inflow Int. Rate Int. Amount

Total Inflow

After 1m 2,00,000 34.90 69,80,000 18 5,23,500 75,03,500

2m 2,00,000 35.20 70,40,000 18 4,22,400 74,62,400

3m 2,00,000 36.60 71,20,000 18 3,20,400 74,40,400

4m 2,00,000 36.00 72,00,000 18 2,16,000 74,16,000

5m 2,00,000 36.50 73,00,000 18 1,09,500 74,09,500

6m 2,00,000 37.00 74,00,000 — — 74,00,000

4,46,31,800

Re. outlay at forward rate : 1500000 x 25.10 = 37650000

Remaining amount = 44631800 – 37650000 = 6981800

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If exchange exposure is not covered in the forward Time Amt. of $

Inflow Spot Rate Rs. Inflow Int. Rate Int. Amount Total Inflow

After 1m 2,00,000 34.80 69,60,000 18 5,22,000 74,82,000 2m 2,00,000 35.10 70,20,000 18 4,21,200 74,41,200 3m 2,00,000 35.75 71,50,000 18 3,21,750 74,71,750 4m 2,00,000 36.10 72,20,000 18 2,16,600 74,36,600 5m 2,00,000 36.70 73,40,000 18 1,10,100 74,50,100 6m 2,00,000 37.25 74,50,000 – – 74,50,000 4,47,31,650

Re. outlay at spot rate = 15,00,000 x 24.60 = 3,69,00,000 Remaining amount = 4,47,31,650 – 3,69,00,000 = 78,31,650 c. From the data computed above, the net residual amount is highest when $ is

converted to DM and lease the exchange position uncovered. However, this is subject to company taking exchange risk on all its inflows and outflows.

From the data given above, it is observed that the Rs./$ parity has been subject to considerable volatility whereas the $/DM parity is not so. The depreciation of the $ against DM is also not up to the expectation. In view of the market expecting a cut in the German interest rates and the steadying of US economy, there is a possibly of $ appreciating against DM. Hence, it is suggested that $ be converted to DM and covered under forward.

As there are signs of improvement of trade between India and Germany in India’s favor and as exports are getting denominated in DM, the company may leave residual DM to be converted in the spot market. The level of risk will be moderate since. The outlay involved is also only the residual amount.

Part E: Caselets Caselet 1

1. If the budget deficit is brought down to 3 percent, borrowings of the government to finance deficits will also come down, as also the money released into the system by the government. Therefore, the currency may either stop depreciating or even appreciate. Therefore, it is advisable to

a. Take a long position in the currencies joining Euro. b. Arbitrage between spot and forward markets by buying the currencies spot and sell

forward and take long position in assets denominated in the currencies. c. Arbitrage between different currencies if the dealer expects that some of the

countries do not finally join the Union. The currencies of such countries will depreciate and if a short position is taken in such currencies, it can be closed out after they depreciate, making a profit.

d. Take a long position in Euro denominated bonds. When interest rates in Euro fall, the price of the bonds will increase. They can then be sold at a profit.

2. The currency of invoicing may be chosen based on a. Stability of the currency b. Liquidity of the currency c. Political dominance of the country to which it belongs. The more dominant the

country, greater will be its ability to bargain favorable terms for itself. In its own interest, the country will maintain a stable exchange rate.

d. Political ideology of the country – whether free market or closed, which may in turn determine its stability and liquidity.

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e. Whether there are any receivables or payables denominated in that currency, so that they can be netted out.

f. Whether there are any sales or purchases denominated in that currency, the payments of which can be netted out.

g. The ability of the central bank of the country (its track record) in handling monetary policy and inflation.

3. The strength of the Euro will depend on a. The level of inflation and interest rates in Euroland. These two, in turn, depend on

the level of industrial activity and unemployment. b. The policies of the Euroland regarding public spending and financing exports and

imports and flow of capital. c. The demand for Euro as a reserve currency. As more and more Euro are held as

reserves, the availability (supply) of Euro in the market will decrease and the Euro will appreciate.

d. The combined GDP reserves of the Euroland are comparable with that of the US. e. The bond markets and equity markets consequent to the Union are large enough to

compete with the US and Japanese markets. Caselet 2

1. India would be an attractive place for investment due to the following reasons: a. Large market. b. Knowledge of English. c. Availability of educated and skilled manpower. The main disadvantages are a. Political instability. b. Lack of continuity in policy making e.g. one politician reversing earlier decision by

another politician. c. Immediate difficulties arising out of sanctions imposed by USA because of Pokhran. 2. Short-Term a. Remove uncertainties in the case of sectors such as power and telecom. b. Allow 100% owned subsidiaries without the need for case to case examination by

F.I.P.B. Long-Term Move towards full convertibility of the rupee. Once this is done, investors will not hesitate

to bring funds into the country. 3. There is a wishful thinking among Indian bureaucrats that foreign investors should be

attracted only to the core sectors – i.e. infrastructure whereas non-core sectors essentially consumer non-durables and durables must be left to Indian businessmen. This thinking is misguided because it is the non-core sector where profits can be made in plenty and in quick time. To expect foreign investors to come to India to take part in core sector projects and toil away year after year, waiting for the gestation period to be over, even as Indian businessmen make easy money by selling consumer goods in a projected domestic market is the height of absurdity.

The artificial distinction between core and non-core areas should be done away with. Even in an apparently non-core area like Tomato Ketchup, there is potential for improving agricultural productivity and generating increased incomes for farmers.

In any case, with all its pious intentions, the government policies in this context have not been successful. What we have today are areas like soft drinks and cell phones where the largest quantum of foreign investments has flown in.

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Caselet 3 1. The measures that a country, willing to attract FDIs, should adopt are a. Liberalization of macroeconomic policies, including sound monetary policies that

ensure price stability and affect the cost of capital. b. Tax policies, that favor investment, should be taken up. c. Liberalization of exchange rate policies that affect the value of acquired assets and

exports. d. Flexibility to repatriate a longer amount of profit. e. Corporate organizational issues that explicitly address the evolving needs of

transnational corporations and domestic firms, should be raised. 2. Asia is still looked upon in a stable context because of the following reasons: a. Asian markets are still unexplored and there is a lot of scope for FDIs. In the case of

European and American market, the saturation limit is being reached. b. The existing foreign players in the Indian markets have experienced tremendous

growth, and there is still much potential for growth. c. The domestic Asian markets are not well developed and there are very few players

in the field. Therefore, the big multinational have a big chance of holding the market and there are few competitors.

d. In most of the South-East Asian countries, both capital account convertibility and current account convertibility are present. Even those countries which do not have the above are planning about having it.

3. The major reasons can be given as a. Corporate networks of integrated international production that already existed in

Asia allowed some transnational corporations to offset declining domestic sales through increased exports spurred by devaluations.

b. Some transnational corporations took advantage of cheaper asset prices. c. In some cases, parent firms increased investment stakes in their existing affiliates,

either to buy some or all shares of distressed joint venture partners or to alleviate affiliates financial difficulties in the woke of the crisis.

d. Some transnational corporations increased their capital investments in response to the relaxation of FDI regimes that occurred as a result of the crisis.

Model Question Paper 5 Time: 3 Hours Total Points: 200

Paper I Part A: Basic Concepts (30 Points)

Answer all the questions. Each question carries one point.

1. An option forward contract is a contract in which a. A customer undertakes to buy a call option at a future date b. A customer undertakes to buy foreign currency at a specified rate in future c. A customer has the option to buy or sell foreign currency on a specified future date d. A customer has the option to buy or sell foreign currency at a predetermined rate

during given period of days. e. None of the above. 2. Which of the following statements is true? a. Premium is to be added to the bid rate while it is deducted from the ask rate, if the

quote is direct. b. Premium is to be always added whether it is bid rate or ask rate, if the quote is

indirect. c. Discount is to be added to bid and ask rates, if the quote is indirect. d. Premium is to be deducted if the quote is direct and discount is to be deducted if the

quote is indirect. e. None of the above. 3. Following rates are observed in Mumbai.

US$ 34.65/34.90 Cash spot 10/15 Call rate 35%

a. Arbitrage profit can be US$ 0.0024 per $. b. Arbitrage profit can be Rs.0.096 per Rs.100. c. No scope for arbitrage. d. Both (a) and (b) above. e. None of the above. 4. The maximum time period prescribed by RBI for realization of cash exports or for payment

of cash imports are a. 3-m and 3-m b. 3-m and 6-m c. 6-m and 6-m d. 6-m and 3-m e. As per the terms of contract/LC. 5. The 1-m forward rate on 01.11.95 for US$ is 35.50/35.80 and the spot rate after 1-month is

expected to be 34.90/35.10. A customer who has one month receivable of US$ 1,00,000 and one month payable of US$ 50,000 would receive the highest inflow in Rs. if he

a. Covered both receivable and payable in a forward market b. Covers the receivable but leave the payable uncovered c. Covers the payable but leave the receivable uncovered d. Leave both receivable and payable uncovered e. Both (a) and (d) above.

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6. Which of the following indicates interest parity between US$ and GBP?

a. rUS – rUK = ( )f ($ / ) S($ / )

S($ / )α − α⎡ ⎤

⎢ ⎥α⎣ ⎦(1 + rUK)

b. (1 + RUS) = F($ / )S ($ / )

αα

(1 + RUK)

c. ( )( )

US

UK

1 rF $ / £S $ / £ 1 r

⎛ ⎞+⎜ ⎟=⎜ ⎟+⎝ ⎠

d. Both (b) and (c) above e. All of (a), (b) and (c) above. 7. The market $/DM spot rate is 1.8015/20. A dealer finds himself with a long position in DM exceeding his limit he should a. Increase his bid rate above market and reduce his offer rate b. Reduce his bid rate and increase his offer rate c. Increase both d. Reduce both e. None of the above. 8. James borrowed $1,00,000 at 6% and invested the amount in Indian currency at 12%

for 6 m. If the current spot rate is Rs.35 what should be the 6 m forward rate, so as to give James positive spread?

a. <36.98 b. <36.02 c. <34.01 d. <33.12 e. None of the above. 9. The current rates are as under: 1 year rate 10% 2 year rate 11% 3 year rate 12% The expected 1 year rate after 2 years is r12 and the expected 2 year rate after 1 year is r21

then a. r12 = 10.5% r21 = 11.5% b. r12 = 11% r21 = 11% c. r12 = 12% r21 = 11% d. r12 = 13% r21 = 14% e. r12 = 14% r21 = 13% 10. When market exchange rates are used, the GDP of poor countries often a. Can be accurately measured b. Is difficult to measure c. Tends to be undervalued d. Tends to be overvalued e. None of the above. 11. A one-month forward deal is done on January 27, 1982, Thursday. Value date for it is

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a. February 28, 1982

b. March 1, 1982

c. February 29, 1982

d. March 2, 1982

e. None of the above.

12. Following spot rates are quoted in the market:

£/$ 1.7500/10

Can $/$ 0.8000/05

The £/Can $ spot rate should be

a. 2.1873/75

b. 2.1861/87

c. 2.1861/73

d. 2.1875/87

e. None of the above.

13. Which of the following statements is false?

a. Authorized dealers are market makers in the foreign exchange market.

b. Foreign currency broker acts as a middleman between two market makers.

c. The counterparty in the foreign exchange market is another bank.

d. Banks buy and sell for their own account and carry `inventory’ of currencies.

e. Foreign exchange brokers buy or sell foreign currencies for their customers.

14. If the value of the Canadian Dollar is worth $0.65 and the Swiss Franc (Sf) is worth $0.90, then the value of the Swiss Franc in Canadian Dollars (C$) is

a. 1.38

b. 0.72

c. 0.59

d. 0.40

e. 0.35.

15. Which of the following is an example of a Euroyen deposit?

a. A deposit held by a Japanese resident in a London bank.

b. A Yen deposit held by anyone in a London bank.

c. A Yen deposit held by non-resident Japanese in a bank in Japan.

d. A Yen deposit held by a foreigner in a Japanese bank in Japan.

e. None of the above.

16. If a forward currency is ‘FLAT’, it means that a. There is no forward quote for that currency b. There is no scope for covered interest arbitrage c. The expected spot rate is equal to the forward rate d. The current spot rate is equal to the forward rate e. None of the above.

17. Hedging through currency invoicing results in

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a. The exporter and importer covering the exposure

b. The exporter covering the exposure

c. The importer covering the exposure

d. Either exporter or importer covering the exposure

e. None of the above.

18. J curve effect is the phenomenon of

a. Improving and subsequent worsening of a trade balance after depreciation

b. Worsening and subsequent improvement of a trade balance after depreciation

c. Improving and subsequent worsening of a trade balance after appreciation

d. Worsening and subsequent improvement of a trade balance after appreciation

e. None of the above.

19. Which of the following flows are not current account entries in the balance of payment?

a. Interest on long-term external borrowings.

b. NRI deposits.

c. Invisible.

d. All of the above.

e. Both (a) and (b) above.

20. The following quotes are available in London on Monday.

FFr/ Spot: 8.0375/85

Spot/Next: 7/12

The rate for delivery on Thursday is

a. 8.0368/73

b. 8.0382/97

c. 8.0387/92

d. 8.0362/78

e. None of the above.

21. The various reasons for the imposition of trade barriers are

a. To protect an infant industry with tremendous growth potential

b. To increase the demand for domestic products

c. To improve the BOP situation

d. Tariffs are a source of revenue for the government.

e. All of the above.

22. _______ is a letter of credit that allows the issuing bank to make the payment to the beneficiary in installments.

a. Unconfirmed LC

b. Revolving LC

c. Back-to-back LC

d. Deferred LC

e. Anticipatory LC.

23. Equity contribution by Indian promoters can be in various forms such as

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a. Capitalization of proceeds of exports in the form of plant and machinery

b. Technical know-how

c. Capitalization of earnings such as royalty and management fees

d. Cash remittances

e. All of the above.

24. Under Transferable Letter of Credit, the LC can be transferred by

a. An importer to another importer

b. A Banker who has opened the LC to another Banker

c. A beneficary to a third party

d. A Banker who is entitled to negotiate the bill to another Banker

e. None of the above.

25. While quoting exchange rates, authorized dealers deal with exchange margins and bid-ask spreads. Which of the following is/are true?

a. Exchange margins and bid-ask spreads are subject to a cap prescribed by FEDAI.

b. Bid-ask spreads are subject to caps by FEDAI.

c. Exchange margins are subject to caps by FEDAI.

d. Bid-ask spreads are subject to cap prescribed by RBI.

e. Both (c) and (d) above.

26. Compensatory Financing

a. Is a form of counter-trade

b. Is an IMF program to assist countries that are in financial difficulties due to drop in exports c.

c. Is a form of transaction that involves asset transfer as a condition of purchase of goods.

d. Is where Banks ask for compensatory balances to be kept with them for their borrowings in a tated percentage

e. Is money flow from higher interest country to lower interest country.

27. As per UCPDC, the term ‘first half `of a month will be construed as

a. 1st to 14th both dates inclusive

b. 1st to 15th both dates inclusive

c. 1st to 14th both dates exclusive

d. 1st to 15th both dates exclusive

e. 1st to 16th both dates inclusive.

28. Exporters who wish to open foreign currency accounts abroad for crediting export proceeds have to make an application to the exchange control department in

a. Form A3

b. Form EFC

c. Form ENC

d. Form ECB

e. Form ECT.

29. An exporter who expects to realize the export proceeds beyond the time stipulated by the exchange control regulations should make an application for the said purpose to RBI in __________ .

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a. Form ECB1 b. Form ETX c. Form GR d. Form A1 e. Form ENC. 30. Which of the following statements is not true? a. No import license is required in case of imports into bond for the purpose of re-export. b. Where goods are imported under penalty, remittance will up to the FOB value of

goods mentioned in the exchange control copy of the customs bill of entry. c. In case shipment of replacement goods is to be made after the expiry of import

license, the mporter will have to apply to the import trade control authorities for revalidation of license

d. Both (a) and (b) above. e. None of the above.

Part B: Problems (50 Points)

Solve all the problems. Points are indicated against each problem. 1. A bank has issued a fixed rate bond for the purpose of meeting its capital adequacy

requirements. The terms are as under: Period : 6 years Coupon : 14% Payment : Annual After one year the bank believed that interest rates would decline and hence swapped its

fixed rate liability with floating rate liability. Market quote for fixed to floating rate swap was 364-day T-Bill rate vs 75/85 bp over 5-year GOI security. The 5-year GOI security was quoting at 11.5%. The 364-day T-Bill was quoting at 12.25%. If the 364-day T-Bill rates increased by 10 bp over the first year, but declined by 5 bp every year after that, what is the effective cost of funds to the bank?

(8 points) 2. While evaluating an international project, a German MNC has calculated the adjusted present

value to be – DM 15 million. The local government in the US has now offered a concessional loan of $100 million which will involve repayment of principal in five equal installments. Interest will be paid on the outstanding amount, annually. If the market rates of interest are 6% and 5% in USA and Germany respectively, at what rate should the MNC negotiate the loan? Assume that the spot rate is DM 1.80/$.

(10 points) 3. On April 16, 2001, National Bank of India entered into a three-month forward contract for

purchase of ¥10 million. The three-month forward quotation on that day was Rs./100 ¥ 37.96/38.05. The delivery date for the transaction was July 18, 2001. On April 30, 2001, the client approached the bank for a purchase of Yen under the contract on the same day. The following rates prevailed on that day. Spot (Rs./100 ¥) 38.20/38.30 Forward rate for delivery on July 18, 2001 (Rs./100 ¥) 38.45/38.55

Calculate the amount to be collected from/paid to the customer due to the early delivery. (9 points)

4. NBA Bank Ltd. transacted the following forward transactions on March 19, 2001. i. Sold $1,000,000 three months forward to Alpha Manufacturing Co. Ltd. at Rs.47.20.

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ii. Purchased Euro 1,000,000 two months forward from Beta Trading Co. Ltd. at Rs.48.05.

On May 19, 2001, both the customers approached the bank. Alpha Manufacturing Co. wants the forward contract to be canceled while Beta Trading Co. wants the contract to be extended by one month. The following exchange rates prevailed on that day: Rs./$ Rs./Euro Spot 47.30/47.35 48.05/48.15 One-month forward 15/20 25/35

Based on the above information, you are required to a. Calculate the amount to be paid to or recovered from Alpha Manufacturing

Company due to the cancellation of the forward contract. b. Calculate the amount to be paid to or recovered from Beta Trading Company due to

the extension of the forward contract. c. Indicate what the bank will do if Alpha Manufacturing Company asks for

cancellation of the contract on the day of maturity. (7 points)

5. You are a FOREX Officer in Finetune Bank Limited. One of your customers has imported 5000 computer components @ US $ 25 each. Now they are enjoying overdraft limit with you for which the applicable rate of interest is 20% p.a. They have option to settle the import bill immediately or in three months time.

They have the following options: i. Pay in three months time with overseas interest at 18% and cover the exchange risk

forward for 3 months. ii. Settle now at the current spot rate and pay interest on the overdraft for 3 months. Current rates: Mumbai Spot Rs./$ 34.50 – 34.75 3 months swap 40/50 You have to advise them keeping in view which method will be cheaper to them duly

ignoring exchange commission. (9 points)

6. On 1st January, Bank ‘B’ entered into a forward purchase contract for USD 250,000 with one of its export customers at a rate of Rs.46.60 delivery 1st April and covers itself by forward sale to the market at a rate of Rs.46.65. However on the due date, the customer failed to execute the contract. On 16th April, the contract is canceled by the bank. The rates prevailing on 1st April and 16th April are as follows:

On 1st April Interbank TT rates Rs./$ 46.75/80 1-month forward 46.90/95 Merchant TT rates 46.67/90 16th April Interbank TT rates Rs./$ 47.10/15 Merchant TT rates 47.05/20 Interest on outlay of funds is 16% p.a. What are the cancelation charges payable by the

customer? (7 points)

Part C: Applied Theory (20 Points)

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Answer the following questions. Points are indicated against each question. 1. Explain the difference between floating rate and fixed rate mechanism.

(5 points) 2. Explain with examples the various motives underlying currency and interest rate swap.

(5 points) 3. Explain the determinants of operating exposure of a firm. Explain, with examples how an

exporter can be hurt despite real depreciation of his home currency and an importer can be hurt despite a real appreciation.

(5 points) 4. ‘A’, who is an authorized dealer, has received a request from `B’ a customer, for reduction

of amount of the bill after it has been negotiated. What are the guidelines in this respect. What are the formalities to be adhered to by the exporter.

(5 points)

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Paper II

Part D: Case Study (50 Points)

Read the case carefully and answer the following questions. 1. Explain the advantages of centralized and decentralized cash management for the MNC.

(6 points)

2. Suppose the UK subsidiary has to pay £50,000 to the Swiss subsidiary on 1/3/98 while the Swiss subsidiary has to pay £30,000 to the UK subsidiary. Explain with necessary calculations, how netting can benefit the MNC.

(6 points)

3. What would have been the benefit from netting in the earlier problem if the following had been the spot rates prevailing on 1/3:

$/£ : 1.605 SF/$ : 1.485

(2 points)

4. Explain briefly the difference between covering exposure in the money market and in the forward market for both receivables and payables.

(6 points)

5. Using detailed calculations, explain to the Japanese subsidiary how it can manage its transactions for the month of March without incurring any forex exposure. Consider two alternatives.

a. Forward market with money market cover only to the extent required.

b. Pure money market cover.

(25 points)

6. Study carefully the figures given in Exhibit I. Assuming that the volume of transactions across the MNC system has grown steadily why do you feel that overseas earnings as a percentage of total revenues have tended to fluctuate?

(5 points)

You are the treasurer of a multinational corporation based in USA. Your company has subsidiaries in many countries. International operations have traditionally been an important source of revenues. The percentage of earnings contributed by overseas businesses is given in Exhibit I.

Even though international businesses have been an important part of the company’s activities, the company has not applied a systematic approach to the management of both cash flows and foreign exchange risk. Traditionally, the subsidiaries have operated with considerable autonomy. As a result, management of foreign exchange risk has been largely left to the country treasurers. Subsidiaries have also been managing cash more or less independently except during emergencies when they receive support from the parent. Excess cash balances have also tended to remain within the subsidiary which typically deploy them in short-term investments in the local markets. However, at the end of the year, the subsidiaries remit their earnings in the form of dollars to the parent.

Since the subsidiaries are located in developed eastern countries, little political risk is involved. There are also few restrictions on the repatriation of dividends.

As the treasurer, who has joined the company recently, you instinctively feel that there is considerable scope for improvement. Your training as a finance professional makes you feel that adequate controls are not being exercised and such a decentralized style of management can lead to unwanted consequences. Having worked in a reputed bank earlier, you are also aware of various sophisticated hedging instruments such as futures and options.

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Since the company is involved in the Fast Moving Consumer Goods (FMCB) business, the traditional emphasis has been on brand building and selling. Preliminary and informed discussions with colleagues have also indicated that it is indeed the marketing personnel who are calling the shorts at most subsidiaries. An additional complicating factor is that each of the subsidiaries on its own has significant volumes of overseas transactions. You have confirmed that the commonly used method of settling payments for both exports and imports has been the irrevocable letter of credit. However, the general practice has been to wait and buy in the spot market to settle payments against imports and sell spot on the date of maturity of the payables in the case of exports. You feel this is a dangerous strategy and would like to inform the top management accordingly. Before going into the specifics, you have identified a few basic issues which need to be considered. • Is decentralized cash management as it exists today really advisable? • Does it make sense to cover foreign exchange exposure? • What are the hedging instruments which ideally suit the risk profile of the company? To make your arguments more effective, you have collected the following information on the transactions of the Japanese subsidiary for the month of March, 1998. You would like to explain to the treasurer in Japan how foreign exchange risk can be managed. March 1, 1998 • Exports to UK worth £2,000,000 are made. Payment will be realized in one month. • Payment of Yen 130 million has to be made towards local taxes immediately. • A payment of DM 1,000,000 will be realized from a German customer. • An equipment worth SF 100,000 will be imported from Switzerland. The payment will be

made in a month from now. April 1, 1998 • Payment of SF 100,000 will have to be made to a supplier against earlier imports: received

two months before. • A customer will remit US 50,000 towards earlier purchases. • The company has to settle a major payable in FF and is exploring opportunities of

mobilizing the required funds. Exhibit II gives exchange rates and interest rates prevailing on 1st March.

Exhibit I Year % of earnings from overseas

operations (on dollar basis) Year % of earnings from overseas

operations (on dollar basis) 1975 25 1987 21 1976 24 1988 22 1977 23 1989 23 1978 24 1990 24 1979 22 1991 25 1980 23 1992 25 1981 24 1993 25 1982 24 1994 26 1983 21 1995 28 1984 20 1996 25 1985 20 1997 22 1986 20

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Exhibit II 1/3/98 Spot rates : $/£ : 1.60/1.61 Yen/$ : 130.5/131.0 DM/$ : 1.80/1.81 SF/$ : 1.48/1.49 FF/$ : 6.10/6.20 Interest rates: $ - 6% : £ - 7% Yen - 2% DM - 4% : SF - 4% FF - 4% One month forward rates: $/£ : 1.59/1.60 Yen/$ : 131.5/132.0 DM/$ : 1.81/1.82 SF/$ : 1.47/1.48 FF/$ : 6.20/6.30

Part E: Caselets (50 Points) Caselet 1

Read the caselet carefully and answer the following questions. 1. Explain how a cut in the CRR or bank rate can affect the exchange rate.

(5 points) 2. Exporters constantly complain that the rupee should depreciate much more in order to

protect the competitiveness of Indian goods. Do you agree with this view? Explain with reasons.

(5 points) 3. The global foreign exchange markets are considered to be among the most perfect in the

world. Speculation is however heavy and probably accounts for more than 97% of the transactions. Explain how the two positions are consistent with each other.

(5 points) 4. Speculation can add to exchange rate volatility. The expectation of currency appreciation or

depreciation on the part of speculators can be self fulfilling. As such, speculation in the forex markets should be severely curbed. Explain with reasons whether you agree with this view.

(5 points) 5. Explain how restrictions on cancelation of forward contracts can strengthen the rupee.

(5 points) A Business Today article (Feb. 7-21, 1998) commented “Everything according to a basic law of physics, is relative except for the Indian rupee that is. For the first eight months of 1997, the rupee resisted the gravitational tug of both the Great Asian markets melt down and the Euro depreciation to remain steady against the dollar in the Rs.35.70–35.80 range. And when the inevitable slide started, it was brought to a screeching halt by large doses of policy intervention. The net result, even at the Rs.40 levels, the rupee is one of the strongest currencies in the world today.” In a bid to stem the decline of the rupee, RBI announced a package of measures. Bank rates were hiked by 200 basic points, and Cash Reserve Ratio (CRR) by 50 basic points. The rupee immediately bounced back to the Rs.38.50–Rs.39.00 range. RBI’s moves came in a bid to check excessive speculation in the forex markets. Business Today criticized the RBI moves and argued that RBI’s earlier actions had themselves added to speculative pressures: “Currency markets rarely behave in an orderly fashion. And the Indian foreign exchange market is no exception. While the daily turnover in the foreign exchange market is about $2.50 billion, that is nearly 10 times the daily trade flow, suggesting that over 90% of the transactions in the market are driven by capital flows, speculation and sentiments – a mix that makes for frequent and sharp gyration. Although the rupee edged past the Rs.40 levels in early January, 1998, there were no signs of a stampede.

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Indeed, much of the acceleration in the case of the decline could be blamed on the heavy handed constraints placed on the foreign exchange market by the RBI itself. Its restrictions on the cancelation of forward contracts and the maintenance of overnight positions limited flexibility and only intensified the scramble for forward cover. Despite heavy intervention in the forward market, the six month premiums zoomed to an 18 month high of 11%. Worse the announced cuts in the Cash Reserve Ratio (CRR) were postponed, squeezing shut liquidity taps.”

Caselet 2

Read the caselet carefully and answer the following questions.

1. Why is FDI in the form of greenfield project, preferred to FDI in the form of mergers and acquisitions?

(4 points) 2. Briefly discuss the measures for worsening BoP deficit. What are the measures initiated by

the government? (4 points)

3. What can be the impact of a BoP crisis on the economy? (5 points)

It is no secret that the past couple of years have witnessed a worsening of India’s external economic position. The deceleration of exports that began from 1996 further intensified subsequently, to the point where exports have effectively stagnated in dollar terrms over the past year and a half, and this has been associated with a burgeoning trade deficit.

Meanwhile, foreign investment inflows have been much less than anticipated by governments that have sought to woo international capital with a variety of sops and incentives.

The main saving grace has been the highly positive role played by inward remittances of workers’ incomes, which have lowered the current account deficit and allowed the economy to avoid further expensive commercial borrowing. However, as the reliance on short-term capital in the overall balance of payments continues to be quite high, the threat posed by a possible flight of capital remains serious.

If the current trends continue, this problem is likely to be aggravated in the coming months, and whichever new government is formed may well have to deal with the consequences of this incipient balance of payments crisis.

The dominant obsession of the latest BJP-led Government, much like the Congress Government of the first-half of the 1990s, has been to attract foreign capital. In addition, the BJP-led Government went even further in terms of efforts to placate and woo such capital after the Pokhran blasts, and has offered a variety of sops and incentives to certain categories of what it classifies as “foreign direct investment”.

The net result of all that effort has been a marginal increase in such FDI inflows, although the gap between actual inflows and stated commitments remains embarrassingly large. However, there are at least two issues relating to such inflows which would certainly cause discomfiture to those who adhere to the BJP’s original economic strategy.

Firstly, the share of FDI, which has been in the form of acquisition of more shares of existing multinational holdings, has gone up quite significantly over the second-half of the decade, and was at its highest precisely in 1998-99, the year of the BJP Government’s tenure.

Secondly, all forms of foreign investment, including borrowing, now involve increasing costs in terms of foreign exchange outflow. Foreign portfolio flows in the form of FII inflows have of course been negative in recent times. But even FDI and external loans have been associated with higher repayment and profit repatriation.

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Caselet 3

Read the caselet carefully and answer the following questions.

1. Bring out the possible reasons for the Euro not standing up to the expectations of the makers.

(4 points) 2. Why do you think the US$ has appreciated when the Fed increased the internal rate?

(4 points) 3. Euro’s fall is expected to help in recovery of the Europe’s economy. How does a weak

currency help an economic recovery? (4 points)

Inventors of the euro expected that it would distinguish itself from its oligopolistic competitors – the dollar and the yen – and attract attention from portfolio investors and central bankers, gradually becoming a key currency. The reality, however, has been painfully far from this expectation, as evidenced by the euro sliding just below dollar parity (December 4) by about 16 percent in less than a year after its launch. This was expected even around August, the question being not `why’, but `when’. The active market participants’ perception of a weak euro seems to have triggered the fall rather more swiftly than expected. Despite its inherent economic strength and many smaller countries going the euro way, the common currency’s career graph is twisted, its strength during the temporary dollar slide of late 1999 being but short-lived. The indomitable Deutsche mark is still contained in the `euro’, but refuses to generate sufficient confidence among investors. However, the DM, as a component of the euro, is not the analytical equivalent of its earlier incarnation as anchor currency (in the erstwhile ERM), against which weak currencies were allowed to depreciate periodically.

Model Question Paper 5 Suggested Answers

Paper I Part A: Basic Concepts

1. (d) An option forward contract is a contract in which a customer has the option to buy or sell foreign currency art a predetermined rate during a given period of days.

2. (c) To calculate the forward rates, the premium must be added to the bid rate and the ask rate and discount has to be deducted when it is a direct quote. In case of indirect quotes premium is deducted and discount is added to get the forward rate.

3. (c) Suppose we borrow $1,000 to get Rs.34,650

If we lend this in call money market we get 34,650(1 + 0.35/365) = Rs.34,683

Cash spot 34.75/35.05

On selling Rs.34,683 we get 34,690/35.05 = $989.53

Loss is 1,000 – 989.53 = $10.46

Hence, there is no scope for arbitrage.

4. (c) The maximum time period prescribed by RBI for realization of cash exports or for payment of cash imports are 6 months and 6 months respectively.

5. (b) As the future spot rate is less than the forward rate the customer would gain if he covers the receivables and leaves the payables uncovered.

6. (e) According to the interest rate parity, the cost of money (i.e., 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. All the given equations refer to interest rate parity between US $ and GBP.

7. (d) When the dealer is in a long position it means that he has overbought DM. The bank is only buying the currency without being able to sell. It means that the market is getting a competitive rate for selling the currency to the dealer, but the dealers selling rate is too high to attract buyers. Hence the bank has to reduce both bid and the ask rates.

8. (b) Amount borrowed $ 1,00,000 at 6%.

Amount to be paid back = 1,00,000 + 6% = 1,06,000

Amount invested in Indian currency at 12% is 35,00,000 i.e., 1,00,000 x 35

Amount received for 6 months = 37,10,000

Only when the forward rate is less than the spot rate James will be able to repay his loan. Hence for James the forward rate should be less than 36.02, to give a positive spread.

9. (e) According to the expectations theory, (1 + r1) (1 + r21) + (1 + r3)2

Where r1 and r3 are interest rates for 1 year and 3 years respectively

And r21 is 2 year rate at the end of 1 year

On substituting we get (1 + r21) = (1.12)2/1.10

r21 = 14%

Similarly 1 year rate after 2 years is given by r12

(1 + r2) (1 + r12) = (1 + r3)2

1 + r12 = (1.12)2/1.11

r12 = 13%

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10. (c) When market exchange rates are used GDP of poor countries often tends to be overvalued, due to the depreciation of exchange rates of the poor countries.

11. (a) The spot settlement date is the second working day from the day of the contract. Here the spot settlement date is 29th January as it is a Saturday the spot settlement date now will be 31st January. The value date is obtained by adding the number of months of forward contract to the spot settlement date. The value date cannot be shifted to the next calendar month while rounding off the settlement date due to holidays. Hence the one month forward value date will be 28th February as it is not a leap year.

12. (b) P/$ = 1.7500/1.7510 Can $/$ = 0.8000/0.8005 P/Can $ = P/$ x 1/(Can $/$) = 2.1806/2.1887 13. (e)The foreign exchange brokers do not actually buy or sell any currency. They do the work

of bringing buyers and sellers together. 14. (a) Can $/Sf = 0.65 Sf/$ = 0.90 Sf/Can $ = Sf/$ x 1/(Can $/Sf) = 0.90 x 1/0.65 = 1.3846

15. (d) A Eurocurrency deposit is a freely convertible currency deposited in a bank outside its country of origin. Hence a Euro-yen deposit is a Yen deposit held by anyone in a London bank.

16. (d) If the forward currency is flat means that the spot rate is equal to the forward rate.

17. (d) Hedging by choosing the currency of invoicing involves invoicing all receivables and payables in the domestic currency. Only one of the parties involved can hedge itself in this manner.

18. (b) J-curve effect is the phenomenon of improving and subsequent worsening of a trade balance after depreciation. It indicates the path of the Balance of Trade over time after a change in exchange rates. This path after a devaluation/depreciation may have the appearance of the letter ‘J’.

19. (b) NRI deposits are capital account entries in the Balance of Payments.

20. (b) The forward rate is obtained by adding the swap points to the spot rate if the swap points are in low/high order. Hence the forward rate will be 8.0382/8.0397.

21 (e) All the alternatives given are reasons for imposition of trade barriers.

22. (d) Deferred LC letter of credit allows the issuing bank to make the payment to the beneficiary in installments. The timing and the amounts of the installments are predetermined.

23. (e) Equity contribution by Indian promoters can be in all the given forms.

24. (c) A transferable letter of credit is one where the beneficiary can transfer his rights to the third party.

25. (b) The authorized dealers have to operate within the rules, regulations and guidelines issued by the Foreign Exchange Dealers Association of India (FEDAI). Only the bid-ask spreads are subject to the caps by FEDAI.

26. (b) An IMF program to assist countries that are in financial difficulties due to drop in exports is called compensatory financing.

27. (b) As per Article 47 of UCPDC, the term ‘first half’of a month shall be construed as the 1st to the 15th, both dates inclusive.

28. (b) Exporters having a good track record may be permitted to open foreign currency accounts with banks abroad for crediting the export proceeds. Exporters intending to avail this facility have to make an application on Form EFC which has to be submitted through the designated branch to the Exchange Control Department under whose jurisdiction the exporter is functioning.

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29. (b) Where the exporter is unable to realize the export proceeds within six months but expects to do so provided extension is granted to him, then he should make an application (in duplicate) for this purpose to the RBI in Form ETX along with necessary documentary evidence.

30. (b) In case of imports under penalty, remittance will be up to the C.I.F value of the goods mentioned in the exchange control copy of the customs bill of entry evidencing import of goods into India.

Part B: Problems 1. The market quotation implies that the bank will be paid 5-year GOI securities rate + 75bp in

return for 364-day T-Bill rate from it. That is, the bank may pay 364-day T-Bill rate in return for a fixed payment of 11.5% + 0.75% = 12.25%. As the bank’s fixed rate liability is higher at 14%, the swap will be to receive 14% and pay 364-day T-Bill rate + (14 – 12.25) or 364-day T-Bill rate + 1.75%.

The interest rates applicable to the bank will be as follows:

Year 364-day T-Bill rate (%)

Floating rate for the bank

(%) 1 12.25 14.00 2 12.35 14.10 3 12.30 14.05 4 12.25 14.00 5 12.20 13.95 6 12.15 13.90

Effective cost of funds: (1.14 x 1.141 x 1.1405 x 1.1395 x 1.139)1/6 – 1 = 0.14 or 14%.

2. 1 2 3 4 5 Payment 100i 80i 60i 40i 20i (X) +20 +20 +20 +20 +20

ΣPV = 2 3 4 5100i 20 80i 20 60i 20 40i 20 20i 20

1.06 1.06 1.06 1.06 1.06+ + + + +

+ + + + = 262.55i + 84.25

Benefit = $ (100 – 262.55i – 84.25) = $(15.75 – 262.55i) = DM (1.8) (15.75 – 262.55i) = 15 or 15.75 – 262.55i = 15/1.8 i = 0.0282 = 2.82%

3. NBI entered into an agreement to purchase ¥10 million in 3-month forward at 37.96. The bank covers the transaction with a contract to sell the ¥ in the interbank market 3-month forward.

On early delivery date the bank buys ¥ from the customer at the agreed upon forward rate of 37.96, and sells the same in the spot market at 38.2. Due to early delivery, there is additional cash flow to the bank on 30-08-2001 to the extent of difference between the spot sell and forward purchase contract rate i.e. Rs.(38.02 – 37.96) = Rs.0.24. Since this additional cash flow is with bank for 109 days, i.e. till the original contract date, NBI will pay interest on this amount at its deposit rate (Fedai Rule).

Interest amount to be paid to the customer = 0.24 10,000,000 109 0.10100 365

× ×× = Rs.716.71

(Assuming deposit rate to be 10%)

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The bank will do a swap by selling the ¥ in the spot market on the day of early delivery and buying forward. In this process the bank would square off the forward contract it had entered to cover itself for the original contract. That is, it sells spot at 38.2 and buys forward at 38.55. The difference between these two i.e. Rs.0.35, the bank will recover from the customer. The swap loss can be recovered by NBI at the time of early delivery or on the day of original contract due date.

Therefore, the net amount to be collected from the customer is Rs.(35,000 – 716.71) i.e. Rs.34,283.29.

4. a. The early cancellation of contracts to sell is made at the bank’s forward buying rate on the day of cancellation. The difference between the two is paid (collected) to (from) the customer. Rate of the original contract = Rs.47.20 Rate for cancellation = Rs.47.30 + Rs.0.15 = Rs.47.45Difference between the two = Rs. 0.25 Amount to be paid to the customer = Rs 0.25 x 1,000,000 = Rs.250,000.

b. To meet the forward purchase from Beta trading company the bank assumes that it entered into a forward contract at Rs.48.05 to sell Euro 1,000,000. The cancellation of this contract has to be met through a purchase of Euro from the spot market at Rs.48.15. The difference, Rs.0.10 per Euro, will be collected from the customer.

The amount to be collected = Rs.0.10 x 1,000,000 = Rs.1,00,000. c. If the cancellation is requested for on the last day of the contract, the bank will still

receive dollars from the other contract it booked to cover itself, sells the dollars spot and collects (or pays) the difference from (to) the customer.

5. Spot rate 34.50 – 34.75 3m Swap 40/50 Hence 3m forward rate 34.90 – 35.25 Interest Rate : Overdraft rate 20% Overdraft rate 18% Amount of import payment = 5,000 x 25 = 1,25,000

Option a: To pay after 3 months together with interest @ 18% Amount to be paid $ 1,25,000 Interest @ 18% for 3 months 5,625 1,30,625

If the forward contract is entered into Rupee equivalent of $130625 46,04,531Option b: To borrow at 20% and pay now

Rupee equivalent of $125000 43,43,750 Interest for 3 months @ 20% 2,17,188 45,60,938

Hence, it is better to borrow at 20% and pay at current spot rate. If the funds are borrowed and paid at the current market rate.

a bRupee equivalent 43,43,750 43,43,750Interest @20% 72,396 1,44,792 44,16,146 44,88,542$ equivalent at forward rate 1,25,280 1,27,335Implicit interest rate 2.69% 11.21%

It is better for the importer to prefer preponement of payment as long as the overseas rates are less than the implicit rates worked above.

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6. The bank would have covered its exposure by entering into a forward sale contract with the market, delivery 1st April. However, because of failure to execute the contract, the bank will now have to buy spot from the market at the selling rate and deliver against the forward sale contract. The bank will thus have to buy dollars at the rate of Rs.46.80 per dollar. As the contract is not canceled by the customer, the amount remains in the exchange position of the bank and to square its position the bank may enter into a forward sale contract for a short period say 15 days at the market one month forward purchase rate of Rs.46.90.

On 16th April, when the bank cancels the contract, it removes the contract from the exchange position. It buys spot from the market at Rs.47.15 and delivers to the market at Rs.46.90.

Exchange Difference The forward purchase contract would be canceled at the merchant TT selling rate on the

date of cancelation. The bank buys $ at Rs.46.60 The bank sells $ at Rs.47.20 Exchange difference payable per dollar by the customer Re. 0.60 i.e. Rs.1,50,000. Swap Difference On 1st April, the bank does a swap of buying $ spot at Rs.46.80 and selling forward at the

rate of Rs.46.90. As it buys low and sells high, there is no swap loss. Interest on Outlay of Funds On 1st April, the bank purchases at Rs.46.80 and delivers at Rs.46.65. Outlay of funds per

dollar is Re.0.15. For US dollars 250,000, the bank is out of funds to the extent of Rs.37,500 from 1st April to 15th April, when the contract is canceled. The bank is entitled to recover interest at the rate of 16% on this amount. Interest on 37,500 at 16% for 15 days is Rs.246.5.

Cancelation Charges Rs. Exchange difference 150000.0 Interest on outlay of funds 246.5 Flat charge 100.0 Total charges on cancelation 150346.5

Part C: Applied Theory 1. The differences between the floating rate mechanism and fixed rate mechanism are a In the floating rate mechanism, the exchange rate is determined by the market

forces, while in fixed rate mechanism, the exchange rate is determined by the government. Therefore, in floating rate mechanism, the exchange rate depends on the perception of the market about the relative worth of various currencies while in the fixed rate mechanism, the rate depends on what the government wants it to be.

b. In fixed rate mechanism, the government needs large amounts of reserves to be able to maintain the currency at the level it wants. In the floating rate system, the government does not interfere in the market.

c. In some variations of the fixed rate mechanism, the value of the currency is adjusted upwards or downwards depending on the values of certain key parameters such as money supply.

d. The fixed rate system though useful for maintaining a stable exchange rate, may give rise to market distortions in the long run. The floating rate system, on the other hand, may result in wide fluctuations in the exchange rates over short time intervals but is expected to settle down at its true value.

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2. Several explanations have been advanced for the existence of a large and growing volume of activity in the swap markets. Most of these hypotheses rely on either a capital market imperfection or factors like differences in investor attitudes, informational asymmetries, differing financial norms, peculiarities of national regulatory and tax structures and so forth to explain why investors and borrowers use swaps.

Borrowers and investors differ in their preferences and market access. For instance, a manufacturing firm or a utility might prefer fixed rate funding to finance long gestation physical investment projects but finds that fixed rate investors do not view it very kindly while it is able to borrow relatively easily in the floating rate market. On the other side is a large international financial institution such as a money center bank which can borrow on excellent terms in the fixed rate market but prefers floating rate funding because it has a large portfolio of floating rate loans. Or consider a firm which has borrowed from a Japanese government agency to finance imports of capital, equipment from Japan. It exports to the Middle Eastern and African markets and expects to earn a steady income stream in US dollars. It might like to match the currency of its foreign exchange receivables and payables to hedge exchange risk. An American firm might find that while it can raise funds easily in the large US dollar domestic market, it is relatively unknown in Europe and faces rather high costs for a fixed rate SFr funding it would like to raise. An investor with a portfolio of fixed rate assets might have strong views that rates are going to rise and may wish to shift to floating rate assets. To sum up, because of differences in preferences, market access and expectations there are at any time borrowers and investors with mismatched assets and liabilities who would like to reshuffle their balance sheets or acquire new assets/liabilities to which direct access may be very difficult or expensive. Finally, swaps are also a low-cost device of achieving certain objectives which can be achieved by other means but at a higher transaction cost. For instance, a firm may wish to retire its foreign currency loan and refund itself in the home currency market. Apart from any penalties attached to prepayment, transaction costs would be higher if it retires an old issue and makes a new issue; the same objective can be achieved via a swap cheaper.

Obviously, swaps must help borrowers and investors overcome the difficulties posed by market access and/or provide opportunities for arbitraging some market imperfection.

Quality Spread Differential (QSD) This is one of the commonly offered explanations of the fixed to – floating interest rate

swaps. The argument can be illustrated by means of an example. Consider XYZ Inc., a manufacturing firm which wants to raise 5-year fixed rate dollar funding to finance an expansion project. Its credit rating is not very high, say BBB. It finds that it will have have to pay 2% over 5-year treasury notes which are currently yielding 9%. In the floating rate market it can issue 5-year FRNs at a margin of 0.75% over the prime rate. On the other hand, ABC Inc. a large bank looking for floating rate funding finds that it will have to pay prime rate while in the fixed rate market it can raise 5-year funds at 50 bp (0.50%) above T-notes due to its AAA rating. Thus the spread demanded by the market between an AAA and a BBB credit is 150 bp in the fixed rate segment while it is only 75 bp in the floating rate segment. This differential is known as quality spread differential (QSD). The requirements and access of the two parties are summarized below: XYZ ABC Requirement Cost fixed $ Cost floating $

Fixed Rate $ 11% Prime + 0.75%

Floating Rate $ 9.5% Prime

The bank ABC has an absolute advantage over the corporation XYZ in both the markets but the corporation has a comparative advantage in the floating rate market. Both can achieve cost saving by each borrowing in the market where it has a comparative advantage and then doing a fixed-to-floating interest rate swap. Suppose the notional principal is $ 100 million. The terms of the swap arranged by a swap bank can be as follows:

ABC borrows $100 million at 9.5% s.a. fixed. XYZ borrows $100 million floating at prime + 0.75 payable semi-annually.

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ABC pays the swap bank (prime-0.25%) on $100 million every six months. The swap bank passes this on the XYZ. XYZ pays the swap bank 9.75% s.a. on $100 million. The swap bank pays ABC 9.5% s.a. Figure given below shows the swap diagrammatically.

The key result is that both the parties have achieved their objectives with some cost saving: XYZ Corp. : 9.75% + (prime + 0.75) – (prime – 0.25)% = 10.75% fixed rate, 25 bp below

its own cost of fixed rate funds. ABC Bank : 9.5% – 9.5% + prime – 0.25% = prime – 0.25%, 25 bp below its own cost of

floating funds. The swap bank earns a margin of 25 bp. The cost savings could be achieved by exploiting the comparative advantage. By ABC

borrowing in the fixed rate market there was a saving of 1.5% (= 11 – 9.5) and by XYZ borrowing in the floating market there was loss of 0.75% (= prime + 0.75 – prime) for a net gain of 0.75%. Notice that the gains of all three parties together equal this total gain. The division of the total gain between these parties is subject to negotiation depending upon supply and demand factors. The equal division assumed in the example is purely illustrative.

QSD was one of the earliest explanations offered for interest rate swaps. It continues to be featured in most non-rigorous discussions of swaps. However, the argument has been questioned by many writers. The existence of quality spread differential between fixed rate lending and floating rate lending has not been satisfactorily explained. There is also a debate about whether the cost savings represent arbitrage gains or compensation for bearing additional risk. Some writers have offered agency-theoretic explanations for the existence of interest rate swaps.

Market Saturation One of the earliest currency swaps was the one between the World Bank and IBM executed

in 1981. At the time the World Bank was looking for fixed rate funding in SFr and DM to on lend the funds to its clients. World Bank loans are serviced in the currency of borrowing so that exchange risk is entirely borne by the borrowing country. World Bank therefore had traditionally tended to borrow extensively in low nominal interest rate currencies such as the SFr and the DM. Because of its frequent resort to these relatively small markets (compared to the US dollar domestic bond market), they had become “saturated” with World Bank paper. Consequently, despite its top AAA rating, World Bank faced rather stiff terms for borrowing fixed rate SFr and DM. IBM had existing liabilities in these currencies contracted at a time when the dollar was weak against these currencies. Since then, due to the appreciation of the dollar, it had made a capital gain on its liabilities which it wanted to lock in. Objectives of both parties were achieved by the World Bank making a dollar bond issue in the US market and then swapping this liability for IBM’s existing liabilities in SFr and DM. Another explanation for currency swaps derives from the differences that were said to exist between attitudes of continental and US investors towards formal credit rating. Continental investors are said to be less sensitive to formal credit rating and attach greater weight to a company’s name, reputation, etc. while US investors are said to be very

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particular about formal rating. As a result of this, a company with worldwide reputation such as Coca-Cola or General Motors, might find that even when its rating is not top quality, the spread that it has to pay over a top rated borrower is less in the continental markets than in the US market. Consequently, it would be better off borrowing in say SFr or DM and swapping into US dollars.

A typical currency swap situation is illustrated by this example: Requirement: Alpha Corp.

Fixed $ funding Beta Bank Fixed SFr Funding

Cost of $ Funding: 12.5% 11.5% Cost of SFr Funding: 6.5% 6%

Once again, an overall saving of 1% can be achieved by the Beta bank borrowing in the dollar market, Alpha corporation in the SFr market and the two swapping the liabilities. Figure given below shows the structure. Alpha corporation has effectively acquired fixed dollar funding at 12.30%, 20 bp below its own cost while the Beta bank has acquired SFr funding at 20 bp below its cost. The swap bank makes a gain of 10 bp for a total gain of 50 bp.

Differing Financial Norms Investors use a variety of financial ratios such as the debt:equity ratio, interest coverage

ratio, etc. to assess financial health of a firm. Norms regarding “acceptable” values of these ratios differ across countries. For instance, Japanese companies tend to have much higher debt: equity ratios than what would be considered acceptable in the US. A Japanese firm wanting to raise dollar funding might find a direct approach to the US market unattractive because its rating may be affected by its high debt:equity ratio. It might be cheaper to borrow at home in Yen and then execute a swap.

Hedging Price Risks The factors considered so far made swaps an attractive funding tool from the point of view

of lowering financing costs. An equally important objective underlying swaps is hedging of interest rate and exchange rate risks. Swapping out of a floating rate debt (or asset) into a fixed rate debt (or asset) could be motivated purely by the desire to eliminate interest rate risk rather than saving on borrowing costs (or improving return on investment). Similarly swapping out of say a DM denominated liability into a dollar denominated liability is a way of eliminating exchange rate exposure if the firm has certain future inflows in dollars. In a basis swap mentioned above, a bank with LIBOR tied assets funded with prime-tied liabilities may wish to eliminate basis risk (created by the fact that prime rate and LIBOR are not perfectly correlated) by doing a swap.

Other Considerations A few other possibilities have been pointed out where swaps provide an efficient way of

achieving the firm’s objectives. In some capital market e.g. Japan, the authorities regulate the timings of foreign issues by means of a queue system. Suppose an American firm is way back in the queue by entering into a currency swap with a firm which is at the head of the queue and is willing to accept dollar funding. A firm may be able to access markets via swaps which it otherwise cannot enter profitably. Occasionally, differences in tax law across countries create profitable swap opportunities.

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3. Operating exposure depends upon • Change in nominal exchange rate • Change in the selling price (output price) • Change in the quantity of output sold • Change in operating costs i.e. quantities and prices of inputs.

Operating exposure can be looked upon as a combination of two effects. The conversion effect refers to the changes in home currency value of a given foreign currency cash flow while competitive effect refers to the impact of exchange of rate changes arising out of changes in prices and quantities. The former is similar to transactions exposure while a meaningful analysis of the latter must inquire into the factors which determine the price impact and the quantity impact exchange rate changes. The most important consideration here is the structure of the markets in which the firm sells its output and buys its inputs.

Consider an Indian firm that exports leather jackets to the United States. It is a very large market in which our firm is an insignificant player. Like a perfectly competitive firm of economic theory, it takes the dollar price of its product as given and can sell as much as it wishes at the going market price.

Figure 1

The area OABC is the firm’s total export revenue while the area ODBC is the total cost of

export production. The hatched area ABD is profit. All are in rupees.

Now suppose the dollar depreciates in real terms against the rupee. For concreteness, assume that US inflation is 5% p.a., Indian inflation is 15% p.a. and the Rs./$ exchange rate increases only by 8%. These figures imply a 2% p.a. real appreciation of the rupee.

From the point of view of our exporter firm the following questions are relevant:

How much will the dollar price of jackets in US go up? Will it go up in proportion to the increase in the US price level viz. 5% or will there be a relative price change?

What will be the effect of the nominal rupee depreciation and inflation at home on its costs?

The answer to the first question depends among other things on the current demand-supply conditions in the market for leather jackets. For instance, if there is excess capacity in the industry, jacket prices may not keep pace with the general inflation. On the other hand, if domestic producers costs increase by 5%, the new equilibrium price in a competitive industry will be 5% higher. The answer to the second question depends partly on import content of jacket production, cost of living adjustments in wages (which may depend partly on the exchange rate if the workers consumption basket contains some imported goods), and prices of other inputs.

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Figure 2

In figure 2 we have assumed that the dollar price in the US market increases in proportion

to US inflation while the Indian firm’s costs increase in proportion to Indian inflation. The new dollar price, P, equals (1.05)PO$, the new Rs./$ exchange rate, S1, equals 1.08S0 and thus the new price translated into rupees, P1R, equals 1.13Por. The marginal cost curve shifts up by 15%. As shown in figure 2, the quantity of exports reduces to X1 from X0 while the price increases. Since the rupee price has increased less than the marginal costs, exporter’s profits have shrunk from the area ABD to A, B, D. A real appreciation has hurt the exporter.

It must be kept in mind that we have made some simplifying assumptions in arriving at this conclusion. In particular, we have assumed away the relative price risk by assuming that output prices increase in proportion to foreign inflation while costs increase in proportion to domestic inflation. In practice, forecasting general inflation rates is comparatively easier; forecasting relative price shifts is a difficult task.

In the long run, it is possible that the fall in profitability might induce some Indian firms – our exporting firm’s domestic competitors – to get out of export markets. Unless Indian exports of leather jackets constitute a significant fraction of the total US market, this is unlikely to have any effect on the US price.

So far we have looked at the exporter’s profits denominated in its home currency. What about its revenue, costs and profits measured in foreign currency? Foreign currency profits also decline.

Arguing along similar lines, it is easy to see that a real depreciation will increase the profitability – measured in home as well as foreign currency – of an exporter provided again that relative price shifts are not significantly adverse.

Consider now the case of a firm which is engaged in the business of importing a product from abroad and selling it in the domestic market. It faces competition from domestic producers of import substitutes. Further, assume that as a buyer in the international market it is a price taker i.e. it can import any quantity at a given price in foreign currency. For concreteness, imaging an Indian firm which imports floppy diskettes from Japan and sells them in the domestic market. The current landed cost of the diskettes is ¥/Rs.= 4.00. Over the following year, Japanese prices increase by 3%, Indian price level goes up by 10% and the yen appreciates by 5% to ¥/Rs. = 3.80. Figure 3 shows the importer’s situation before and after the changes.

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Figure 3

The importer’s costs will increase by 8% since – Japanese prices have increased by 3% and

the rupee has depreciated by 5%. In figure 3 we have assumed that the demand curve for the imported diskettes shifts up by 10%, the inflation rate in India. The importer’s profits measured in rupees are given by the area ABEF before the changes and area A’B’E’F’ after the real appreciation of the rupee.

Analysis in terms of the foreign currency is straightforward. The demand curve in terms of yen will shift up by 5% (10% Indian inflation minus 5% rupee depreciation) while costs in terms of yen will increase by 3%. Once again importer’s profits will increase.

Conversely, a real depreciation of the home currency will reduce importer’s profits measured in either currency.

The case of a firm which imports raw materials and components for further processing at home and sells the output in the home market is more difficult. The effect on profit of a real depreciation depends upon the share of imported inputs in total costs, the elasticity of demand and the behavior of other costs. The simplest case is shown in Figure 4 where we have assumed away inflation at home and abroad and considered only the effect of a home currency depreciation on costs. As the producer’s costs increase, the price has to be increased which leads to a reduction in revenue measured in home currency as output declines proportionately more than price increase. Whether profits decline or not cannot be determined a priori.

Figure 4

4. In case the exporter wants to reduce the amount after the bills are negotiated/sent for

collection, he is first required to make an application to such bank giving full details of the shipment, an attested copy of the invoice and documentary evidence in support of the reduction sought for. However, approval will be granted provided:

a. reduction in amount does not exceed 10% of invoice value

b. the export does not relate to gold or silver or articles made out of cut and polished diamonds. It does not relate to commodities subject to floor price stipulations and the exporter is not on the caution list of RBI.

c. the proportionate export incentive availed of is surrendered.

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Exporters who are in the field of exports for more than three years may be allowed to reduce the amount without any ceiling provided their track record is satisfactory i.e. export outstandings should not exceed 5% of the average annual export realization during the preceding three calendar years.

In this context, the exporter should submit a declaration certified either by his auditors or a CA indicating the total export realization during each of the preceding three calendar years and the export bills outstanding beyond the prescribed period for realization of export proceeds and average outstandings in absolute and percentage terms.

For determining the percentage of outstanding export bills to average export realizations during the preceding three calendar years, an exporter is permitted to ignore outstanding export bills in respect of exports made to countries facing externalization problems, provided the payments have been made by the buyers in the local currency.

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Paper II

Part D: Case Study 1. The following are the significant advantages and disadvantages of Centralized Cash

Management. Advantages

• Reduction of transaction costs • Pooling – reduces overall cash requirements • Efficient management of cash in a big center • Scope for reaping benefits from currency diversification.

Disadvantages • Restriction on movement of funds • Time taken to move funds • Subsidiaries may have a need for immediate payment, e.g. local tax authorities, key local

suppliers, etc. • Increased hedging costs.

2. Swiss subsidiary With netting Without netting Outflow (30,000)(1.61)(1.49) = 71,967 Inflow (20,000)(1.60)(1.48) = 47,360 (50,000)(1.60)(1.48) = 118,400 Net inflow = SF47,360 = SF46,433

Benefit due to netting = 47360 – 46433 = SF 923 Alternatively Without netting: Inflow = $ (50,000)(1.60) = 80,000 Outflow = $ (30,000)(1.61) = 48,300 Net inflow = $ 31,700 With netting: Net inflow = $ (20,000)(1.60) = $ 32,000 Benefit = $ 300 3. Since no transaction costs are involved, here is no benefit through netting. 4. Forward Market

Covering in forward market involves entering into a contract today which does not involve any cash flow.

However, covering through money market involves borrowing or lending now and then closing all the transactions on the date of maturity. The steps involved in actual transactions are furnished hereunder. • Sell receivables forward • Convert into home currency on the delivery date • Buy payable forward • Convert home currency into foreign currency on the delivery date.

Money Market Receivables

• Borrow receivables/(1 + i) • Convert into home currency and invest • Pay off loan with receivable • Realize the maturing investment in home currency

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Payables

• Borrow home currency • Convert into foreign currency at spot and invest in foreign currency

• Use maturing investment to settle foreign currency payable • Settle home currency loan.

5. a. March 1 April 1

– Yen 130,000,000 + £ 2,000,000 + DM 1,000,000 – SF 100,000 + $ 50,000 – SF 100,000

Forward cover

March 1

Yen requirement = 130,000,000 – (1,000,000)(130.5)/ (1.81)

= Yen 57,900,552

Repayment = (57,900,552) (1 + 0.02/12) = Yen 57,997,053

April 1

£ needed to settle

Yen loan = 57,997,0531.59 131.5×

= 277,385

£ needed to settle

SF liability = 200, 0001.59 1.47×

= 85,569

= 362,954

FF obtained = (2,000,000 – 362,954)(1.59) (6.20) + (50,000)(6.20) = FF 16,448,000

b. Pure money market cover

SF 200,000 after one month = SF( )

200, 000111 0.04 /12+

= SF 199,336 today

= £ ( ) ( )

199, 3361.60 1.48

= £ 84,179 today

Yen 130,000,009 = £( )( )130,000,0001.60 130.5

= 622,605

£ 2,000,000 after one month = £ 2, 000, 0001 0.07 / 2+

today = £ 1,988,400 today

Surplus sterlings today = 1,281,616

$ 50,000 after one month = $ 50,0001 0.06 /12+

today = 849,751

FF which can be invested today

= (1,281,616)(1.60)(6.10) + (1,000,000) (6.10)/(1.81) + (49,751)(6.10) = 16,182,219

FF available after one month = (16,182,219)(1 + 0.04/12) = FF 16,236,180

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Alternative III

Borrow = £ ( )2,000,000 200,000 /1.59 1.47

1 0.07 /12− ×+

= £ 1,903,328

$ = $ 49,751

Yen 130,000,000 = £ = £ 622,605

Total FF which can be invested today = (1,903,328 – 622,605)(1.60)(6.10) + (1,000,000)(6.10/1.81) + (49,751)(6.10)

= FF 16,173,474

FF after one month = (16,173,474)(1 + 0.04/12) = FF 16,227,386

6. This could be because of the overall appreciation/depreciation of the dollar against the currencies of the subsidiaries.

Part E: Caselets Caselet 1

1. A cut in Cash Reserve Ratio implies banks have more loanable funds. With excess supply of rupees in the market for a given level of forex reserves, the value of the rupee should fall vis-á-vis the dollar for obvious reasons.

When bank rate is lowered, the interest rate on rupees decreases. As a result, foreign portfolio investors find the rupee to be less attractive. On the other hand, speculators would find it attractive to borrow rupees, so short on rupee, buy dollars and sell dollars forward to square up earlier short position. Either way, there is downward pressure on the spot rupee.

2. Depreciation can make Indian goods cheaper in dollar terms. This is a convenient argument for boosting exports in the short run. In the ultimate analysis however, Indian exports can achieve rapid growth only through quality, uniqueness, prompt delivery and better customer service. The present request of exporters can be dismissed off as a case of sour grapes. They must be advised to improve efficiencies, reduce costs and improve quality.

3. For any well functioning market, the speculator must be a price taker. This necessitates the presence of a large number of players. Without a large number of speculators, the market would lack depth. Under such conditions, the markets would become imperfect. Thus, speculators, by increasing the volume of trading and creating new trading positions make the forex markets as close to perfect as we can have them.

4. It is tempting for Governments to blame speculators for adding to exchange rate volatility. What is conveniently forgotten is that speculators are people who buy a currency when it is low and sell when its price increases. Similarly, they may sell a currency when it is high and buy it back when it falls. In either case, the speculator, in the process of making profits, helps the currency to correct its under or overvaluation. Action of speculators are based on their reading of economic fundamentals. While it is true that during volatile conditions, speculation can add to instability, this is a price which we must be willing to pay so that close to perfect trading conditions prevail in the forex markets for most of the year. Governments should spend less time trying to shut down speculators and more time in setting their macroeconomic policies right.

5. This obviously refers to cancelation of forward contracts by exporters expecting to receive dollars in the future. If exporters cancel these contracts in the hope that the rupee will further depreciate one can expect the forward premium to keep facing up. This would invariably put pressure on the spot rupee. As a result, the downslide would continue unabated. On the other hand, if the originally struck forward deals go through undisturbed, there might be a temporary respite from the downward pressure on the rupee.

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Caselet 2 1. FDIs in the form of greenfield projects are always preferred to FDIs in the form of mergers

and acquisitions. The reasons are as follows.

a. New projects and new establishments create employment opportunities, which would not be in the case of mergers and acquisitions.

b. ergers and Acquisitions may take place in the form of hostile takeovers, which are not welcomed.

c. Greenfield projects require huge capital inflows and creation of new assets take place.

d. The number of companies will go up in a particular industry, in the case of greenfield projects while this might not happen in the case of M&As.

2. During 1999-2000, Indian economy witnessed a worsening BoP account. The deficit kept on increasing steadily. The reasons can be attributed to the following:

i. Petroleum imports constitute a major portion (40%–45%) of total Indian imports. Recently there was a 2 to 3 times increase in petroleum prices. Therefore, it led to higher costs of petroleum imports.

ii. The past few years have witnessed a soft attitude of the authorities towards importers. There has been a constant deduction in customs duty and other taxes levied on importers. There has been an increased liberalization policy towards imports.

iii. As the European economy, which is the longest importer of Indian products, is undergoing a slow down, it has hit the exports of India because of falling demand.

iv. The infrastructure facilities available in India are not enough to accommodate large amount of exports. There are not enough ports. Sometimes the exporters have to wait for 2 to 3 months to get their goods shipped. This is a very discouraging factor for exporters.

The government has taken up the following measures to stop the worsening of the BoP deficit.

There has been an increase in the export promotion schemes. Incentives in the form of tax rebates are given to exporters.

There has been a widespread boosting of software exports (from India) both by the central government and the state government.

The government is trying to keep the trade balance in check by trying to slow down the import growth.

Moreover, the government has been trying to attract FDIs in which it has got little success.

3. A BoP crisis can lead to a run on the currency which makes it difficult for the country to finance its import and it will result in capital outflow. This excessive capital outflow will depreciate the currency of that country and increase the money supply which will result in inflation. Interest will raise the general price level of the economy.

The price level will increase because of costlier imports and the inability to finance essential imports.

A higher demand and a diminishing supply will lead to macroeconomic instabilities.

To balance the situation interest rates will be raised in order to cut down the excessive money supply to arrest inflation.

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Caselet 3

1. Euro was expected to outperform the US $. It was being rated as the next big thing in the worldwide forex market. But the performance of the Euro has been miserable in relation to the expectations. Main reasons for this fall of the Euro can be attributed to the following:

i. At the time of the launch of the Euro, the American economy was booming and the US $ was strengthening. So the first set back to the Euro came in this form, as the US$ was appreciating.

ii. Euro was heavily dependent on the German economy. Some authorities in Germany even went to the extent of calling Euro as a version of the DM. In 1999, the German economy slowed down and there was an overall economic slow down in Europe. This was a major factor which determined the performance of Euro.

iii. The US Federal Reserve Bank, in order to cool down the economy, increased the interest rates periodically. This led to buying spree on the US$. This increased demand for the US$ also led to the decline of Euro.

2. If the interest rates of a particular currency increased, it will lead to higher cost of borrowing but also a higher return on investment. Thus more and more people will start converting their domestic currencies into that particular currency. Thus the demand for that currency will rise, leading to an appreciation against other currencies.

When the Federal reserve increased the interest rates, then foreign investors eyed U.S. for investment as the rate of return was more. It led to an increased demand for dollars, as more and more investors wanted dollars to invest.

On the other hand, the supply of the dollars will decrease. This is because the local investors would invest in the U.S. and not in outside countries having low interest rates.

3. A weak currency does help in an economic recovery. If a currency is weak in relation to some other currency, then its exports will be cheaper, and more lucrative for the exporter.

i. This is because the exporter will get more amount of domestic currency for the same amount of foreign currency. Therefore, he will have an incentive to export more. Keeping the profit margin constant, can reduce the foreign currency price. An exporter can play competitively in the foreign market as he can reduce the foreign currency cost of his product while keeping the profits at the same level.

ii. On the other hand, the imports become costly if their currencies are depreciating. In order to make payments, they will buy the foreign currency. They have to pay more units of domestic currency in order to purchase the same amount of foreign currency. Therefore, the import costs would go up.

iii. As the import costs will rise, consumption of imported goods will go down and more and more domestic products will be consumed. This will result in a shift in demand towards domestically produced goods and better utilization of the country’s resources.

Therefore, a weak currency can increase the demand for domestically produced goods and help the economic recovery.