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Master of Business Administration - MBA Semester 4

MF0015 - International Financial Management


Assignment Set- 1

Q1. What is meant by BOP? How are capital account convertibility and current account
convertibility different? What is the current scenario in India?

Ans:- The balance of payments (or BOP) of a country is a record of international transactions
between residents of one country and the rest of the world over a specified period, usually a year.
Thus, India’s balance of payments accounts record transactions between Indian residents and the
rest of the world. International transactions include exchanges of goods, services or assets. The
term “residents” means businesses, individuals and government agencies and includes citizens
temporarily living abroad but excludes local subsidiaries of foreign corporations.

The balance of payments is a sources-and-uses-of-funds statement. Transactions such as exports


of goods and services that earn foreign exchange are recorded as credit, plus, or cash inflows
(sources). Transactions such as imports of goods and services that expend foreign exchange are
recorded as debit, minus, or cash outflows (uses).

The Balance of Payments for a country is the sum of the Current Account, the Capital
Account and the change in Official Reserves.

The current account is that balance of payments account in which all short-term flows of
payments are listed. It is the sum of net sales from trade in goods and services, net investment
income (interest and dividend), and net unilateral transfers (private transfer payments and
government transfers) from abroad. Investment income for a country is the payment made to its
residents who are holders of foreign financial assets (includes interest on bonds and loans,
dividends and other claims on profits) and payments made to its citizens who are temporary
workers abroad. Unilateral transfers are official government grants-in-aid to foreign
governments, charitable giving (e.g., famine relief) and migrant workers’ transfers to families in
their home countries. Net investment income and net transfers are small relative to imports and
exports. Therefore a current account surplus indicates positive net exports or a trade surplus
and a current account deficit indicates negative net exports or a trade deficit.

The capital (or financial) account is that balance of payments account in which all cross-border
transactions involving financial assets are listed. All purchases or sales of assets, including direct
investment (FDI) securities (portfolio investment) and bank claims and liabilities are listed in the
capital account. When Indian citizens buy foreign securities or when foreigners buy Indian
securities, they are listed here as outflows and inflows, respectively. When domestic residents
purchase more financial assets in foreign economies than what foreigners purchase of domestic
assets, there is a net capital outflow. If foreigners purchase more Indian financial assets than
domestic residents spend on foreign financial assets, then there will be a net capital inflow. A
capital account surplus indicates net capital inflows or negative net foreign investment. A
capital account deficit indicates net capital outflows or positive net foreign investment.

Current scenario in India

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The official reserves account (ORA) records the total reserves held by the official monetary
authorities (central banks) within the country. These reserves are normally composed of the
major currencies used in international trade and financial transactions. The reserves consist of
“hard” currencies (such as US dollar, British Pound, Euro, Yen), official gold reserve and IMF
Special Drawing Rights (SDR). The reserves are held by central banks to cushion against
instability in international markets. The level of reserves changes because of the central bank’s
intervention in the foreign exchange markets. Countries that try to control the price of their
currency (set the exchange rate) have large net changes in their Official Reserve Accounts. In
general, a net decrease in the Official Reserve Account indicates that a country is buying its
currency in exchange for foreign exchange reserves, to try to keep the value of the domestic
currency high with respect to foreign currencies. Countries with net increases in the Official
Reserve Account are usually attempting to keep the price of the domestic currency cheap relative
to foreign currencies, by selling their currencies and buying the foreign exchange reserves. When
a central bank sells its reserves (foreign currencies) for the domestic currency in the foreign
exchange market, it is a credit item in the balance of payment accounts as it makes available
foreign currencies. Similarly, when a central bank buys reserves (foreign currency), it is a debit
item in the balance of payment accounts.

The Balance of Payments identity states that: Current Account + Capital Account = Change
in Official Reserve Account. If a country runs a current account deficit and it does not run down
its official reserve to cover this deficit (there is no change in official reserve), then the current
account deficit must be balanced by a capital account surplus. Typically, in countries with
floating exchange rate system, the change in official reserves in a given year is small relative to
the Current Account and the Capital Account. Therefore, it can be approximated by zero. Thus,
such a country can only consume more than it produces (or imports are greater than exports; a
current account deficit) only if it has a capital account surplus (foreign residents are willing to
invest in the country). Even in a fixed exchange rate system, the size of the official reserve
account is small compared to the transactions in the current and capital account. Thus the
residents of a country cannot have a current account deficit (imports exceeding exports) unless
the foreigners are willing to invest in that country (capital account surplus).

Q2. What is arbitrage? Explain with the help of suitable example a tow-way and a three-
way arbitrage.

Ans:- Arbitrage is the activity of exploiting imbalances between two or more markets. Foreign
money exchangers operate their entire businesses on this principle. They find tourists who need
the convenience of a quick cash exchange. Tourists exchange cash for less than the market rate
and then the money exchanger converts those foreign funds into the local currency at a higher
rate. The difference between the two rates is the spread or profit.

There are plenty of other instances where one can engage in the practice arbitrage. In some cases,
one market does not know about or have access to the other market. Alternatively, arbitrageurs
can take advantage of varying liquidities between markets.

The term 'arbitrage' is usually reserved for money and other investments as opposed to
imbalances in the price of goods. The presence of arbitrageurs typically causes the prices in

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different markets to converge: the prices in the more expensive market will tend to decline and
the opposite will ensue for the cheaper market. The the efficiency of the market refers to the
speed at which the disparate prices converge.

Engaging in arbitrage can be lucrative, but it does not come without risk. Perhaps the biggest risk
is the potential for rapid fluctuations in market prices. For example, the spread between two
markets can fluctuate during the time required for the transactions themselves. In cases where
prices fluctuate rapidly, would-be arbitrageurs can actually lose money.

There are basically two types of arbitrage. One is two-way arbitrage and the other is three-
way arbitrage. The more popular of the two is the two-way forex arbitrage.

In the international market the currency is expressed in the form AAA/BBB. AAA denotes the
price of one unit of the currency which the trader wishes to trade and it refers the base currency.
While BBB is international three-letter code 0f the counter currency. For instance, when the
value of EUR/USD is 1.4015, it means 1 euro = 1.4015 dollar.

If the speculator is shrewd and has a deeper understanding of the forex market, then he can make
use of this opportunity to make big profits. Forex arbitrage transactions are quite easy once you
understand the method by which the business is conducted.

For instance, the exchange rates of EUR/USD = 0.652, EUR/GBP = 1.312 and USD/GBP =
2.012. You can buy around 326100 Euros with $500,000. Using the Euros you buy
approximately 248420 Pounds which is sold for approximately $500,043 and thereby earning a
small profit of $43.

To make a large profit on triangular arbitrage you should be ready to invest a large amount and
deal with trustworthy brokers.

Arbitrage is one of the strategies of forex trading. To make a substantial income out of this
strategy you need to make an enormous amount of investment. Though theoretically it is
considered to be risk free, in reality it is not the case. You should enter into this transaction only
if you have deeper understanding of forex market. Hence, it would be wise not to devote much
time in looking out for arbitrage opportunities. However, forex arbitrage is a rare opportunity and
if it comes your way, then grab it without any hesitation.

Three Way (Triangular) Arbitrage

The three way arbitrate inefficiency now arises when we consider a case in which the EUR/JPY
exchange rate is NOT equivalent to the EUR/USD/USD/JPY case so there must be something
going on in the market that is causing a temporary inconsistency. If this inconsistency becomes
large enough one can enter trades on the cross and the other pairs in opposite directions so that
the discrepancy is corrected. Let us consider the following example :

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EUR/JPY=107.86
EUR/USD=1.2713
USD/JPY = 84.75

The exchange rate inferred from the above would be 1.2713*84.75 which would be 107.74 and
the actual rate is 107.86. What we can do now is short the EUR/JPY and go long EUR/USD and
USD/JPY until the correlation is reestablished. Sounds easy, right ? The fact is that there are
many important problems that make the exploitation of this three way arbitrage almost
impossible.

Q3. You are given the following information:

Spot EUR/US: 0.7940/0.8007


Spot USD/GBP:1.8215/1.8240
Three months swap: 25/35
Calculate three month EUR/USD rate.

Ans:-1stMethod:

Forward Points = ((Spot * (1 + (OCR rate * n/360))) / (1 + (BCR rate * n/360))) - Spot

OCR = Other Currency Rate


BCR = Base Currency Rate
Forward points = ((0.07940 * (1 + (0.018215 * 90/360))) / (1 + (0.08007 * 90/360))) – 0.07940
SWAP = -0.00120
Forward rate = 0.07940 - 0.00120 = 0.0782

Customer sells EUR 3 Mio against USD at 0.0782 at 3 month (0.07940 - 0.00120).

Customer wants to Buy EUR 3 Mio against USD 3 months forward.

Q.4 Explain various methods of Capital budgeting of MNCs.

Ans:- Methods of Capital Budgeting

Discounted Cash Flow Analysis (DCF)

DCF technique involves the use of the time-value of money principle to project evaluation. The
two most widely used criteria of the DCF technique are the Net Present Value (NPV) and the
Internal Rate of Return (IRR). Both the techniques discount the projects’ cash flow at an
appropriate discount rate. The results are then used to evaluate the projects based on the
acceptance/rejection criteria developed by management.

NPV is the most popular method and is defined as the present value of future cash flows
discounted at an appropriate rate minus the initial net cash outlay for the projects. The discount

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rate used here is known as the cost of capital. The decision criteria is to accept projects with a
positive NPV and reject projects which have a negative NPV.

The NPV can be defined as follows:

NPV =

Where,

I0 = initial cash investment

CFt = expected after-tax cash flows in year t.

k = the weighted average cost of capital

n = the life span of the project.

The NPV of a project is the present value of all cash inflows, including those at the end of the
project’s life, minus the present value of all cash outflows.

The decision criteria is to accept a project if NPV ≥ o and to reject if


NPV < o.

IRR is calculated by solving for r in the following equation.

where r is the internal rate of return of the project.

The IRR method finds the discount rate which equates the present value of the cash flows
generated by the project with the initial investment or the rate which would equate the present
value of all cash flows to zero.

Adjusted Present Value Approach (APV)

A DCF technique that can be adapted to the unique aspect of evaluating foreign projects is the
Adjusted Present Value approach. The APV format allows different components of the project’s
cash flow to be discounted separately. This allows the required flexibility, to be accommodated
in the analysis of the foreign project. The APV approach uses different discount rates for
different segments of the total cash flows depending upon the degree of certainty attached with
each cash flow. In addition, the APV format helps the analyst to test the basic viability of the
foreign project before accounting for all the complexities. If the project is acceptable in this

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scenario, no further evaluation based on accounting for other cash flows is done. If not, then an
additional evaluation is done taking into account the other complexities.

As mentioned earlier, foreign projects face a number of complexities not encountered in


domestic capital budgeting, for example, the issue of remittance, foreign exchange regulation,
lost exports, restriction on transfer of cash flows, blocked funds, etc.

The APV model is a value additivity approach to capital budgeting, i.e., each cash flow as a
source of value is considered individually. Also, in the APV approach each cash flow is
discounted at a rate of discount consistent with the risk inherent in that cash flow. In equation
form the APV approach can be written as:

APV =

Where the term Io = Present value of investment outlay

= Present value of operating cash flows

= Present value of interest tax shields

= Present value of interest subsidies

The various symbols denote

Tt = Tax savings in year t due to the financial mix adopted

St = Before-tax value of interest subsidies (on the home currency) in year t due to project specific
financing

id = Before-tax cost of dollar debt (home currency)

The last two terms in the APV equation are discounted at the before-tax cost of dollar debt to
reflect the relative certain value of the cash flows due to tax savings and interest savings.

Q.5 a. What are depository receipts?

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Ans:- Depository Receipt (DR) is a negotiable certificate that usually represents a company’s
publicly traded equity or debt. When companies make a public offering in a market other than
their home market, they must launch a depository receipt program. Depository receipts represent
shares of company held in a depository in the issuing company’s country. They are quoted in the
host country currency and treated in the same way as host country shares for clearance,
settlement, transfer and ownership purposes. These features make it easier for international
investors to evaluate the shares than if they were traded in the issuer’s home market.

There are two types of depository receipts – GDRs and ADRs. Both ADRs and GDRs have to
meet the listing requirements of the exchange on which they are traded.

Q.5 b. Boeing commercial Airplane Co. manufactures all its planes in United States and
prices them in dollars, even the 50% of its sales destined for overseas markets. Assess
Boeing’s currency risk. How can it cope with this risk?

Ans:- Boeing faces foreign exchange risk for two reasons: (1) It sells half its planes overseas and
the demand for these planes depends on the foreign exchange value of the dollar, and (2) Boeing
faces stiff competition from

Airbus Industrie, a European consortium of companies that builds the Airbus. As the dollar
appreciates, Boeing is likely to lose both foreign and domestic sales to Airbus unless it cuts its
dollar prices. One way to hedge this operating risk is for Boeing to finance a portion of its assets
in foreign currencies in proportion to its sales in those countries. However, this tactic ignores the
fact that Boeing is competing with Airbus. Absent a more detailed analysis, another suggestion is
for Boeing to finance at least half of its assets with ECU bonds as a hedge against depreciation of
the currencies of its European competitors. ECU bonds would also provide a hedge against
appreciation of the dollar against the yen and other Asian currencies since European and Asian
currencies tend to move up and down together against the dollar (albeit imperfectly).

Q6. Distinguish between Eurobond and foreign bonds? What are the unique characteristics
of Eurobond markets?

Ans:- A Eurobond is underwritten by an international syndicate of banks and other securities


firms, and is sold exclusively in countries other than the country in whose currency the issue is
denominated. For example, a bond issued by a U.S. corporation, denominated in U.S. dollars, but
sold to investors in Europe and Japan (not to investors in the United States), would be a
Eurobond. Eurobonds are issued by multinational corporations, large domestic corporations,
sovereign governments, governmental enterprises, and international institutions. They are offered
simultaneously in a number of different national capital markets, but not in the capital market of
the country, nor to residents of the country, in whose currency the bond is denominated. Almost
all Eurobonds are in bearer form with call provisions and sinking funds.

A foreign bond is underwritten by a syndicate composed of members from a single country, sold
principally within that country, and denominated in the currency of that country. The issuer,
however, is from another country. A bond issued by a Swedish corporation, denominated in
dollars, and sold in the U.S. to U.S. investors by U.S. investment bankers, would be a foreign

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bond. Foreign bonds have nicknames: foreign bonds sold in the U.S. are "Yankee bonds"; those
sold in Japan are "Samurai bonds"; and foreign bonds sold in the United Kingdom are
"Bulldogs."

Figure 4 specifically reclassifies foreign bonds from a U.S. investor`s perspective.

FIGURE 4
FOREIGN BONDS TO U.S. INVESTORS

Foreign currency bonds are issued by foreign governments and foreign corporations,
denominated in their own currency. As with domestic bonds, such bonds are priced inversely to
movements in the interest rate of the country in whose currency the issue is denominated. For
example, the values of German bonds fall if German interest rates rise. In addition, values of
bonds denominated in foreign currencies will fall (or rise) if the dollar appreciates (or
depreciates) relative to the denominated currency. Indeed, investing in foreign currency bonds is
really a play on the dollar. If the dollar and foreign interest rates fall, investors in foreign
currency bonds could make a nice return. It should be pointed out, however, that if both the
dollar and foreign interest rates rise, the investors will be hit with a double whammy.

Characteristics of Eurobond markets

1. Currency denomination: The generic, plain vanilla Eurobond pays an annual fixed
interest and has a long-term maturity. There are a number of different currencies in which
Eurobonds are sold. The major currency denominations are the U.S. dollar, yen, and euro.
(70 to 75 percent of Eurobonds are denominated in the U.S. dollar.) The central bank of a
country can protect its currency from being used. Japan, for example, prohibited the yen
from being used for Eurobond issues of its corporations until 1984.
2. Non-registered: Eurobonds are usually issued in countries in which there is little
regulation. As a result, many Eurobonds are unregistered, issued as bearer bonds. (Bearer
form means that the bond is unregistered, there is no record to identify the owners, and
these bonds are usually kept on deposit at depository institution). While this feature
provides confidentiality, it has created some problems in countries such as the U.S.,
where regulations require that security owners be registered on the books of issuer.
3. Credit risk: Compared to domestic corporate bonds, Eurobonds have fewer protective
covenants, making them an attractive financing instrument to corporations, but riskier to

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bond investors. Eurobonds differ in term of their default risk and are rated in terms of
quality ratings.
4. Maturities: The maturities on Eurobonds vary. Many have intermediate terms (2 to 10
years), referred to as Euronotes, and long terms (10-30 years), and called Eurobonds.
There are also short-term Europaper and Euro Medium-term notes.
5. Other features:

• Like many securities issued today, Eurobonds often are sold with many
innovative features. For example:

a) Dual-currency Eurobonds pay coupon interest in one currency and principal in


another.
b) Option currency Eurobond offers investors a choice of currency. For instance, a
sterling/Canadian dollar bond gives the holder the right to receive interest and
principal in either currency.

1. A number of Eurobonds have special conversion features. One type of


convertible Eurobond is a dual-currency bond that allows the holder to
convert the bond into stock or another bond that is denominated in another
currency.
2. A number of Eurobonds have special warrants attached to them. Some of
the warrants sold with Eurobonds include those giving the holder the right
to buy stock, additional bonds, currency, or gold.

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Master of Business Administration - MBA Semester 4
MF0015 – International Financial Management
Assignment Set- 2

Q.1 What do you mean by optimum capital structure? What factors affect cost of capital
across nations?

Ans:- The objective of capital structure management is to mix the permanent sources of funds in
a manner that will maximise the company’s common stock price. This will also minimise the
firm’s composite cost of capital. This proper mix of fund sources is referred to as the optimal
capital structure. Thus, for each firm, there is a combination of debt, equity and other forms
(preferred stock) which maximises the value of the firm while simultaneously minimising the
cost of capital. The financial manager is continuously trying to achieve an optimal proportion of
debt and equity that will achieve this objective.

Cost of Capital across Countries

Just like technological or resource differences, there exist differences in the cost of capital across
countries. Such differences can be advantageous to MNCs in the following ways:

1. Increased competitive advantage results to the MNC as a result of using low cost capital
obtained from international financial markets compared to domestic firms in the foreign
country. This, in turn, results in lower costs that can then be translated into higher market
shares.
2. MNCs have the ability to adjust international operations to capitalise on cost of capital
differences among countries, something not possible for domestic firms.
3. Country differences in the use of debt or equity can be understood and capitalised on by
MNCs.

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We now examine how the costs of each individual source of finance can differ across countries.

Country differences in Cost of Debt

Before tax cost of debt (Kd) = Rf + Risk Premium

This is the prevailing risk free interest rate in the currency borrowed and the risk premium
required by creditors. Thus the cost of debt in two countries may differ due to difference in the
risk free rate or the risk premium.

(a) Differences in risk free rate: Since the risk free rate is a function of supply and demand, any
factors affecting the supply and demand will affect the risk free rate. These factors include:

• Tax laws: Incentives to save may influence the supply of savings and thus the
interest rates. The corporate tax laws may also affect interest rates through effects
on corporate demand for funds.
• Demographics: They affect the supply of savings available and the amount of
loanable funds demanded depending on the culture and values of a given country.
This may affect the interest rates in a country.
• Monetary policy: It affects interest rates through the supply of loanable funds.
Thus a loose monetary policy results in lower interest rates if a low rate of
inflation is maintained in the country.
• Economic conditions: A high expected rate of inflation results in the creditors
expecting a high rate of interest which increases the risk free rate.

(b) Differences in risk premium: The risk premium on the debt must be large enough to
compensate the creditors for the risk of default by the borrowers. The risk varies with the
following:

• Economic conditions: Stable economic conditions result in a low risk of


recession. Thus there is a lower probability of default.
• Relationships between creditors and corporations: If the relationships are close
and the creditors would support the firm in case of financial distress, the risk of
illiquidity of the firm is very low. Thus a lower risk premium.
• Government intervention: If the government is willing to intervene and rescue a
firm, the risk of bankruptcy and thus, default is very low, resulting in a low risk
premium.
• Degree of financial leverage: All other factors being the same, highly leveraged
firms would have to pay a higher risk premium.

Q.2 What is sub-prime lending? Explain the drivers of sub-prime lending? Explain briefly
the different exchange rate regime that is prevalent today.

Ans:- Subprime lending is the practice of extending credit to borrowers with certain credit
characteristics – e.g. a FICO score of less than 620 – that disqualify them from loans at the prime

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rate (hence the term ’sub-prime’). Sub-prime lending covers different types of credit, including
mortgages, auto loans, and credit cards. Since sub-prime borrowers often have poor or limited
credit histories, they are typically perceived as riskier than prime borrowers. To compensate for
this increased risk, lenders charge sub-prime borrowers a premium. For mortgages and other
fixed-term loans, this is usually a higher interest rate; for credit cards, higher over-the-limit or
late fees are also common. Despite the higher costs associated with sub-prime lending, it does
give access to credit to people who might otherwise be denied. For this reason, sub-prime
lending is a common first step toward “credit repair”; by maintaining a good payment record on
their sub-prime loans, borrowers can establish their creditworthiness and eventually refinance
their loans at lower, prime rates.
Sub-prime lending became popular in the U.S. in the mid-1990s, with outstanding debt
increasing from $33 billion in 1993 to $332 billion in 2003. As of December 2007, there was an
estimated $1.3 trillion in sub-prime mortgages outstanding.20% of all mortgages originated in
2006 were considered to be sub-prime, a rate unthinkable just ten years ago. This substantial
increase is attributable to industry enthusiasm: banks and other lenders discovered that they
could make hefty profits from origination fees, bundling mortgages into securities, and selling
these securities to investors.

These banks and lenders believed that the risks of sub-prime loans could be managed, a belief
that was fed by constantly rising home prices and the perceived stability of mortgage-backed
securities. However, while this logic may have held for a brief period, the gradual decline of
home prices in 2006 led to the possibility of real losses. As home values declined, many
borrowers realized that the value of their home was exceeded by the amount they owed on their
mortgage. These borrowers began to default on their loans, which drove home prices down
further and ruined the value of mortgage-backed securities (forcing companies to take write
downs and write-offs because the underlying assets behind the securities were now worth less).
This downward cycle created a mortgage market meltdown.

The practice of sub-prime lending has widespread ramifications for many companies, with direct
impact being on lenders, financial institutions and home-building concerns. In the U.S. Housing
Market, property values have plummeted as the market is flooded with homes but bereft of
buyers. The crisis has also had a major impact on the economy at large, as lenders are hoarding
cash or investing in stable assets like Treasury securities rather than lending money for business
growth and consumer spending; this has led to an overall credit crunch in 2007. The sub-prime
crisis has also affected the commercial real estate market, but not as significantly as the
residential market as properties used for business purposes have retained their long-term value.

The International Monetary Fund estimated that large U.S. and European banks lost more than
$1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These
losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit
$1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks
were about 60 percent through their losses, but British and euro zone banks only 40 percent.

Drivers of sub-prime lending

Home price appreciation

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Home price appreciation seemed an unstoppable trend from the mid-1990’s through to today.
This "assumption" that real estate would maintain its value in almost all circumstances provided
a comfort level to lenders that offset the risk associated with lending in the sub-prime market.
Home prices appeared to be growing at annualized rates of 5-10% from the mid-90s forward. In
the event of default, a very large percentage of losses could be recouped through foreclosure as
the actual value of the underlying asset (the home) would have since appreciated.

Lax lending standards

Outstanding mortgages and foreclosure starts in 1Q08, by loan type. The reduced rigor in lending
standards can be seen as the product of many of the preceding themes. The increased acceptance
of securitized products meant that lending institutions were less likely to actually hold on to the
risk, thus reducing their incentive to maintain lending standards. Moreover, increasing appetite
from investors not only fueled a boom in the lending industry, which had historically been
capital constrained and thus unable to meet demand, but also led to increased investor demand
for higher-yielding securities, which could only be created through the additional issuance of
sub-prime loans. All of this was further enabled by the long-term home price appreciation trends
and altered rating agency treatment, which seemed to indicate risk profiles were much lower than
they actually were.

As standards fell, lenders began to relax their requirements on key loan metrics. Loan-to-value
ratios, an indicator of the amount of collateral backing loans, increased markedly, with many
lenders even offering loans for 100% of the collateral value. More dangerously, some banks
began lending to customers with little effort made to investigate their credit history or even
income. Additionally, many of the largest sub-prime lenders in the recent boom were chartered
by state, rather than federal, governments. States often have weaker regulations regarding
lending practices and fewer resources with which to police lenders. This allowed banks relatively
free rein to issue sub-prime mortgages to questionable borrowers.

Adjustable-rate mortgages and interest rates

Adjustable-rate mortgages (ARMs) became extremely popular in the U.S. mortgage market,
particularly the sub-prime sector, toward the end of the 1990s and through the mid-2000s.
Instead of having a fixed interest rate, ARMs feature a variable rate that is linked to current
prevailing interest rates. In the recent sub-prime boom, lenders began heavily promoting ARMs
as alternatives to traditional fixed-rate mortgages. Additionally, many lenders offered low
introductory, or “teaser”, rates aimed at attracting new borrowers. These teaser rates attracted
droves of sub-prime borrowers, who took out mortgages in record numbers.

While ARMs can be beneficial for borrowers if prevailing interest rates fall after the loan
origination, rising interest rates can substantially increase both loan rates and monthly payments.
In the sub-prime bust, this is precisely what happened. The target federal funds rate (FFR)
bottomed out at 1.0% in 2003, but it began hiking steadily upward in 2004. As of
mid-2007, the FFR stood at 5.25%, where it had remained for over one year. This 4.25%
increase in interest rates over a three-year period left borrowers with steadily rising payments,
which many found to be unaffordable. The expiration of teaser rates didn’t help either; as these

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artificially low rates are replaced by rates linked to prevailing interest rates, sub-prime borrowers
are seeing their monthly payments jump by as much as 50%, further driving the increasing
number of delinquencies and defaults. Between September of 2007 and January 2009, however,
the U.S. Federal Reserve slashed rates from 5.25% to 0-.25% in hopes of curbing losses. Though
many sub-prime mortgages continue to reset from fixed to floating, rates have fallen so much
that in many circumstances the fully indexed reset rate is below the pre-existing fixed rate; thus,
a boon for some sub-prime borrowers.

The exchange rate is an important price in the economy and some governments like to control
it, manage it or influence it. Others prefer to leave the exchange rate to be determined only by
market forces. This decision is the choice of exchange rate regime. Many alternative regimes
exist:

Floating Exchange Rate (Flexible) Regimes: A flexible exchange rate system is one where the
value of the currency is not officially fixed but varies according to the supply and demand for the
currency in the foreign exchange market. In this system, currencies are allowed to:

• Appreciate – when the currency becomes more valuable relative to others.


• Depreciate– when the currency becomes less valuable relative to others.

Fixed Exchange Rate Regimes: A Fixed exchange rate system is one where the value of the
currency is set by official government policy. The exchange rate is determined by government
actions designed to keep rates the same over time. The currencies are altered by the government:

• Revaluation – Government action to increase the value of domestic currency relative to


others.
• Devaluation – Government action to decrease the value of domestic currency.

After the transition period of 1971-73, the major currencies started to float. Flexible exchange
rates were declared acceptable to the IMF members. Gold was abandoned as an international
reserve asset. Since 1973, most major exchange rates have been “floating” against each other.
However, there are countries which have fixed exchange rate regimes.

Q.3 What is covered interest rate arbitrage?


Assume spot rate of £ = $ 1.60
180 day forward rate £ = $ 1.56
180 day interest rate in U.K. = 4%
180 day U.S interest rate = 3%
Is covered interest arbitrage by U.S investor feasible?

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Q.4 Explain double taxation avoidance agreement in detail .

Ans:- Double Taxation Avoidance Agreements

Double taxation relief

Double taxation means taxation of same income of a person in more than one country. This
results due to countries following different rules for income taxation. There are two main rules of
income taxation (a) source of income rule and (b) residence rule.

As per source of income rule, the income may be subject to tax in the country where the source
of such income exists (i.e. where the business establishment is situated or where the
asset/property is located) whether the income earner is a resident in that country or not.

On the other hand, the income earner may be taxed on the basis of his residential status in that
country. For example if a person is resident of a country, he may have to pay tax on any income
earned outside that country as well.

Further some countries may follow a mixture of the above two rules.

Thus problem of double taxation arises if a person is taxed in respect of any income on the basis
of source of income rule in one country and on the basis of residence in another country or on the
basis of mixture of above two rules.

Relief against such hardship can be provided mainly in two ways

• Bilateral relief
• Unilateral relief.

Bilateral Relief

The governments of two countries can enter into agreement to provide relief against double
taxation, worked out on the basis of mutual agreement between the two concerned sovereign
states. This may be called a scheme of ‘bilateral relief’ as both concerned powers agree as to the
basis of the relief to be granted by either of them.

Unilateral Relief

The above procedure for granting relief will not be sufficient to meet all cases. No country will
be in a position to arrive at such agreement as envisaged above with all the countries of the world
for all time. The hardship of the taxpayer, however, is a crippling one in all such cases. Some
relief can be provided even in such cases by home country irrespective of whether the other
country concerned has any agreement with India or has otherwise provided for any relief at all in
respect of such double taxation. This relief is known as unilateral relief.

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Types of Agreements

Agreements can be divided into two main categories:

1. Limited agreements
2. Comprehensive agreements

Limited agreements are generally entered into to avoid double taxation relating to income
derived from operation of aircraft, ships, carriage of cargo and freight.

Comprehensive agreements, on the other hand, are very elaborate documents which lay down
in detail how incomes under various heads may be dealt with.

Countries with which no agreement exists [section 91] [unilateral relief]

If any person who is resident in India in any previous year proves that, in respect of his income
which accrued or arose during that previous year outside India (and which is not deemed to
accrue or arise in India), he has paid in any country with which there is no agreement under
section 90 for the relief or avoidance of double taxation, income-tax, by deduction or otherwise,
under the law in force in that country, he shall be entitled to the deduction from the Indian
income-tax payable by him of a sum calculated on such doubly taxed income ‘at the Indian rate
of tax or the rate of tax of the said country, whichever is the lower, or at the Indian rate of tax if
both the rates are equal’.

In other words, unilateral relief will be available, if the following conditions are satisfied:

1. The assessee in question must have been resident in the taxable territories.
2. That some income must have accrued or arisen to him outside the taxable territory during
the previous year and it should also be received outside India.
3. In respect of that income, the assessee must have paid by deduction or otherwise tax
under the law in force in the foreign country in question in which the income outside
India has arisen.
4. There should be no reciprocal arrangement for relief or avoidance from double taxation
with the country where income has accrued or arisen.

India has agreements for avoidance of double taxation with over 60 countries.

If all the above conditions are satisfied, such person shall be entitled to deduction from the
Indian income-tax payable by him of a sum calculated on such doubly taxed income

• At the average Indian rate of tax or the average rate of tax of the said country, whichever
is the lower, or
• At the Indian rate of tax if both the rates are equal.

Average rate of tax means the tax payable on total income divided by the total income.

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Steps for calculating relief under this section:

Step I: Calculate tax on total income inclusive of the foreign income on which relief is available.
Claim relief if available under sections 88, 88B and 88C.

Step II: Calculate average rate of tax by dividing the tax computed under Step I with the total
income (inclusive of such foreign income).

Step III: Calculate average rate of tax of the foreign country by dividing income-tax actually
paid in the said country after deduction of all relief due but before deduction of any relief due in
the said country in respect of double taxation by the whole amount of the income as assessed in
the said country.

Step IV: Claim the relief from the tax payable in India at the rate calculated at Step II or Step III
whichever is less

Q.5 Explain American depository receipt sponsored programme and unsponsored


programme.

Ans:- When a company establishes an American Depositary Receipt program, it must decide
what exactly it wants out of the program, and how much time, effort and resources they are
willing to commit. For this reason, there are different types of programs that a company can
choose.

ADRs may be sponsored or unsponsored; however, unsponsored ADRs are increasingly rare
and cannot be listed on the major American stock exchanges because they are not registered with
the SEC, and lack other necessary qualifications. An unsponsored ADR is created by a U.S.
investment bank or brokerage that buys the shares in the country where the shares trade, deposits
them in a local bank—the custodian bank, which is often a branch of a U.S. bank, called the
depositary bank (aka depository bank). The depositary bank then issues shares that represent
an interest in the stocks and handles most of the transactions with the American investors,
serving both as transfer agent and registrar for the ADR. The shares of the foreign stock that are
held in the custodian bank are called American Depositary Shares (ADS), although this term is
sometimes used as a synonym for ADRs.

Most often, the company will sponsor the creation of its own ADR, in which case it is a
sponsored ADR. There are 3 levels of sponsorship.

A Level 1 sponsored ADR is created by the company to extend the market for its securities to
this country, but without needing to register with the SEC, or conforming to generally accepted
accounting principles (GAAP). Consequently, this ADR can only be traded in the OTC
Bulletin Board or Pink Sheets trading systems, usually by institutional investors. These ADRs
have more risk, and it is more difficult to compare a Level I ADR with other investments,
because of the differences in accounting.

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Level 2 and Level 3 sponsored ADRs must register with the SEC, and financial statements
must be reconciled to generally accepted accounting principles. A Level 2 ADR requires partial
compliance with GAAP, while a Level 3 ADR requires complete compliance. A Level 3
sponsorship is required, if the ADR is a primary offering and is used to raise capital for the
company. Only Level 2 and Level 3 sponsored ADRs can be listed on the New York Stock
Exchange, the American Stock Exchange, or NASDAQ.

Q.6 Explain (a) Parallel Loans (b) Back – to- Back loans

Ans;- Parallel loan

The forerunner of a swap; a method of raising capital in a foreign country to finance assets there
without a cross-border movement of capital. For example, a $US loan would be made to an
Australian company to finance its factory in the US; at the same time the US party which made
the loan would borrow $A in Australia from the Australian company's parent to finance a project
in Australia. Parallel loans enjoyed considerable popularity in the 1970s in the UK when they
were frequently used to circumvent strict exchange controls.

Back-to-back loan

A Back-to-back loan is a loan agreement between entities in two countries in which the
currencies remain separate but the maturity dates remain fixed. The gross interest rates of the
loan are separate as well and are set on the basis of the commercial rates in place when the
agreement is signed.

Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a way
of avoiding currency regulations, the practice had, by the mid-1990s, largely been replaced by
currency swaps.

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