Assignment Master of Business Administration MBA Semester 4 MF 0015 International Financial Management

Name : Rakesh Kumar SMU Roll No. 581117457 Centre Code: 2805

Question 1- Define swaps contracts. Write a note on forward swaps.

Answer: Swap Contracts: A swap is a contract between two counter-parties to exchange two streams of payments for an agreed period of time. These may be fixed or floating interest rate commitment (plain vanilla swap), one currency for another currency (currency swap) and both of these (cocktail swap). Also, these may be basis swap and asset swap. Swaps are not debt instruments to raise capital, but a tool used for financial management. Forward Swaps: A swap transaction (not to be confused with the swap rate) is a double-leg deal, in which one buys spot currency X selling currency Y and simultaneously sells forward currency X buying currency Y. Let us give an example to show the rationale of such a transaction. Assume that an American investor has a future receipt in DM. In addition, assume that he thinks that German bonds are presently a good investment. So he has dollar assets but does not hold cash in DM. In plain words, he needs DM right now and cannot wait for the future receipt DM to come. One solution would be to sell dollars and buy DM in the spot market. However, suppose he does not wish to block money in a foreign exchange adventure for he cannot forecast the exchange value of the future receipt. In this case he sells dollars against DM spot getting his DM and buying his bonds. Simultaneously he buys dollars forward against DM matching the value date of the receipt. Upon expiration of the forward period, the investor cashes the receipt, pays back the DM that he owes and gets his original dollars. Hence, he has been able to overcome the time lag problem. Example: A trader may give the following quotations. Spot Rs/$ Rs/DM 43.3125/25 22.9410/40 1-month 10/15 30/20 3-month 20/15 20/25 6-month 15/20 15/19

The trader will know whether the quotes represent a premium or discount on the spot rate. This can be determined in an easy way. If the first forward quote (i.e., buying rate) is smaller than the second forward quote (i.e., the asking rate) then there is a premium. In such a case, points are added to the spot rate. However, if the first quote is greater than the second, then it is a discount and points are subtracted from the spot rate
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Question 2- Briefly explain how an MNC can calculate its cost of equity capital.
Answer: The Cost of Equity Capital: The cost of equity capital is the required rate of return needed to motivate the investors to buy the firms stock. Calculation of the cost of equity is a difficult process and needs more approximations than calculating the cost of debt. For established firms, the dividend growth model may be used for computing the cost of equity. This model is also called the Gordon model.

Ke = D1 / P0 + g
Where, Ke is the cost of equity capital, D1 are Dividends expected in year one, P0 is the current market price of the firms stock, g is the compounded annual rate of growth in dividends or earnings. Alternatively, the cost of equity capital may be calculated by using the modern capital market theory. According to this theory, an equilibrium relationship exists between an assets req uired rate of return and its associated risk which can be calculated by the Capital Asset Pricing Model (CAPM). The cost of equity may be calculated by the CAPM by using the following formula

E(Rj) = Rf +

j(E(Rm) Rf)

Where E(Rj) is the expected rate of return on asset j. Rf is the rate of return on a risk free asset measured by the current rate of return or yield on treasury bonds. E(Rm) is the expected rate of return on a broad market index such as the standard and poor index of industrial stocks. j isbeta of Stock j, measured by the rerlative variability or volatility of the rate of return on the stock compared to the variability of the return on a board market index.

Fig. : The Capital Assets Pricing Model

Question 3- Compare the purchasing power parity theory and the international Fisher effect theory.
Answer: Purchasing Power Parity (PPP): The PPP theory focuses on the inflation-exchange rate relationships. If the law of one price were true for all goods and services, we could obtain the theory of PPP. There are two forms of the PPP theory. 1) Absolute Purchasing Power Parity: The absolute PPP theory postulates that the equilibrium exchange rate between currencies of two countries is equal to the ratio of the price levels in the two nations. Thus, prices of similar products of two different countries should be equal when measured in a common currency as per the absolute version of PPP theory. 2) Relative Purchasing Power Parity: The relative form of PPP theory is an alternative version which postulates that the change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the two nations over the same time period. This form of PPP theory accounts for market imperfections such as transportation costs, tariffs and quotas. Relative PPP theory accepts that because of market imperfections prices of similar products in different countries will not necessarily be the same when measured in a common currency. International Fisher Effect (IFE): The IFE uses interest rates rather than inflation rate differential to explain the changes in exchange rates over time. IFE is closely related to the PPP because interest rates are significantly correlated with inflation rates. The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the International Fisher Effect. The IFE suggests that given two countries, the currency in the country with the higher interest rate will depreciate by the amount of the interest rate differential. That is, within a country, the nominal interest rate tends to approximately equal the real interest rate plus the expected inflation rate. Both, theoretical considerations and empirical research, had convinced Irving Fisher that changes in price level expectations cause a compensatory adjustment in the nominal interest rate and that the rapidity of the adjustment depends on the completeness of the information possessed by the participants in financial markets. Comparison of Purchasing Power Parity Theory and International Fisher Effect Theory: Both theories relate to the determination of exchange rates. Yet, they differ in their implications. The, PPP theory and IFE theory focus on how a currencys spot rate will change over time. While PPP theory suggests that the spot rate will change in accordance with inflation differentials, IFE theory suggests that it will change in accordance with interest rate differential. The PPP theory focuses on the inflation-exchange rate relationships. The IFE uses interest rates rather than inflation rate differential to explain the changes in exchange rates over time.

Question 4- What is the influence of Government Interventions on the exchange rate ?

Answer: Each country has a central bank that may intervene in the foreign exchange market to control its currencys value. Central banks manage exchange rates: to smooth exchange rate movements, to establish implicit exchange rate boundaries, and to respond to temporary disturbances. Intervention could be classified into different categories according to its characteristics: A. Direct and indirect intervention: 1. Direct intervention - is generally defined as foreign exchange transactions that are conducted by the monetary authority and aimed at influencing exchange rate. 2. Indirect intervention - Indirect currency intervention is a policy that influences the exchange rate indirectly. Some examples are capital controls (taxes or restrictions on international transactions in assets), and exchange controls. Those policies may lead to inefficiencies or reduce market confidence, but can be used as an emergency damage control. B. Sterilized Intervention and Non-Sterilized Intervention: 1. Sterilized intervention - Sterilized intervention is a policy that attempts to influence the exchange rate without changing the monetary base. The procedure is a combination of two transactions. First, the central bank conducts a non-sterilized intervention by buying (selling) foreign currency bonds using domestic currency that it issues. Then the central bank sterilizes the effects on the monetary base by selling (buying) a corresponding quantity of domestic-currency-denominated bonds to soak up the initial increase (decrease) of the domestic currency. 2. Non-sterilized intervention - is a policy that alters the monetary base. Specifically, authorities affect the exchange rate through purchasing or selling foreign money or bonds with domestic currency. C. Spot and Forward Markets Intervention: 1. Spot market transaction - is an agreement to buy or sell currency at the current exchange rate. The delivery time is usually two days or less. 2. Forward market transaction - is an agreement to buy or sell currencies for settlement at least three days later, at predetermined exchange rates. The forward market transaction has the advantage of not requiring immediate cash outlay and is often used to reduce the exchange rate risk. If a central bank expects that the need for intervention will be short-lived and reversed in the future, then a forward market intervention may be conducted discreetly with no observable effect on foreign exchange reserves.

Question 5- What is the major components of BOP ?

Answer: Balance of Payment (BOP) Meaning The Balance of Payments (BOP) is a record of all transactions made between one particular country and all other countries during a specified period of time usually a year. Economic transactions include exports and imports of goods and services, capital inflows and outflows, gifts and other transfer payments and changes in a countrys international reserves. Components of Balance of Payments The balance of payment statement records all types of international transactions that a country consummates over a certain period of time. It is divided into three sections: 1. The Current Account: The current account is typically divided into three sub-categories; the merchandise trade balance, the services balance and the balance on unilateral transfers. Entries in this account are current in value as they do not give rise to future claims. A surplus in the current account represents an inflow of funds while a deficit represents an outflow of funds. 2. The Capital Account: The capital account is an accounting measure of the total domestic currency value of financial transactions between domestic residents and the rest of the world over a period of time. This account consists of loans, investments, other transfers of financial assets and the creation of liabilities. It includes financial transactions associated with international trade as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits. The capital account can be divided into three categories: direct investment, portfolio investment and other capital flows. 3. The Official Reserve Account: Official reserves are government owned assets. The official reserve account represents only purchases and sales by the central bank of the country (e.g., the Reserve Bank of India). The changes in official reserves are necessary to account for the deficit or surplus in the balance of payments. For example, if a country has a BOP deficit, the central bank will have to either run down its official reserve assets such as gold, foreign exchange and SDRs or borrow fresh from foreign central banks. However, if a country has a BOP surplus, its central bank will either acquire additional reserve assets from foreigners or retire some of its foreign debts.

Question 6- What are the benefit of ADRs ? a) To the investors b) To the issuing company
Answer: American Depository Receipt (ADR) An ADR is a dollar denominated negotiable certificate that represents a non-US companys publicly traded equity. It falls within the regulatory framework of the USA and requires registration of the
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ADRs and the underlying shares with the Securities Exchange Commission (SEC). (In 1990, changes in Rule 144A allowed companies to raise capital without having to register with SEC.) Benefit of ADRs to the Investors are: 1. Depository receipts are US securities: Depository receipts are registered with the US Securities and Exchange Commission and trade like any other US security in the over-the-counter market or on a national exchange. Depository receipt investors enjoy rights which are comparable to those of holders of the underlying securities, plus they have the benefits, convenience and efficiency of trading in the US securities markets. 2. Depository receipts are easy to buy and sell: Investors purchase and sell depository receipts through their US brokers in exactly the same way as they purchase or sell securities of US companies. Many regional NASD brokers/dealers, and virtually all New York brokers/dealers, make markets in and know how to create depository receipts. 3. Depository receipts are liquid: Depository receipts are as liquid as their underlying securities because they are interchangeable. 4. Depository receipts are global: Investors can choose from more than 1500 different equity depository receipts and several debt depository receipts from 50 countries, including Australia, Brazil, United Kingdom, France, Germany, Hong Kong, Italy, Japan, Mexico, Singapore, Spain, Sweden and Thailand. Benefit of ADRs to the issuing company are: 1. An ADR programme can stimulate investor interest, enhance a companys visibility, broaden its shareholder base, and increase liquidity. 2. By enabling a company to tap US equity markets, the ADR offers a new avenue for raising capital, often at highly competitive costs. For companies with a desire to build a stronger presence in the United States, an ADR programme can help finance US initiatives or facilitate US acquisitions. 3. ADRs can provide enhanced communications with shareholders in the United States. 4. ADRs provide an easy way for US employees of non-US companies to invest in their companies employee stock purchase plans. 5. Features such as dividend reinvestment programmes can help ensure a continual stream of investment into an issuers programme. 6. ADR ratios can be adjusted to help ensure that an issuers ADRs trade is in a comparable range with those of its peers in the US market. 7. May increase local prices as a result of global demand/trading through a more broadened and a more diversified investor exposure.