Q1.

Globalization is a process of international integration that arises due to increasing human

connectivity as well as the interchange of products, ideas and other aspects of culture. Give brief
introduction of globalization and identify its advantages and disadvantages.
Answer : Globalization :
Globalization can be defined as the process of international integration that arises due to
increasing human connectivity as well as the interchange of products, ideas and other
aspects of culture. It includes the spread and connectedness of communication,
technologies and production across the world and involves the interlacing of cultural and
economic activity. The term 'globalization' was used by the late professor Theodore Levitt of
Harvard Business School in an article titled 'Globalization of Markets' which appeared in
Harvard Business Review in 1983. The world turning into a global market has its own
advantages and disadvantages for various countries.
Advantages of Globalization
1. Economic growth: An open economy can have a higher GDP growth than a closed one
because of increased access to various markets and exposure to better technology. An
economy can be called a closed economy if it has no economic transactions with any other
economy. An open economy is one that has economic interactions with other economies.
2. Lower costs: Open economies can import inputs, raw materials, and technology at
cheaper rates and, thus benefit in terms lower cost structure.
3. Improved availability of goods and services: Open economies have access to many
countries. They can use the best among all that are available. India which is a labour-
intensive country has been able to use cheap Chinese goods due to open trade.
4. Global prosperity and flow of productive resources: Open economies can exchange
raw materials and other goods with other. This will benefit both the producers and the
customers.
5. Incentives for research and adoption of innovations: The countries that have human
resources can develop new products and technology and use the market of less-developed
countries to increase trade.
6. Raise cheaper loans: Open economies not only gain on the customer end, but also have
access to financial markets of the countries in which they do business with. They can raise
cheaper loans than their home country.
Disadvantages of Globalization
1. Open economies are interdependent that makes them prone to unavoidable risks like
trade cycles. The most recent example is that of the American recession that had affected
the whole world.
2. Import dependence can expose a country to undue political, economic and cultural risks.
3. Large-scale increase in international capital flows has increased the problem of heavy
indebtedness of some countries and their inability to repay their debts.
4. Problems of foreign exchange due to different currencies of different countries.

Q2. Foreign exchange markets, where money in one currency is exchanged for another. Write the
history of foreign exchange. Explain the fixed and floating rates and the advantages and
disadvantages of fixed rates system.
Answer : History of foreign exchange :
The 17th century saw the start of the depositing of coins and bullion with money changers,
goldsmiths, etc. The first people to start the system of money by book entry were the
goldsmiths in England. This development further led to the expansion of banking services
and the people started gaining the confidence that they can receive certain commodities
against the bank note they possessed. Thus, the history of foreign exchange can be traced
back to the time when the moneychangers in the Middle East would exchange money from
all over the world. In 1880, the practice of using gold as the standard of value started whose
main aim was to guarantee any currency against a set amount of gold.
Under the gold standard exchange rates, currency was backed by gold and was measured
in ounces. For this, the countries needed huge reserves of gold in order to back the demand
for currency. The foreign exchange rate was determined by the difference of the price of gold
between these two countries. The foreign exchange history changed due to the birth of an
international standard through which foreign exchange can take place conveniently between
different countries. During the First World War, financial issues arose in Europe which gave
way to a lack of gold and this led to a historical change in foreign exchange.
There emerged a void due to the abolishment of the Gold standard and to discuss this
concern, a convention was held in July 1944 at Bretton Woods, New Hampshire. The new
Bretton Woods monetary system led to a changed forex market which put forward the
following solutions:
A new method was to be established in order to obtain a fixed foreign exchange rate
The US Dollar is to replace the gold standard as the new final exchange currency
The US dollar will be the only currency which will be backed by gold
Three international authorities will be founded who would guard over all the foreign
transactions.
Fixed and Floating Rates
The currency system in which the regulator tries to keep exchange rate constant between
domestic currency and foreign currencies is known as the fixed exchange rate system. In
this system, the government of a country determines the value of its currency against a fixed
amount of another currency. The gold standard is the oldest fixed exchange rate regime.
The gold standard functioned till the beginning of the World War I and even few years after
that. According to the gold standard, the currency in circulation is convertible into gold at a
fixed rate. Therefore, the exchange rate between any two currencies is determined by the
value of the currencies in terms of gold. After the fall of the gold standard, the world
monetary system was in chaos and the volume of international trade fell considerably. Thus,
in place of the gold standard, the gold exchange standard, popularly known as the Bretton
Woods System, was put up after the World War II by the victorious allies of the war.
Advantages of fixed rates system
1. The system provides exchange rates stability by eliminating uncertainty.
2. Volatility of exchange rate is controlled as it insulates the economy from external
disturbances.
3. Foreign investors are encouraged to invest in countries without the fear of exchange rate
fluctuations.
4. Poorer nations could get foreign exchange for development purposes at low costs.
Disadvantages of fixed rates system
1. The system required regular rigorous control and monitoring by the monetary authorities.
2. The system is not self equilibrating therefore over-valuation and undervaluation existed.
3. Since the realignment was to be done only when all other avenues to correct the balance
of payment were exhausted, therefore the burden accumulated and the economies which
resorted to devaluation faced a lot of economic problems.
4. The system required regular rigorous control and monitoring by the monetary authorities.
Q3. Swap is an agreement between two or more parties to exchange sets of cash flows over a
period in future. What do you understand by swap? Explain its features, kinds of swap and various
types of interest rates swap.
Answer : Meaning of swap :
Swap is an agreement between two or more parties to exchange sets of cash flows over a
period in future. The parties that agree to swap are known as counter parties. It is a
combination of a purchase with a simultaneous sale for equal amount but different dates.
Swaps are used by corporate houses and banks as an innovating financing instrument that
decreases borrowing costs and increases control over other financial instruments. It is an
agreement to exchange payments of two different kinds in the future. Financial swap is a
funding technique that permits a borrower to access one market and then exchange the
liability for another type of liability. The first swap contract was negotiated in 1981 between
Deutsche Bank and an undisclosed counter party.
The International Swap Dealers association (ISDA) was formed in 1984 to speed up the
growth in the swap market by standardizing swap documentation. In 1985, ISDA published
the standardized swap code.
Features of swap
Swaps are contracts of exchanging the cash flows and are tailored to the needs of counter
parties. Swaps can meet the specific needs of customers.
Counter parties can select amount, currencies, maturity dates etc.
Exchange trading involves loss of some privacy but in the swap market privacy exists and
only the counter parties know the transactions.
There is no regulation in swap market.
There are some limitations like
(a) Each party must find a counter party which wishes to take opposite position.
(b) Determination requires to be accepted by both parties.
(c) Since swaps are bilateral agreements the problem of potential default exists.
There are two kinds of swap, they are as follows:
1. Currency swap: It is an agreement whereby currencies are exchanged at specified
exchange rates and at specific intervals. The reason is to lock in the exchange rate. Large
commercial banks that serve as an intermediary agree to swap currencies with a firm. Two
currencies are exchanged in the beginning and again at the maturity, they are re exchanged
because one counter party is able to borrow a particular currency at a lower interest rate
than the other counter-party.
2. Interest rate swap: It is an arrangement whereby one party exchange one set of interest
rate payments for another. Most common arrangement is an exchange of Fixed Interest rate
payment for another rate of over a period of time.
Features
The following are the features:
The principal value upon which the interest rate is to be applied should be known
Fixed interest rate to be exchanged for another rate.
Formula type of index is used to determine the flowing rate.
Frequency of payment is agreed upon.
Life time of swap.
Various types of interest rate swap
Following are the most important types of interest rate swap:
Plain vanilla swap: This swap involves the periodic exchange of fixed rate payments for
floating rate payments. It is sometimes referred as fixed for floating swaps.
Forward swap: This involves an exchange of interest rate payments that does not begin
until a specified future point in time. It is a swap involving fixed for floating interest rates.
Callable swap: Another use of swap is through swap options (swaptions). A callable swap
provides a party making the fixed payments it the right to terminate the swap prior to its
maturity. It allows a fixed rate payer to avoid exchanging future interest rate payments if its
so desired.
Putable swap: It provides the party making the floating rate payments with a right to
terminate swap.
Extendable swap: It contains an extendable feature that allows fixed for floating party to
extend the swap period.
Zero coupon for floating swap: In this swap, the fixed rate pair makes a bullet payment
at the end and floating rate pair makes the periodic payment throughout the swap period.
Rate capped swaps: This involves the change of fixed rate payments for floating rate
payments whereby the floating rate payments are capped. An upfront fee is paid by the
floating rate party to fixed rate party for the cap.
Equity swaps: An equity swap is a financial derivative contract where a set of future cash
flows are agreed to be exchanged between two counterparties at set dates in the future.

Q4. International credit markets are the forum where companies and governments can obtain
credit. Bring out your understanding on international credit markets and explain the two very
important aspects of international credit market. Refer and give one example.
Answer : International credit market :
International credit markets are the forum where companies and governments can obtain
credit (loans in various forms) from the creditors/investors. These markets are an important
part of international capital markets. International capital market is that financial market or
world financial centre where shares, bonds, debentures, currencies, mutual funds and other
long term securities are purchased and sold. These markets provide the opportunity for
international companies and investors to deal in shares and bonds of different companies
from various countries. Two very important aspects of international credit market are the
syndicated loans and impact of credit crisis on the credit market, which are explained below.
Syndicated Loans
Syndicated loans are credits granted by a group of banks, called a syndicate to a borrower
who may be a company or the government. Interest rates can be fixed for the term of the
loan or floating based on a benchmark rate such as the London Interbank Offered Rate
(LIBOR).These are hybrid instruments combining features of relationship lending and
publicly traded debt. These allow sharing of credit risk between various financial institutions
without the disclosure and marketing burden that bond issuers face.
Syndicated credits are a very significant source of international financing, these accounting
for more than a third of all international financing, including bonds, commercial papers and
equity issues.
Two or more banks agree jointly to make a loan to a borrower. There is a single loan
agreement. Every member of the syndicate has a claim on the debtor. The creditors can be
many syndicate members led by one or several lenders, acting as lead managers or agents.
Leading banks are selected by the borrower to form a syndicate who is willing to lend money
at specified terms. Syndicate leaders are generally borrowers relationship banks, who
provide major portion of loan and join in with other participants for relatively smaller portions
of loan. The number and size of the syndicate member banks depends on the size of the
loan, the terms involved and concurrence of the borrower.
External Commercial Borrowings (ECB)
ECBs refer to loans from commercial banks, suppliers credit, buyers credit, fixed rate
bonds, floating rate notes, credit from authorized export credit agencies, and loans from
institutions such as IFC (International Finance Corporation), ADB (Asian Development Bank)
and CDC (Commonwealth Development Corporation). Guidelines for ECBs were first
liberalized in India in 1997. Ever since then, corporate firms have been allowed to raise
capital for expanding existing capacity, making new investments and finance working capital.
All infrastructure and Greenfield projects are allowed to make use of ECB up to 35 per cent
of total project expenses. The average maturity time of ECBs ranges from three to five to
seven years. ECBs are mostly used for:
(a) Project related cost of infrastructure projects
(b) License fee payments in the telecom sector
(c) Foreign exchange cost of capital goods and services
Those corporate firms which manage to acquire ECBs with maturity time of 10 to 20 years
are able to use the capital for general corporate purposes. However, the funds acquired
through ECBs cannot be invested in stock markets or for dabbling in real estate. How much
an ECB can be mobilized depends on the relative value of current rates of interest in India
and other countries. The cost of an ECB should ideally include the margin of
depreciation/appreciation in the value of the rupee abroad. Also, if interest rates in India are
low, the demand for the ECB would also be low. Commonly, it has been seen that when the
value of the rupee falls, the value of the ECB increases. The interest rate restrictions on ECB
acquired for project financing permit an interest spread of up to 350 basis points over the
LIBOR/US treasury rate. A corporate can only opt for an ECB only after they have obtained
government approval. The government has specifies limits on the overall ECB that can be
financed in a particular year. As happens with other types of foreign capital, the ECB actually
received may be less than the amount approved.
In a nutshell we can say that, arranging a syndicated loan meets borrowers demand for loan
requirements without the lender having to bear the market and credit risk. The prime goal of
syndicate lending is to spread out the risk of default amongst a number of lending banks or
institutional investors.
Q5. Cost of capital is the minimum rate of return required by a firm on its investment in order to
provide the rate of return by its suppliers of capital. Describe the cost of capital across countries.
Answer : Effect of country difference in the cost of debt :
The cost of debt in a country is based primarily on risk free rate and the risk premium
demanded by creditors. Differences in risk free rate depend upon the rate of interest which is
available on government securities at any point in time and thus depends on the general
economic conditions, financial policies, tax laws and political stability. It also depends on the
demand and supply of funds for investment. These conditions are different in each country.
Tax laws in some countries provide high incentives for savings and therefore, more funds
will be available for investment. Further, tax laws relating to tax rate on profits, depreciation
tax provisions, investment and investment tax incentives affect the demand of the firms for
funds.
Demographical differences between countries affect their supply of funds and hence, the
interest rate; countries with higher proportion of younger population have higher rate of
interest, as the tendency today is to spend more and save less compared to senior age
group. The central bank in each country like RBI in India implements the monetary policies
which influence the supply of funds and this in turn influences the interest rates. One
exception to this is that European Central Bank controls the supply of Euros and hence all
the member countries using Euros as currency have identical risk free rate.
Country differences in cost of equity
A firms cost of equity depends upon the opportunity cost based upon alternate investment
options which the investor would have used, if he had not invested in the firm. Return on
equity consists of two parts, a risk free interest rate that they would have achieved by
depositing their funds in government securities and the premium to cover the risk of the firm.
Since risk free interest rate is different between the countries, accordingly the cost of equity.
The cost of equity is also dependent on the investment options in the country. If there are
many investment opportunities in a country, the cost of equity will be high and vice versa.
Examining debt and equity cost together
The cost of debt and equity can be combined in proportion to their market value to obtain
overall cost of capital also called Weighted Average Cost of Capital (WACC). Due to
differences in the cost of debt and equity in different countries, the cost of capital will be
different. Some countries like Japan have relatively low cost of capital. They have low risk
free rate which also has reducing effect on the cost of equity. The price earnings multiples
are high and funding can be obtained at a lower cost. MNCs can obtain such low cost
funding. However, if these funds are used to finance operations in another country, the cost
of this capital is exposed to exchange rate risk. The firms using such capital must be careful
that the ultimate cost of using such low cost capital may turn out to be more expensive due
to the exchange rate involved.
Estimating the cost of capital
MNCs can estimate the cost of debt and equity when they want to finance new projects in
order to decide about the capital structure to use for the project. Post-tax cost of debt can be
estimated relatively easily by looking at the data of other firms with similar risk level as the
project. The cost of equity is an opportunity cost which the investors could earn while
deploying their funds in other investments with similar risk. The MNCs can try to determine
the expected return on other stocks with similar risk level and this can be used as cost of
equity.
The cost of capital for the project which is also called discount rate or required rate of return
is the weighted average cost of the estimated debt and equity cost.

Q6. Explain the principles of taxation and double taxation. Give some important points on tax
havens and its types.
Answer : Principles of taxation :
Two common principles of international taxation are the residence principle and the source
principle. The residence principle calculates the tax liabilities by considering the place where
the tax payer resides and the source principle law considers the source of income of the tax
payer as the basis of assessing tax liabilities.
Residence principle: Residents of a country are taxed uniformly on their world-wide
income, regardless of the source of that income whether it is domestic or of foreign origin.
Non-residents who earn in home country are not taxed by the home country on their income
originating in that country.
Source principle: Income originating in the home country is uniformly taxed, regardless of
the residency of the receiver of the income. Residents of the home country are not taxed by
the home country on the foreign source of income.
Countries may adopt any of the two principles in their pure form. They may also use a
mixture of these two principles. A mixture of these two principles, either within the same
country or among different countries, may involve double taxation on the same income.
Double taxation is removed by a system of domestic tax credits for foreign taxes. If all
countries stick to the same pure principle, i.e., either residence or source principle, there will
be no double taxation.
If both home country and foreign country adopt the residence principle, then all the four
categories of income will be taxed only once. The categories are follows:
Income of home country residents originating in home country is taxed only by home
country.
Income of residents of home country originating abroad is taxed only by the home country.
Income of residents of a foreign country originating in the home country is taxed only by the
foreign country.
Income of the residents of a foreign country originating in the foreign country is taxed only
by the foreign country.

Double Taxation
Double taxation is one of the risks associated with doing business outside the home country.
Business transactions may be subject to tax both in the country of their origin as well as of
their completion. An item of income can be subjected to tax in one country on the basis of
residential status and in another country on the basis of the fact that income was earned in
that country. Corporate income tax is levied when a firm earns income but if the posttax
income is remitted to foreign countries, the recipient of such income is taxed again. Double
taxation reduces the incentive of an MNC to invest. For this purpose, the entire income from
foreign sources should be exempted from tax.
Tax Havens
A tax-haven country is one that has zero rates or a very low rate of income tax and
withholding tax. MNCs are accused of (MIS) using tax havens to shield income from the
local tax collector.
R. Gordon (1981) has given the following features of tax-haven countries:
Strict rules on secrecy and confidentiality with respect of business transactions
Relative importance of banking and other financial activities
Lack of currency controls
Governmental measures promoting tax-haven status
Alworth (1988) groups the tax havens into four types:
(i) Those having no income or corporate gain tax: The countries that can be covered
under this head are Bahamas, Bermuda, The Cayman Islands, Nauru, New Hebrides and
Turks and the Caicos Islands. Governments of these countries do not impose any specific
rate of taxes but has fixed a small amount of tax. This ensures that MNCs get a long-term
guarantee against taxes.
(ii) Those having a very low rate of tax: The countries that can be covered under this head
are British Virgin Islands, Netherlands, Antilles, Montserrat, Gersey, Guernsey and Isle of
Man. Tax rates are low in these countries. Also, special tax privileges are provided to
shipping, aviation and holding companies.
(iii) Those exempting from tax all income from foreign sources: The countries that can
be covered under this head are Costa Rica, Hong Kong, Liberia and Panama. The
governments of these countries tax only locally generated income and not the income
coming from the foreign sources.
(iv) Those allowing special tax privileges in specific cases: The countries that can be
covered under this head are Luxembourg, Netherlands, Switzerland, Liechtenstein,
Gibraltar, Barbados and Grenada. In the first four countries, special tax privileges are
provided to qualified holding companies, while in the latter three countries, low rates of taxes
are applicable to special-status companies or to international business companies.