CHAPTER 1

INTERNATIONAL FINANCE

MEANING:

International Finance is the economic and monetary system that crosses national borders. It is
concerned with studying global capital market. It involves movements in foreign exchange rates,
global investment flows and cross border trade practices.

It is a branch of economics that studies the dynamics of exchange rates, foreign investment and
how these effects international trade.

International finance (also referred to as international monetary economics or international

macroeconomics) is the branch of financial economics broadly concerned with
monetary and macroeconomic interrelations between two or more countries. International
finance examines the dynamics of the global financial system, international monetary
systems, balance of payments, exchange rates, foreign direct investment, and how these topics
relate to international trade.

2.ISSUES INVOLVED IN INTERNATIONAL FINANCE:

a.Global financial System

b.Interntional Monetary System

c.Balance Of Payments: Current Account and Capital Account

d.Exchange Rate

e.FDI & FII

3.METHODS OF FINANCE/PAYMENT

1.Cash in advance

2.Letter of credit

3.Draft

4.Consigment

5.Open account

6.Electronic funds transfer

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 1.Cash in advance:

Cash in advance affords the exporter the greater protection because payment is received
either before shipment or upon the arrival of goods. This methods enables the exporter to less of
owned funds.

2.Letter of credit:

Importers will often resent at paying cash in advance and will demand credit terms
instead. When credit is extended the letter of credit denoted as 'LS' offers the exports the greatest
level of safety.

Letter of credit is a letter addressed to the seller ,written and signed by banker acting on behalf
of the buyers.In the letter, the bank promises that it will honour drafts drawn on itself if the
seller confirms to the specific condition set forth in the letter of credit.

3.Draft:

It is called as the bill of exchange. It is written by an exporters on the importers

directing the latter to pay a certain sum on a specified date for having goods shipped to the
importers.The exporters submits the bill to its bankers, who collects the stated amounts from the
importers bank and remits the proceed to the seller or to the bearer.

4.Consignment:

Under the consignment the exporters sends goods on consignments, to the importers
who arranges for the sale of goods and makes payments to the exporters, after deducting a
specified commission.Goods on cosignments are duly shipped to the importers but they are not
sold.The exporter retains the title to the goods until the importers has sold them to a third party.

5.Open account:

Open account selling is shipping goods first and billing the importers later. The credit
terms are arranged between the buyer and the seller but the seller as little evidence of the
importers obligation to pay a certain sum at a certain date. Sales on open account, therefore, are
made only to a foreign affiliate or to a customers with which the exporters has a long history of
favourable business dealings.

6.Electronic fund transfer:

With the advent of internet ,e-banking ,e-business, and e-commerce, the international
business gained further momentum. The banking and technological intervention interface
enabled the banker to transfer the funds of individuals,MNCs,countries, from one place to

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another easily.As a method of payment in international business EFTwill go a long way in
making the world as a global village.

4.HOME CURRENCY:

 The primary currency that is used to conduct business within a country's borders. For
example, the dollar is the domestic currency of the United States and the peso is the
domestic currency of Mexico.Rupee is the domestic currency of India.

 According to INTERNATIONAL MONETARY FUND ,“In a currency union, one

currency is issued which is legal tender in the union‟s member countries. From the point
of view of the currency union area, this currency is a domestic currency, and all other
currencies are foreign currencies.”

Home currency is also called as base currency which is generally the first currency which is
quoted in foreign exchange.It is a unit of exchange that can be used to purchase goods and
services in the home country.

5.FOREIGN CURRENCY:

 Foreign exchange also refers to the global market where currencies are traded virtually
around the clock. The largest trading centers are London, New York, Singapore and
Tokyo. The term foreign exchange is usually abbreviated as "forex" and occasionally as
"FX.“

 Under this definition, British pounds, U.S. dollars, and European euros are examples
of currency. These various currencies are recognized stores of value, and are traded
between nations in foreign exchange markets, which determine the relative values of the
different currencies.

 Foreign currency refers to money and currency of other country.

 EX:JAPAN,UNITED KINGDOM,CANADA,AUSTRALIA ETC..

6.DIRECT QUOTE:

 When a currency is quoted, it is done in relation to another currency, so that the value of
one is reflected through the value of another. Therefore, if you are trying to determine the
exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote
would look like this:

 USD/JPY = 119.50.

 This is referred to as a currency pair. The currency to the left of the slash is
the base currency, while the currency on the right is called the quote or counter currency.

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 The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case,
US$1), and the quoted currency (in this case, the Japanese yen) is what that one base unit
is equivalent to in the other currency. The quote means that US$1 = 119.50 Japanese yen.
In other words, US$1 can buy 119.50 Japanese yen.

 Also US $ 1=Rs.67.65 (DIRECT QUOTE)

 A direct quote is a form of foreign exchange rate that is quoted as the domestic
currency.It is quoted as the domestic currency. It mainly involves quoting in fixed units
of foreign currency.

 Direct quotes are also known as price quotations. Compared to indirect quotes, direct
quote are most commonly used in exchange rate.

7.INDIRECT QUOTES:

 A currency quotation in the foreign exchange markets that expresses the amount of
foreign currency required to buy or sell one unit of the domestic currency. An indirect
quote is also known as a “quantity quotation,” since it expresses the quantity of foreign
currency required to buy units of the domestic currency. In other words, the domestic
currency is the base currency in an indirect quote, while the foreign currency is
the counter currency. An indirect quote is the opposite or reciprocal of a direct quote, also
known as a “price quotation,” since it expresses the price of one unit of a foreign
currency in terms of the domestic currency.

FOR EXAMPLE-

Rs.1=1/67.67 US $

Consider the example of the Canadian dollar (C$), which we assume is trading at 1.0400 to
the US dollar. In Canada, the indirect form of this quote would be C$1 = US$0.9615 (i.e.
1/1.040)

 An indirect quote is currency quotation in the foreign exchange markets, that usually
expresses the amount of foreign currency which is required to buy or sell one unit of
the domestic currency.
 In indirect currency domestic currency is the base currency, while the foreign currency is
the counter currency.

8.BID AND ASK :

 A two-way price quotation that indicates the best price at which a security can be sold
and bought at a given point in time. The bid price represents the maximum price that a
buyer or buyers are willing to pay for a security. The ask price represents the minimum
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 price that a seller or sellers are willing to receive for the security. A trade or transaction
occurs when the buyer and seller agree on a price for the security.

 The difference between the bid and asked prices, or the spread, is a key indicator of
the liquidity of the asset.

 bid–offer spread (also known as bid–ask or buy–sell spread ) for securities (such
as stocks, futures contracts, options, or currency pairs) is the difference between the
prices quoted (either by a single market maker or in a limit order book) for an immediate
sale (bid) and an immediate purchase (offer). The size of the bid-offer spread in a security
is one measure of the liquidity of the market and of the size of the transaction cost.

 A bid price is the highest price that a buyer (i.e., bidder) is willing to pay for a good. It is
usually referred to simply as the "bid." In bid and ask, the bid price stands in contrast to
the ask price or "offer", and the difference between the two is called the bid–ask spread.

9.SPOT :

 In finance, a spot contract, spot transaction, or simply spot, is a contract of buying or

selling a commodity, security or currency for settlement (payment and delivery) on the
spot date, which is normally two business days after the trade date. The settlement price
(or rate) is called spot price (or spot rate). A spot contract is in contrast with a forward
contract or futures contract where contract terms are agreed now but delivery and
payment will occur at a future date.

 A spot contract refers to buying and selling a commodity, security or currency for
settlement and payment on the spot date, which is normally two business days after the
trade, has been made. The price at which settlement is made is called as the spot rate.

10.FORWARD RATE:

 The forward exchange rate (also referred to as forward rate or forward price) is
the exchange rate at which a bank agrees to exchange one currency for another at a future
date when it enters into a forward contract with an investor.[1][2][3] Multinational
corporations, banks, and other financial institutions enter into forward contracts to take
advantage of the forward rate for hedging purposes.[1] The forward exchange rate is
determined by a parity relationship among the spot exchange rate and differences
in interest rates between two countries, which reflects an economic equilibrium in
the foreign exchange market under which arbitrage opportunities are eliminated. When in
equilibrium, and when interest rates vary across two countries, the parity condition
implies that the forward rate includes a premium or discount reflecting the interest rate
differential. Forward exchange rates have important theoretical implications for
forecasting future spot exchange rates.

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  The forward exchange rate (also referred to as forward rate or forward price) is
the exchange rate at which a bank agrees to exchange one currency for another at a
future date when it enters into a forward contract with an investor.

 A forward contract is one where contract terms are agreed in the present day but delivery
and payment will occur at a future date.The settlement price of a forward contract is
called a forward rate.

11.APPRECIATION OF CURRENCY:

 Currency depreciation is the loss of value of a country's currency with respect to one or
more foreign reference currencies, typically in a floating exchange rate system. It is most
often used for the unofficial increase of the exchange rate due to market forces, though
sometimes it appears interchangeably with devaluation. Its opposite, an increase of value
of a currency, is currency appreciation.

 The depreciation of a country's currency refers to a decrease in the value of that

country's currency. For instance, if the Canadian dollar depreciates relative to the euro,
the exchange rate (the Canadian dollar price of euros) rises: it takes more Canadian
dollars to purchase 1 euro (1 EUR=1.5 CAD → 1 EUR=1.7 CAD).

*REASONS FOR APPRECIATION OF CURRENCY:

 WHEN EXPORTS ARE HIGH BUYERS NEED THATCOUNTRY‟S CURRENCY

WHICH RESUTS IN….

 WHEN CENTRAL BANK INCREASES INTEREST RATES RATE OF THE

CURRENCY…..

 WHEN PER CAPITA INCOME INA COUNTRY INCREASES ALONG WITH

EMPLOYMENT THE DEMAND FOR ITS GOODS AND SERVICES INCREASES
RESULTING IN DEMAND FOR THAT CURRENCY TO INCREASE.

 DEMAND OF THE CURRENCY IF IS HIGH IN FOREIGN EXCHANGE MARKET

IT LEADS TO APPRECIATION OF THE CURRENCY.

 THE CURRENCY RATE INCREASES DUE TO GOVT BORROWING OR

LOOSENING OF FISCAL POLICY.

*ASSESSMENT OF CURRENCY APPRECIATION

 BASED ON ELASTICITY.

 SITUATION OF ECONOMY

 DEPENDS ON ECONOMIC GROWTH IN OTHER COUNTRIES.

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  DEPENDS ON INCREASING VALUE OF EXCHNAGE RATE(CURRENCY RATE
OF OTHER COUNTRIES)

*EFFECTS OF APPRECIATION

 IMPROVES STANDARD OF LIVING.

 RESULTS IN COMPETITIVENESS.

 REDUCES INFALTION..

 ELASTICITY OF DEMAND..

12.DEPRICIATION OF CURRENCY:

 Currency depreciation is the loss of value of a country's currency with respect to one or
more foreign reference currencies, typically in a floating exchange rate system. It is most
often used for the unofficial increase of the exchange rate due to market forces, though
sometimes it appears interchangeably with devaluation. Its opposite, an increase of value
of a currency, is currency appreciation.

 The depreciation of a country's currency refers to a decrease in the value of that

country's currency. For instance, if the Canadian dollar depreciates relative to the euro,
the exchange rate (the Canadian dollar price of euros) rises: it takes more Canadian
dollars to purchase 1 euro (1 EUR=1.5 CAD → 1 EUR=1.7 CAD).

*REASONS FOR DEPRICIATION OF CURRECNY

 FALL IN WORLD PRICE OF A COUNTRY‟S MAJOR EXPORT.

 BOP DEFICIENCY..

 MONETARY POLICIES DESIGNED BY CENTRAL BANK OF THE COUNTRY..

 SPECULATION BY MARKET LEADERS.A SPECULATION IN FALL IN PRISES

MAY ENCOURAGE TRADERS TO SELL OF ASSETS.

 LARGE CURRENT ACCOUNT DEFICIET..TENDS A COUNTRY‟S CURRENCY TO

FALL.

 RATE OF CURRENCY FALLS IF MARCOECONOMIC CONDITIONS WORSEN IN

THE ECONOMY.

13. DIFFERENCE BETWEEN SPOT AND FORWARD RATE:

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14.CONCEPTS OF CURERNCY:

 YIELD AND RETURN

 LEVERAGING RETURNS

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  CARRY TRADES

 ROI

15.CROSS CURRENCY RATES:

 A cross rate is the currency exchange rate between two currencies, both of which are not
the official currencies of the country in which the exchange rate quote is given in.

 When an individual who wishes to exchange a sum of money into a different currency
would be required to first convert that money into U.S dollars, and then convert it into the
desired currency; cross currencies help individuals and traders bypass this step. The
GBP/JPY cross, for example, was invented to help individuals in England and Japan who
wanted to convert their money directly without having to first convert it into U.S dollars.

 A cross currency rate is the currency exchange rate between two currencies.Both these
currencies are not the official currency of the country in which exchange rate is given in.

CHAPTER -2

FOREIGN EXCHANGE AND BALANCE OF PAYMENTS.

Foreign exchange market

It is place where money denominated in one currency is bought and sold with money
denominated in another currency

What are American Depository Receipts(ADR)?

A negotiable certificate issued by a U.S. bank representing a specified number of shares (or one
share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S.
dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to
reduce administration and duty costs that would otherwise be levied on each transaction.

An American depositary receipt (ADR) is a negotiable certificate issued by a U.S. bank

representing a specified number of shares (or one share) in a foreign stock traded on a U.S.
exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S.
financial institution overseas, and holders of ADRs realize any dividends and capital gains in
U.S. dollars, but dividend payments in euros are converted to U.S. dollars, net of conversion
expenses and foreign taxes. ADRs are listed on either the NYSE, AMEX or Nasdaq but they are
also sold OTC.

GDR Global Depository Receipt

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 GDR is a certificate issued by a depository bank, which purchases shares of foreign
companies and deposits it on the account. GDRs represent ownership of an underlying number of
shares.

Prices of global depositary receipt are often close to values of related shares, but they are
traded and settled independently of the underlying share.

Foreign Exchange market

The foreign exchange market is merely a part of the money market in the financial
centres is a place where foreign moneys are bought and sold. The buyers and sellers of claims on
fore money and the intermediaries together constitute a foreign exchange market.

Features of foreign exchange market

 its huge trading volume representing the largest asset class in the world leading to
high liquidity;

 it is geographically dispersed. It is not restricted to any given country or a geographical

area.

 It operates continuous . 24 hours a day except weekends, i.e., trading from 20:15 GMT on
Sunday until 22:00 GMT Friday;

 the variety of factors that affect exchange rates;

 it low margins of relative profit compared with other markets of fixed income; and

 the use of leverage to enhance profit and loss margins and with respect to account size.

Dealers/ Transactorsintermediaries in forex market

There is a wide variety of dealers in the foreign exchange market.

Ist level dealers-

1)Retail dealers-It includes various retail dealers like tourists, importers, exporters,
investors. They are the immediate users and suppliers of forex.

II nd level dealers –

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 2)Commercial banks.- Banks dealing in foreign exchange have branches with
substantial balances in different countries. Through their branches and correspondents the
services of such banks, usually called 'Exchange Banks', are available all over the world.

These banks discount and sell foreign bills of exchange, issue bank drafts, effect telegraphic
transfers and other credit instruments, and discount and collect amounts for such documents..

3)Acceptance houses are another class of dealers in foreign exchange. They help foreign
remittances by accepting bills on behalf of customers.

4)Non bank dealers-non banking financial institutions will alsodeal in foreign exchange

IIIrd level dealers

4)FXBrokers – who act as an intermediate and through whom the nations inflow and out flow
of foreign exchange happens

5)Speculators-they are deliberate risk takers who are involved in day trading .

6)Arbitraguers- They are intermediaries who will make profit by discovering price differences
between pairs of currencies at different dealers of bank

7)Hedgers- T hose who limit their poterntial losses by locking in guaranteed foreign exchange
positions

VI th level dealers

8)The central bank – They are also dealers in foreign exchange. Both may intervene in the
market occasionally and manage exchange rates and implement exchange controls in various
ways. In India, there is a strict exchange control system and there is no foreign exchange market
as such.

Functions of the Foreign Exchange Market:

The foreign exchange market performs the following important functions:

(i) to effect transfer of purchasing power between countries- transfer function;

(ii) to provide credit for foreign trade - credit function; and

(iii) to furnish facilities for hedging foreign exchange risks - hedging function.

Transfer Function:

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The basic function of the foreign exchange market is to facilitate the conversion of one currency
into another, i.e., to accomplish transfers of purchasing power between two countries. This
transfer of purchasing power is effected through a variety of credit instruments, such as
telegraphic transfers, bank drafts and foreign bills.

In performing the transfer function, the foreign exchange market carries out payments
internationally by clearing debts in both directions simultaneously, analogous to domestic
clearings.

Credit Function:

Another function of the foreign exchange market is to provide credit, both national and
international, to promote foreign trade. Obviously, when foreign bills of exchange are used in
international payments, a credit for about 3 months, till their maturity, is required.

Hedging Function:

A third function of the foreign exchange market is to hedge foreign exchange risks. In a free
exchange market when exchange rates, change, there may be a gain or loss to the party
concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are
huge amounts of net claims or net liabilities which are to be met in foreign money.

Exchange risk as such should be avoided or reduced. For this the exchange market provides
facilities for hedging anticipated or actual claims or liabilities through different instruments

Exchange RateMechanism

Exchange rate between two currencies is the rate at which one currency will be exchanged for
another. It is also regarded as the value of one country‟s currency in terms of another currency

Factors influence Exchange rate

 Trade movements- export and import goods and services

 Interest Rates.
 Capital flows- inflows and out flows of capital
 Sale and purchase of securities
 Banking operations
 Relative inflation Rates.
 Balance of Payments.
If a country has a large current account deficit it means it is importing more goods and
services than it is exporting.

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  Speculative buying.
Foreign currencies are heavily traded and some investment banks try to make profit from
buying and selling.
 Politicalfactors- government policies , stability
 Economic factors. –monetary policy, fiscal policy,bankrate,inflaton
 Exchange control measures

Types of Foreign exchange rates :

Spot rate

Forward rate

Long rate

Cross rate

Fixed exchange rate

Flexible exchange rate

Exchange rate determination

It is decided based on demand and supply of foreign exchange in one country

Demandfor foreign exchange is due to following reasons

1. Imports of goods
2. Investment in foreign countries‟
3. Payments in international transaction
4. Out flows like grant donations give

Supply for foreign exchange is due to following reasons

1. Export of goods
2. Investments made by foreign companies in our country
3. Payments made to government and remittance to country
4. Inflows of capital as grants donations

Types of exchange rate

Broadly speaking, there can be two types of exchange rate systems;

(a) fixed exchange rate system; and (b) flexible exchange rate system.

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 Theories of exchange rate determination

Purchasing Power Parity PPP Theory

The first original reference of PPP Theory was made by David Ricardo. However, Gustav Cassel
popularized this theory in 1918. According to PPP theory, when exchange rates are of a
fluctuating nature, the rate of exchange between two currencies in the long run will be fixed by
their respective purchasing powers in their own nations.

. Purchasing power parity (PPP) is a theory which states that exchange rates between currencies
are in equilibrium when their purchasing power is the same in each of the two countries. This
means that the exchange rate between two countries should equal the ratio of the two countries'
price level of a fixed basket of goods and services.It asks how much money would be needed to
purchase the same goods and services in two countries, and uses that to calculate an implicit
foreign exchange rate. Using that PPP rate, an amount of money thus has the same purchasing
power in different countries

The basis for PPP is the "law of one price". In the absence of transportation and other transaction
costs, competitive markets will equalize the price of an identical good in two countries when the
prices are expressed in the same currency

.
PPP calculation

The simplest way to calculate purchasing power parity between two countries is to compare the
price of a "standard" good that is in fact identical across countries. Every year The
Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that
compares the price of a McDonald's hamburger around the world. More sophisticated versions of
PPP look at a large number of goods and services. One of the key problems is that people in
different countries consumer very different sets of goods and services, making it difficult to
compare the purchasing power between countries.

Interest rate parity theory

Given foreign exchange market equilibrium, the interest rate parity condition implies that the
expected return on domestic assets will equal the exchange rate-adjusted expected return on
foreign currency assets. Investors cannot then earn arbitrage profits by borrowing in a country
with a lower interest rate, exchanging for foreign currency, and investing in a foreign country
15
with a higher interest rate, due to gains or losses from exchanging back to their domestic
currency at maturity.

BALANCE OF PAYMENTS:

Balance of payments (Bop) accounts are an accounting record of all monetary transactions
between a country and the rest of the world for a specific period, usually a year, and are prepared
in a single currency, typically the domestic currency for the country concerned.

These transactions include payments for the country's exports and imports of goods, services,
financial capital, and financial transfers. , it summarizes international transactions Sources of
funds for a nation, such as exports or the receipts of loans and investments, are recorded as
positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are
recorded as negative or deficit items.

Structure or Components of Balance of Payment Account

1. Trade Balance
2. Current Account Balance
3. Capital Account Balance
4. Errors and Omissions
5. Foreign Exchange reserves

Balance of Payment always Balances . Discuss.

1. The balance of payments always balances.

 Goods, services, and resources traded internationally are paid for; thus every
movement of products is offset by a balancing movement of money or some other
financial asset.
 If a U.S. retailer imports $1 million of Japanese televisions, there is a
corresponding or balancing movement of money to the Japanese producer.
 A surplus in the Current account is by definition offset by a deficit in the Capital
account.
 Another way to think of this is that if we export goods and services, then
we import financial assets of the foreigners who purchased those goods
and services.
 Similarly, a deficit in the Current account must be offset by a surplus in the
Capital account.
 In practical terms, if Americans import foreign products, then we export
our financial assets to pay for them.

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  While the Current account deficit of recent years has received much media
attention, there is little public awareness that this trade deficit is accompanied by a
surplus in the Capital account.

Causes of Disequilibrium in BOP

A. Import related Causes

1. Population growth
2. Development programs
3. Imports of essential items
4. Reduction of import duties
5. Inflation
6. Demonstration effect

B. Export related causes

1. Increase in population
2. Inflation
3. Appreciation of currency
4. Discovery of substitutes
5. Technological development
6. Protectionist Trade Policy
C. Other causes
1. Flight of capital
2. Globalization
3. Cyclical transmission
4. Structural Adjustments
5. Political factors

Measures to Correct Disequilibrium in BOP

1. Monetary measures
a. Monetary policy for inflation and deflation
b. Fiscal policy for inflation and deflation
c. Exchange rate policy - Devaluation & Depreciation
2. Non-monetary /General measures

-tariffs

- Quotas

- Export Promotion

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 - Import Substitution

ADR American Depository Receipt.

ADR is a U.S. dollar denominated form of equity ownership in a non-U.S.

company. It is a stock that trades in the US but represent a specified number of shares in
a foreign corporation.
It represents the foreign shares of the company held on deposit by a custodian
bank in the company's home country and carries the corporate and economic rights of the
foreign shares, subject to the terms specified on the ADR certificate.

Types of ADR’s
Level 1-
 This is basic type of ADRwhich is not qualified to be listed .
 It is traded in OTC market.
 It is exempted from from compliance with the SEC(securities and exchange
commission)
 They are easy to get and less expensive

Level 2-
 These are listed in and quoted in NASDAQ and other exchanges.
 They should comply with the requirements from SEC.

Level 3
 These are top level ADR‟s which is of demand
 It should comply all the requirements of SEC
 It is allowed to raise capital through a public offering proided

Procedure to issue ADR

 Company planning to issue gets its accounts consolidates and audited to US
GAAP by an independence agency.
 Company will appoint a lead manager and investment banker.
 The team will prepare draft prospectus or the registration statement which will
be submitted to the SEC.
Advantages to issuing company
 Broadens share holders base
 Broaden global visibility
 Enable to tap us equity market
 Raise capital from foreign market

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  Enhance good will of company

Advantages to the investors

 Easy and cost effective way to buy foreign shares

 They are liquid
 Easy to buy and sell
 Cost effective they are globally dealt instruments

Questions

Section – A

 What is a foreign exchange market ?

 What is fixed exchange rate or flexible exchange rate?
 What is an ADR?
 What is Balance of Payment account?

Section - B

 Components of BOP
 What are the features and benefits of an ADR?
 Factors affecting exchange rate?
 Discuss the Forex market intermediaries.

Section – C

 What are the merits & Demerits of Flexible exchange rate system?
 What are the merits & Demerits of Fixed exchange rate system?
 What are the causes of Disequilibrium in BOP?
 What are the Measures to correct Disequilibrium in BOP?
 Discuss the theories relating to Forex rate determination ?

Unit – 3

INTERNATIONAL FINANCIAL MARKETS

What is an International Financial Market ?

The International Financial Market is the place where financial wealth is traded between
individuals (and between countries). It can be seen as a wide set of rules and institutions where
assets are traded between agents in surplus and agents in deficit and where institutions lay down
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the rules.
The financial market comprises the markets (stock market, bond market, currency market,
derivatives market, commodity market and money market), the institutions which work in them
with different aims and functions (Central Bank, Ministry of Economy and Finance), as well as
direct/indirect policies orientated to making the market the place where the exchange between
surplus and deficit units is carried out as efficiently as possible.

Nature and features

1. They facilitate transferring purchasing power from lenders and investors to parties who
desire to acquire assets that they expect to yield future benefits.
2. Involve exchange of assets between residents of different countries
3. International financial centres are reservoirs of savings and transfer them to their most
efficient use irrespective of where the savings are generate.

Functions :

1. The interactions of buyers and sellers determine the prices of assets traded also called
Price discovery process.
2. Ensure liquidity
3. Reduce cost of transactions and information
4. Deals with buying and selling of financial security instruments like stocks and bonds,
commodities like precious metals and other exchangeable items on an international basis.
5. Helps companies regarding financing of capital in capital markets
6. Helps international commerce and trade in the foreign exchange market.
7. Helps transfer of risk in the derivative markets.

Classification or types of International Financial Markets

 Euro Market
 Euro Currency Market
 Bond Market
 Equity market

FINANCIAL GLOBALIZATION OF CAPITAL MARKET:

Financial globalization refers to the process by which financial markets of various countries of
the globe are integrated as one. Financial globalization requires the introduction of worldwide
single currency managed and regulated by a single international monetary authority.

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Discuss Implication of Globalization on Business

1. Expanded markets - Domestics sellers can access global markets

2. Cheaper resources – like acess to cheap labour reduces cost and increases profit.
3. International development
4. Increased competition among companies
5. Exchange of technology
6. Knowledge or information transfer
7. Cultural exchanges and interaction
8. More efficient markets
9. Transportation
10. Raised the rate of investment
11. Accelerated industrial growth

Benefits of Financial Globalization

1. Enhance capital flow in each and every country with which a country always remain
prepared to counter any financial crisis
2. The capital flows between nations increases which causes well organized world
allocation of money
3. It improves living standards of the people
4. Safeguards a nation against national shocks and is an excellent system for efficient global
allocation of resources
5. Results in market stability and regulation strengthening investors trust in a given
country‟s market
6. Due to access of a larger pool of investors increased competitiveness will drive down the
cost of funds for businesses
7. From global perspective this will lead to better allocation of capital
8. It enables the investors to make varied investments allowing risk diversification
9. Advances in information and computer technologies
10. Globalization of National economies has helped emergence of MNCs
11. Competition among the providers of intermediary services like investment banks, mutual
funds,insurance companies has helped economic growth.

Risks of Financial Globalization

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 1. If the economy of a country is is not strong , it could be affected by the financial shocks
of a different country.
2. It can also cause severe disorder and cost high for stock market turbulence , bank failures,
corporate bankruptcies, currency depreciation etc.
3. There is always risk of market disturbance due to factors beyond that of the domestic
market.
4. Although financial globalization helps in spreading of risk but when a crisis does occur ,
no financial market or country is protected.
5. Globalization of financial markets will penalize investors who don‟t regard profits as
their only priority.
6. Sometimes leads to huge foreign indebtedness, mainly the developing countries.
7. Economies are highly exposed to exchange instability of foreign exchange risk.

International Portfolio Management

International Portfolio - A grouping of investment assets that focuses on securities from

foreign markets rather than domestic ones. An international portfolio is designed to give the
investor exposure to growth in emerging and international markets and provide diversification.

Porfolio management refers to the management or administration of a portfolio of securities to

protect and enhance the value of the underlying investment.It is a service done by financial
intermediaries .

Foreign portfolio investment (FPI) consists of securities and other financial assets passively held
by foreign investors. It does not provide the investor with direct ownership of financial assets
and is relatively liquid depending on the volatility of the market. Foreign portfolio investment
differs from foreign direct investment (FDI), in which a domestic company runs a foreign firm,
because although FDI allows a company to maintain better control over the firm held abroad, it
may face more difficulty selling the firm at a premium price in the future.

Objectives:

1. Security of Principal Investment

2. Consistency of returns
3. Capital growth
4. Marketability
5. Liquidity
6. Diversification of Portfolio
7. Favorable Tax status

Steps in Portfolio Management:

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 1.Learn the basic principles of finance.
2. Set portfolio objectives
3.Formulate an investment strategy
4.Have a game plan for portfolio revision
5.Evaluate performance
6. Protect the portfolio when appropriate.

Benefits of International Portfolio Diversification :

1.Development of Global and multinational companies and organization.

2. Advances in information technology.

3. Deregulation of the financial systems of the major industrialized countries.

4. Explosive growth in international capital flows

5. Abolishment of foreign exchange controls

TYPES OF INNOVATIVE FINANCIAL INSTRUMENTS IN FOREIGN PORTFOLIO

MANAGMENT:

 DEBT INSTRUMENTS:

 COMMERCIAL PAPERS

 CONVERTIBLE BOND

 CARROT AND STICK BOND

 CONVERTIBLE BOND WTH A PREMIUM PUT

 DEBT WITH EQUITY BOND

 DUAL CURRENCY BONDS

 COPS(COVERED OPTION SECURITIES)

 ECU(EUROPEAN CURRENCY UNIT BOND)

 ICONS(INDEXED CURRENCY OPTION NOTES)

 PERLS(PRINCIPAL EXCHANGE RATE LINKED SECURITIES)

 FRNS (FLAOTING RATE NOTES)

 CAPPED FLOATER

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 CONVERTIBLE FRNS

 DROP –LOCK FRN

 MINIMAX FRN

 INDEXED DEBT INSTRUM

 PUT BONDS

 BULL-BEAR BOND

 GOVT SECURITIES

 CATS (CERTIFICATES OF ACCRUAL ON TREASURY CERTIFICATES)

 COUGRS(CERTIFICATE OF GOVT RECEIPTS)

 STAGS

 STRIPS

 TIGR

 ZEBRAS

 LYONS

 ZERO COUPON BONDS

ASSET BACKED SECURITIES:

 COMS-COLLATERIZED MORTGAGE OBLIGATIONS

 MORTGAGE BACKED SECURITIES

 CARDS-CERTIFICATES OF AMORTIZING REVOLVING DEBTS

 CARS-CERTIFICATES OF AUTOMOBILE RECEIVABLES

 CLEOS-COLLATERIZED LEASE EQUIPMENT OBLIGATIONS

 FRENDS-FLOATING RATE ENHANCED DEBT SECURITIES

EQUITY INSTRUMENTS:

 MMP-MONEY MARKET PREFERRED STOCK

 CMPS-CAPITAL MARKET PREFERRED STOCK

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 ZEBRAS

 LYONS

 ZERO COUPON BONDS

ASSET BACKED SECURITIES:

 COMS-COLLATERIZED MORTGAGE OBLIGATIONS

 MORTGAGE BACKED SECURITIES

 CARDS-CERTIFICATES OF AMORTIZING REVOLVING DEBTS

 CARS-CERTIFICATES OF AUTOMOBILE RECEIVABLES

 CLEOS-COLLATERIZED LEASE EQUIPMENT OBLIGATIONS

 FRENDS-FLOATING RATE ENHANCED DEBT SECURITIES

EQUITY INSTRUMENTS:

 MMP-MONEY MARKET PREFERRED STOCK

 CMPS-CAPITAL MARKET PREFERRED STOCK

 DARTS-DUTCH AUCTION RATE TRANSFERABLE SECURITIES

 FRAPS-FIXED RATE AUCTION PREFERRED STOCK

 MAPS-MARKET AUCTION PREFERRED STOCK

 STRAPS-STATED RATE AUCTION PREFERRED STOCK

 PIK-PAY IN KIND

 EXCHANGEABLE PIK

HEDGING INSTRUMENTS:

 BUTTERFLY SPREAD

 CALENDAR SPREAD

 CANCELABLE FORWARD EXCHANGE CONTRACTS

 CIRCUS-COMBINED CURRENCY AND INTEREST RATE SWAP

 CONVERTIBLE OPTION CONTRACTS

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  CYLINDER OPTIONS

Unit -4

FOREIGN EXCHANGE RISK:

Exposure and its management

Exposure refers to the degree to which a company is affected by exchange rate changes.

Exchange rate risk is defined as the variability of a firm‟s value due to uncertain
changes in the rate of exchange. Is the chance of loss due to unexpected changes in the
relative value of currencies.

Foreign exchange exposure is a financial risk posed by an exposure to unanticipated

changes in the exchange rate between two currencies .it is a measure of the potential for
a firm's profitability, net cash flow, and market value to change because of unexpected
changes in exchange rates.

Investors and multinational businesses exporting or importing goods and services or

making foreign investments throughout the global economy are faced with an exchange
rate risk which can have severe financial consequences if not managed appropriately

Managing accounting exposure centers around the concept of hedging, which means:

 Entering into an offsetting currency position so whatever is lost/gained on the

original currency exposure is exactly offset by a corresponding currency gain/loss
on the currency hedge.

 The coordinated buying or selling of a currency to minimize exchange rate risk.

Types of Exposures

1. Transaction Exposure
2. Translation Exposure
3. Economic exposure

1. Transaction Exposure

It is the extent to which income from individual transaction is affected by

fluctionsof foreign exchange values. It arises when company is committed to foreign
exchange transaction entered into before the change in exchange rate. It measures the

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 effect of an exchange rate change on outstanding obligations which existed before the
change but settled after the exchange rate changes

It includes obligations for the purchase or sale of goods and services at previously
agreed prices and borrowings and lending of funs in foreign currencies.. It can result in
real gain and losses in contrast to book keeping.

 It arises from the various types of transactions that require settlement in a foreign
currency.

 Purchasing or selling on credit goods or services denominated in foreign currency.

 Borrowing and lending funds with repayment made in foreign currency.

 Acquiring assets denominated in foreign currency.

For example, let‟s say a domestic company signs a contract with a foreign company. The
contract states that the domestic company will ship 1,000 units of product to the foreign
company and the foreign company will pay for the goods in 3 months with 100 units of foreign
currency. Assume the current exchange rate is: 1 unit ofdomestic currency equals 1 unit of
foreign currency. The money the foreign company will pay the domestic company is equal to
100 units of domestic currency.

The domestic company, the one that is going to receive payment in a foreign currency,
now has transaction exposure. The value of the contract is exposed to the risk of exchange rate
fluctuations

The next day the exchange rate changes and then remains constant at the new exchange rate for 3
months. Now one unit of domestic currency is worth 2 units of foreign currency. The foreign
currency has devalued against the domestic currency. Now the value of the 100 units of foreign
currency that the foreign company will pay the domestic company has changed – the payment is
now only worth 50 units of domestic currency.

The contract still stands at 100 units of foreign currency, because the contract specified payment
in the foreign currency. However, the domestic firm suffered a 50% loss in value. Thus
Transaction exposure arises from fixed-price contracting in a world where exchange rates are
changing randomly.

Some strategy to manage transaction exposure

Risk Shifting and risk sharing

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The firm can shift, share or diversify exchange risk by appropriately choosing the currency of
invoice. Firm can avoid exchange rate risk by invoicing in domestic currency, there by shifting
exchange rate risk on buyer

Invoice in home currency

One easy way is to insist that all foreign customers pay in your home currency and that
your company pays for all imports in your home currency.
However the exchange-rate risk has not gone away, it has just been passed onto the
customer. It will work if company are in a monopoly position, however in a competitive
environment this is an unrealistic approach
Exposure Netting
It is offsetting exposure in one currency with exposure in the same or another currency

Hedging via lead and lagAnother operational technique the firm can use to reduce transaction
exposure is leading and lagging foreign currency receipts and payments. To “lead” means to pay
or collect early, where as “lag” means to pay or collect late. The firm would like to lead soft
currency receivables and lag hard currency receivables to avoid the loss from depreciation of the
soft currency and benefit from the appreciation of the hard currency.
B) Contractual Hedges

Forward Market Hedge

In this a company that is in surplus of foreign exchange will sell the foreign
currency and company that is short in currency will buy the currency forward
Money Market Hedge
It involves simultaneous borrowing and lending activities in two different
currencies to lock in the home currency value of future foreign currency cash
flow
Options Market Hedge
If firm I sun certain whether the hedged currency inflow and out flow they can
buy put option or call option
Futures Market Hedge


Financial Hedges
 Swaps
In a forex swap, the parties agree to swap equivalent amounts of currency for a
period and then re-swap them at the end of the period at an agreed swap rate. The
swap rate and amount of currency is agreed between the parties in advance. Thus
it is called a fixed rate/fixed rate swap.

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2. Translation Exposure (Accounting Exposures)
Translation exposure is defined as the likely increase or decrease in the parent company‟s net
worth caused by a change in exchange rates since last translation. This arises when an asset or
liability is valued at the current rate. No exposure arises in respect of assets/liabilities valued at
historical rate, as they are not affected by exchange rate differences. Translation exposure is
measured as the net of the foreign currency denominated assets and liabilities valued at current
rates of exchange.

Translation exposure arises they translate or convert foreign currency assets or liabilities into
the home currency for the purpose of finalizing the accounts for any given period.

Translation loss or gain is measured by the difference between the value of assets and
liabilities at the historical rate and current rate. A company which has a positive exposure will
have translation gains if the current rate for the foreign currency is higher than the historic rate.
In the same situation, a company with negative exposure will post translation loss. The position
will be reversed if the currency rate for foreign currency is lesser than its historic rate of
exchange. The translation gain/loss is shown as a separate component of the shareholders‟ equity
in the balance-sheet. It does not affect the current earnings of the company.

Translation Methods

 Current/Noncurrent Method
 Monetary/Nonmonetary Method
 Temporal Method
 Current Rate Method

 Current/Noncurrent Method

The underlying principal is that assets and liabilities should be translated based on their maturity.

Current assets translated at the spot rate.Noncurrent assets translated at the historical rate in
effect when the item was first recorded on the books

 Monetary/Nonmonetary Method

The underlying principle is that monetary accounts have a similarity because their value
represents a sum of money whose value changes as the exchange rate changes.

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All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.)of a
foreign subsidiary are translated at the current exchange rate.

All other (nonmonetary) balance sheet accounts (owners‟ equity, land) are translated at the
historical exchange rate in effect when the account was first recorded.

 Temporal Method

The underlying principal is that assets and liabilities should be translated based on how they are
carried on the firm‟s books.

Balance sheet account are translated at the current spot exchange rate if they are carried on the
books at their current value.

Items that are carried on the books at historical costs are translated at the historical exchange
rates in effect at the time the firm placed the item on the books.

 Current Rate Method

All balance sheet items (except for stockholder‟s equity) are translated at the current
exchange rate.This method is very simple method in application.An equity account named
cumulative translation adjustment is used to make the balance sheet balance.

3. Economic Exposure
Economic exposure can be defined as the extent to which the value of the firm would be
affected by unanticipated changes in exchange rates. An economic exposure is more a
managerial concept than a accounting concept. A company can have an economic exposure to
say Yen: Rupee rates even if it does not have any transaction or translation exposure in the
Japanese currency. This would be the case for example, when the company‟s competitors are
using Japanese imports. If the Yen weekends the company loses its competitiveness (vice-versa
is also possible). The company‟s competitor uses the cheap imports and can have competitive
edge over the company in terms of his cost cutting. Therefore the company‟s exposed to
Japanese Yen in an indirect way.

In simple words, economic exposure to an exchange rate is the risk that a change in the
rate affects the company‟s competitive position in the market and hence, indirectly the bottom-
line. Broadly speaking, economic exposure affects the profitability over a longer time span than
transaction and even translation exposure. Under the Indian exchange control, while translation
and transaction exposures can be hedged, economic exposure cannot be hedged.

Some strategy to manage operating exposure

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 Selecting low cost production sites: When the domestic currency is strong or expected to
become strong, eroding the competitive position of the firm, it can choose to locate production
facilities in a foreign country where costs are low due to either the undervalued currency or
under priced factors of production.
 Flexible sourcing policy: Even if the firm manufacturing facilities only in the domestic
country, it can substantially lessen the effect of exchange rate changes by sourcing from where
input costs are low
 Diversification of the market: Another way of dealing with exchange exposure is to diversify
the market for the firm‟s products as much as possible.
 R&D efforts and product differentiation: Investment in R&D activities can allow the firm to
maintain and strengthen its competitive position in the face of adverse exchange rate
movements..
 Financial hedging: While not a substitute for the long-term, financial hedging can be used to
stabilize the firm‟s cash flow. For example, the firm can lend or borrow foreign currencies as a
long term basis. Or, the firm can use currency forward of options contracts and roll them over
if necessary.

Transactions
1. Spot market
2. Forward market
3. Futures
4. Options
5. Swaps
6. Arbitrage

Spot market / Spot Exchange Rate'

Spot exchange rates are the rates that are applicable for purchase and sale of foreign
exchange on spot delivery basis or immediate delivery basis
It , is an agreement between two parties to buy one currency against selling another currency at
an agreed price for settlement on the spot date on current rate . The exchange rate at which the
transaction is done is called the spot exchange rate.
It is alse known as "benchmark rates", "straightforward rates" or "outright rates", spot rates
represent the price that a buyer expects to pay for a foreign currency in another currency.

Though the spot exchange rate is said to be settled immediately, The standard and actual
settlement timeframe for foreign exchange spot transactions is T + 2 days; i.e., two business
days from the trade date.
In spot market rates are quoted in 2 methods

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 1)Direct method - Under this, a given number of units of local currency per unit of
foreign currency is quoted. They are designated as direct/certain rates because the rupee cost of
single foreign currency unit can be obtained directly. Direct quotation is also called home
currency quotation.

 Direct Quote: 1 foreign currency unit = x home currency units

Eg: 1 $ = 54.09 Rs

2)Indirect method – Under this, a given number of units of foreign currency per unit of local
currency is quoted. Indirect quotation is also called foreign currency quotation

 Indirect Quote: 1 home currency unit = x foreign currency units

Eg: 1 Rs = .01846 $

Cross rate in spot market

Cross Rates

It is exchange rate between 2 currencies that is derived from the exchange rates of those
currencies with a third currency .Cross Rates are used when a direct quote of the home currency
or any other currency is not available in the foreign exchange market. Cross rates are the
exchange quotes of other pairs of currencies. It is defined as the rate of exchange of two
currencies on the basis of exchange quotes of other pairs of currencies.

Cross are calculated on basis of various currencies relative to US Dollors

For eg: cross rate between british pound, and Euro is calculated as follows

Cross rate = dollor/ pound X Euro/ Dollor = Euro / pounds

The idea of cross rates implies two exchange rates with a common currency, which
enables you to calculate the exchange rate between the remaining two currencies.

For example, you can easily find, the euro–dollar or the yen–dollar exchange rates in
financial media. However, the euro–yen exchange rate may not be listed. Because the dollar is
the common currency in this example, you can calculate the euro–yen (and also the yen–euro)
exchange rate.

listed the yen–dollar and euro–dollar rates as ¥78.56 and €0.7802, respectively. Suppose
you want to know the euro–yen exchange rate. In this case,

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and

and you want to know what the following is:

Because the dollar is the common currency here, cancel it. Think in terms of the
currencies involved: When you divide the euro–dollar exchange rate by the yen–dollar exchange
rate, the dollars cancel and you get the euro–yen exchange rate:

Therefore, if you divide the euro–dollar exchange rate by the yen–dollar exchange rate,

the euro–yen exchange rate turns out to be €0.0099.

Bid, Ask (offer)Spread

The Bid-Ask Spread, is the quote of the price at which participants in a market are
willing to buy or sell a good or security.

the bid price is the price at which a party is willing to purchase,

the ask (or offer) price is the price at which the same person or another party is willing to sell
the same good or security.

The spread

Spread is the difference between the ask price (which is the sale price) and the purchase
price (which is the bid price).

The factors affecting Spread are the currencies involved in trading, the volume of
business transactions during the day and the sentiments and rumours in the foreign exchange
market. The size of the Spread will be directly related to the volatility of the currency. If the

33
involved currency is subject to high volatility, the Spread will be higher to compensate for the
higher risk involved and vice versa.

bid-ask spread is calculated as follows:

Derivatives

Derivative is a financial instrument whose value is based on or value is derived from one
or more underlying assets. The under lying asset may be a share, stock market index, a
commodity, an interest rate or a currency. When the price of asset changes value of derivative
will also change. In practice, it is a contract between two parties that specifies conditions
(especially the dates, resulting values of the underlying variables, and notional amounts) under
which payments are to be made between the parties.

Derivative is similar to insurance. Insurance protects against specific risk like fire, flood
accident, whereas derivatives protects from market risks.

Derivatives are of two categories

1) Exchange traded

2) Over the counter.

 Exchange traded derivatives, as the name signifies are traded through organized
exchanges around the world. These instruments can be bought and sold through these
exchanges, just like the stock market. Some of the common exchange traded derivative
instruments are futures and options.

 Over the counter (popularly known as OTC) derivatives are not traded through the
exchanges. They are not standardized and have varied features. Some of the popular
OTC instruments are forwards, swaps, swaptions etc.

TYPES OF DERIVATIVES

1. FORWARDS
2. FUTURES
3. OPTIONS
a. CALL OPTION
b. PUT OPTION
SWAPS

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 WARRANTS AND CONVERTIBLES

1) FORWARDS

A forward contract is an agreement between two parties – a buyer and a seller to purchase or sell
something at a later date at a price agreed upon today A forward contract is a customized
contract between two entities, where settlement takes place on a specific date in the future at
today's pre-agreed price. Any type of contractual agreement that calls for the future purchase of a
good or service at a price agreed upon today and without the right of cancellation is a forward
contract.

Features of forwards

1) They are bilateral contracts in which all contract details such as delivery date, price and
quantity are negotiated bilaterally by the parties to the contact

2) Counter party risk – both parties bear risk of default

3) The contract has to be settled by delivery by delivery of assets or cash on expiry date.

4) The underlying assets could be stock bonds, foreign exchange , commodities etc.

5) Contract price not known in public.

Limitations

 Since these are customised contracts it cannot be traded in stock exchange

 Risk is more because there is possibility of default from any party
 No transpency of prices.

Forward rates may be greater than the current spot rate or less than the current spot rate. The
forward exchange rate of a currency will be slightly different from the spot exchange rate at the
present date due to uncertainties and future expectations.

Currency Contract U.S. Dollar Equivalent Currency per U.S. Dollar

U.K (Pound) Spot 1.6181 0.6180
forward30-day maturity 1.6161 0.6188
forward 60-day maturity (future) 1.6150 0.6192
forward 90-day maturity (future) 1.6070 0.6223

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Discount and Premium:

Forward exchange contract for 3 months or 90 days. Spot rate is the rate of exchange of the day
on which the transaction takes place and of the days the transaction is executed. Forward
exchange rates can be at a premium or at a discount.

A foreign currency is said to be at a premium when its forward rate is higher than the spot rate.

A foreign currency is said to be at a discount when its spot rate is higher than the forward rate. It
can be expressed as follows:

Forward Rate > Spot Rate, then forward rate of foreign currency is at a Premium

Spot Rate > Forward Rate, then forward rate of foreign currency is at a Discount

Calculation of Forward rate Premium or Discount in annualized percentages:

Premium= x12 months

Forward rate – Spot rate
N
Spot rate

Discount = Spot rate – Forward rate x 12 months

Spot rate N

Where: N = number of months for which forward contract has been made.

Example:

From the data given below, let us calculate forward premium or discount, as it is applicable in
the case:

INR per British Pound

Spot Rate =>INR 78.0001 –INR 78.2254

1 month forward rate =>INR 78.4256 –INR 78.5200
3 months forward rate=>INR 77.8952 –INR 77.9999

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6 months forward rate=>INR 78.8925 –INR 78.9925

Solution:

Premium with respect to Bid Price:

1 month =(78.4256 – 78.0001)x12 x 100 = 6.5%
78.0001 1
6 months=(78.8925 – 78.0001)x12 x 100 = 2.29%
78.0001 6

Premium with respect to Ask Price:

1 month =(78.5200 – 78.2254)x12 x 100 = 4.52%
78.2254 1
6 months=(78.9925 – 78.2254)x12 x 100 = 1.96%
78.2254 6

Please note: Spot rates are higher than the forward rates in the case of 3 months forward contract.
Hence, forward rates are at a discount.

Discount with respect to Bid Price:

3 months=(78.0001 – 77.8952)x12 x 100 = 0.54%
78.0001 3

Discount with respect to Ask Price:

3 months=(78.2254 – 77.9999)x12 x 100 = 1.15%
78.2254 3

2) FUTURES

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined
time. If you buy a futures contract, it means that you promise to pay the price of the asset at a

37
specified time. If you sell a future, you effectively make a promise to transfer the asset to the
buyer of the future at a specified price at a particular time.
They are contracts to buy or sell an asset on or before a future date at a price specified today. A
futures contract differs from a forward contract in that the futures contract is a standardized
contract written by a clearing house that operates an exchange where the contract can be bought
and sold; the forward contract is a non-standardized contract written by the parties themselves

Types of futures contract

Agricultural

Metallurgical

Interest rate

Foreign exchange

Stock index

Mechanisiminfuture trading

Forward Contract Futures Contract

Meaning: A forward contract is an
agreement between two parties to
buy or sell an asset at a pre-
agreed future point in time.
A futures contract is a standardized
contract, traded on a futures exchange, to
buy or sell a certain underlying instrument
at a certain date in the future, at a
specified price.

Structure & Customized to customers need. Standardized. Initial margin payment

Purpose: Usually no initial payment required. Usually used for Speculation.
required. Usually used for
Hedging

Transaction Negotiated directly by the buyer Quoted and traded on the Exchange
method: and seller

Market Not regulated Government regulated market

regulation:

Institutional The contracting parties Clearing House

guarantee:

Risk: High counterparty risk Low counterparty risk

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Guarantees: No guarantee of settlement until
the date of maturity only the
forward price, based on the spot
price of the underlying asset is
paid
Both parties must deposit an initial
guarantee (margin). The value of the
operation is marked to market rates with
daily settlement of profits and losses.

Contract Forward contract mostly mature Future contracts may not necessarily
Maturity: by delivering the commodity mature by delivery of commodity

Expiry date: Depending on the transaction Standardized

Contract size: Depending on the transaction and Standardized

the requirements of the contracting
parties.

Features of Futures Market

 Trading is conducted in a competitive arena by „Open Outcry‟ of bids , offers and

amounts
 Contract terms are standardised
 Non member participants deal through brokers
 Participants include banks corporations, financial institutions, individual investors and
speculators
 The clearing house of the exchange becomes the opposite side to each cleared
transactions
 Margin deposits are required from all participants
 Settlement are made daily through the exchange clearing house . Gains on open positions
may be withdrawn and losses are collected daily.
 Long & short positions are liquidated easily
 Settlements are normally made in cash with only a small percentage of all contract
resulting in actual delivery.
 A single round trip (in and out the market), commission is charged .It is negotiated
Between broker and customer and is relatively snall in relation to the value of the
contract.
 Trading is regulated

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3)OPTIONS

Options are contracts that give the owner the right, but not the obligation, to buy or sell
an asset like stock, commodity, currency, index, or debt, at a specified price during a
specified period of time. The price at which the sale takes place is known as the strike price, and
is specified at the time the parties enter into the option. The option contract also specifies a
maturity date. Each option has a buyer, called the holder, and a seller, known as the writer. In the

case of a security that cannot be delivered such as an index, the contract is settled in cash.
For the holder, the potential loss is limited to the price paid to acquire the option. When an
option is not exercised, it expires.

Types

Call Option

The buyer of a Call option has a right to buy a certain quantity of the underlying asset, at
a specified price on or before a given date in the future, he however has no obligation whatsoever
to carry out this right. A customer will buy a call option when he believes that underlying asset
price will move higher

Eg: Mr A wants to buy some Reliance shares. Present rate is 250 per share. He will buy
a call option from B to buy 100 Reliance share at the price of 300 on Jan 31st 2013. For that A
will pay 25 Rs premium for per share. So as initial investment he will pay 25x100=2500 Rs to B.
If market price goes to 400 per share investor will exercise his right by paying 300000 Rs. He
can sell the shares in market for 400 get 400000 net gain is (400000-300000)-2500=7500If price
goes down to 200 he will not exercise the contract for that his loss will be only 2500

Put option

The buyer of a Put option has the right to sell a certain quantity of an underlying asset, at
a specified price on or before a given date in the future, he however has no obligation whatsoever
to carry out this right. A person buys a put option when he believes that asset price will become
low

For same above eg A buys a put option from B to sell reliance shares at 300 on Jan 31 st
2013, by paying premium 25/share.if share price goes down 200 he will exercise the option. Net
gain will be (300000-200000) -2500=7500. If price goes up by 350 , he will not exercise the
option and his loss will be just 2500

Currency option

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It gives the holder a right not he obligation to buy or sell a currency at a predetermined rate on
or before maturity.

Some aspects of currency options:

1. The cost of currency options is normally expressed as a percentage of the spot rate
prevailing at the time of entering into contract. This cost may be limited to the amount of
premium.

2. Usually in call option contracts, the risk seems to be more to the seller than the buyer.
These kinds of option contracts are mainly dealt in the major revolving currencies used
around the globe and that which are traded in OTC market actively. OTC refers to over-
the-counter market.

3. The option is called anEuropean option when it can be exercised only on the maturity
date. The option is called an American option when it can be exercised on any date upto
maturity.

4. If the exercise of an option immediately yields a positive value to its holder, it is said to
be in-money. The option is said to be at-money, in case where the strike price (exercise
price) is equal to the spot price. An option is said to be out-of-money when it has no
positive value.

5. At the time of entering into an option contract, the price paid by the buyer is called as
the option price or premium.

6. Exercise price or strike price is the pre-determined price at which the purchaser of the
option can exercise his option to purchase or sell the foreign currency.

7. Currency options can be repurchased or sold before the maturity date. This facility is
applicable in case of American options.

8. The intrinsic value of European and American options is given below:

American option intrinsic value = Spot rate – Exercise price

European option intrinsic value = Forward rate – Exercise price

Difference between options and futures

OPTIONS FUTURES

gives the buyer the right, but not the A futures contract gives the buyer the obligation to
obligation to buy (or sell) a certain purchase a specific asset, and the seller to sell and
asset at a specific price at any time deliver that asset at a specific future date, unless the

41
during the life of the contract holder's position is closed prior to expiration

Aside from commissions, an investor an options position does require the payment of
can enter into a futures contract with no a premium
upfront cost

It has asymmetric risk profile It has symmetric risk profile

Option price changes with change in asset and other

factors
Contract Prices changes with change in
underlying asset

Benefits of options

1) They are means of insurance against adverse price movement

2) It provide high leverage as with a small investment in form of premium

3) Trading options are cheaper in stock exchange

Key Differences

The major difference between an option and forwards or futures is that the option holder has no
obligation to trade, whereas both futures and forwards are legally binding agreements. Also,
futures differ from forwards in that they are standardized and the parties meet through an open
public exchange, while futures are private agreements between two parties and their terms are
therefore not public. Options can be standardized and traded through an exchange or they can be
privately bought or sold, with terms crafted to suit the needs of the parties involved. Another key
difference is that you must always pay money to buy an option because having th

SWAPS

Swaps are contracts to exchange cash (flows) on or before a specified future date based on the
underlying value of currencies exchange rates, bonds/interest rates, commodities exchange,

42
stocks or other assets. It is an agreement between two or more counterparties to exchange sets of
cash flows over a period in the future.

A swap is nothing but a barter or exchange A swap is the exchange of one set of cash flows for
another. It is a contract between two parties in which the first party promises to make a payment
to the second and the second party promises to make a payment to the first. Both payments take
place on specified dates.

Features

1. Counterparties – It involves the exchange of series of periodic payments between at least

2 parties

2. Facilitators- agreements are arranged by swap facilitators like brokers or swap dealers

3. Cash flows-Swap deal is an exchange of two financial obligations in future and both in
parties will have same financial obligation before swap deal

4. Documentations- transactions may be done faster since their documentation and

formalities are less compares to loan deals

5. Transaction cost- is relatively low compared to loan deals

6. Benefits to parties-deal are done only when both the parties are benefited

7. Termination- agreement between parties cannot be terminated without others consent

8. Default risk-swap deals are bilateral agreements so default from counter party exist

9. Duration -In a short-term swap (or money market swaps) the closing period can be up to
two years ahead. In a long/medium-term swap the closing period can be from two years onwards
(I've seen a 30-year swap traded

10. Unlike most standardized options and futures contracts, swaps are not exchange-traded
instruments. Instead, swaps are customized contracts that are traded in the over-the-
counter (OTC) market between private parties.

Uses of swap

The swap are used for 2 purpose:.

 Commercial needs

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The normal business operations of some firms lead to certain types of interest rate or currency
exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of
interest on deposits (e.g. liabilities) and earns a fixed rate of interest on loans (e.g. assets). This
mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a
fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into
floating-rate assets, which would match up well with its floating-rate liabilities.

 Comparative advantage

Some companies have a comparative advantage in acquiring certain types of financing.

However, this comparative advantage may not be for the type of financing desired. In this case,
the company may acquire the financing for which it has a comparative advantage, and then use a
swap to convert it to the desired type of financing.

For example, consider a well-known U.S. firm that wants to expand its operations into Europe,
where it is less known. It will likely receive more favorable financing terms in the U.S. By then
using a currency swap, the firm ends with the euros it needs to fund its expansion.

TYPES OF SWAPS

1. Interest Rate Swaps,

2. Equity Swaps,

3. Currency Swaps,

4. Commodity Swaps

Interest Rate Swap

It is an agreement between 2 parties who wishes to change the interest payments, or

receipts in same currency, on assets or liabilities. An interest rate swap (IRS) is the exchange of
two payment streams between two counterparties over an agreed period. The payments are
calculated using different interest rates and are based on the same notional principle amount.
The purpose of an IRS is to allow counterparties to convert an exposure from one stream of
payments into a second stream of payments. Normally, an IRS is the exchange of a fixed
payment for a floating payment with no principle being exchanged.

Currency Swap

A currency swap is an agreement between two parties in which one party promises to
make payments in one currency and the other promises to make payments in another currency. A
currency swap is the exchange of a fixed amount of one currency per annum for a fixed amount
of another currency per annum followed by an exchange of principal on maturity of the swap..
All currency flows are paid at an exchange rate agreed in advance. Currency swaps are used to

44
hedge foreign currency exposures. The most heavily traded currency swaps are: US dollars,
Euro, Yen and Sterling .

Difference – currency swap and interest rate swap

Currency swaps help eliminate the differences between international capital markets.
Interest rates swaps help eliminate barriers caused by regulatory structures. While currency
swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed
rate of interest with a variable rate. The needs of the parties in a swap transaction are
diametrically different.

Equity Swap

An equity swap is the exchange of two payment streams between two counterparties over
an agreed period where the first party makes payments that are based on the returns on a stock or
a stock index and the counterparty makes payments of either a fixed amount, a floating amount
or payments based on the returns of a stock or a stock index. Practically under an equity swap,
the shareholder effectively sells his holdings to a bank, promising to buy it back at market price
at a future date. However, he retains a voting right on the shares .But the returns from an equity
swap can be negative.

Commodity Swap

A commodity swap is the exchange of two payment streams between two counterparties
where the cash flows are dependant on an underlying commodity Commodities are physical
assets such as metals, energy stores and food including cattle. E.g. A producer of a commodity
may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange
for a rate linked to the commodity prices.

The first party (e.g. an oil user) would pay a fixed amount and receive payments based on the
market value of the commodity involved (i.e. a specified volume of the commodity over a
specified period) and the oil producer would do the opposite i.e. make payments based on the
market value of the commodity and receive fixed payments for the commodity

Arbitrage refers to an act of purchasing a currency in one foreign exchange market at a

lower price and selling it in another market at a higher price. This results in equilibrium in the
exchange rates of different currencies. In spot markets, the arbitrage can take the type of
geographical arbitrage or triangular arbitrage. In forward markets, the arbitrage can take the form
of covered interest arbitrage.

Hedging ,speculation and Arbitrage

The risk involved in dealing in the forward foreign exchange market can be covered by activities
like hedging, speculation and arbitrage.

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~ The activities allow the dealers not only to cover the risks involved but also to earn profit by
taking advantage of the forward exchange market.

HEDGING:

 Hedging covers the risk arising out of changes in the exchange rate. It is especially
essential for firms having large amounts receivables or commitments to pay in foreign
currencies.
 The strategy of hedging involves increasing the currency that is likely to appreciate and
decreasing the currency that is likely to depreciate.
 It also involves decreasing liabilities in the currency that is likely to appreciate and
increasing liabilities in the currency that is likely to depreciate.

SPECULATION:

 Speculation involves purchase and sale of foreign exchange in the forwards market with
the intention of making profit by taking advantage of changes in foreign exchange rates.
 They speculate on the basis of their own calculation of the difference between the
forward rate and spot rate that may prevail at a future date.
 Speculators try to minimise their loss by entering in spot and forward agreements
simultaneously.
 Speculation may have stabilising or destabilising effect.
 Stabilising speculation refers to purchase of foreign currency when the domestic price of
a foreign currency when the domestic price of a foreign currency falls with the
expectation of its increase in the future.
 Destabilising speculation refers to sale of foreign currency when the exchange rate falls
with the expectation that it would fall further. This magnifies exchange rate fluctuations
and proves highly disruptive to the international flow of trade and investment.

ARBITRAGE:

 Arbitrage refers to purchase of an asset in a low price market and its sale in a higher price
market.
 This process leads to equalisation of price of an asset in all the segments of the market.
 Arbitrageurs take advantage of the different exchange rates prevailing in various foreign
exchange markets due to different interest rates.
 They purchase foreign currency from the foreign exchange market with lower exchange
rate and sell the same in market with a higher exchange rate.

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  Arbitrage is also possible within the country where two banks offer two different bids and
asking rate.
 When arbitrage involves only two currencies or two countries, it is called two-point
arbitrage. It increases the supply of dearer currency.

QUESTIONS

2marks:

1. What is exchange rate

2. What is derivatives
3. What is forward
4. What is Futures
5. What is Option
6. What is American option and European option
7. What is Swaps
8. What is Strike price
9. What is Hedging
10. What is Ask. bid and spread
11. What is exposure
12. What is netting

8marks:
13. Types of options.
14. Explain the trading mechanism of futures
15. Features of forwards
16. Features of future market
17. Explain currency swap with a example.
18. What are the advantages of currency options
19. Distinguish between futures and options

16marks:

1. Explain different types of derivatives used in forex market

2. Explain different types of exposure and methods to manage those exposures
3 Distinguish between forwards and futures
4 What are swaps. Give advantages and disadvantages.

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 5 Explain mechanism of future trading.
6 Explain types of swaps.
7 Explain the types of options.
8 What are the techniques of hedging.

Unit 5

International Financial Institutions & Liquidity

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At the Bretton Woods Conference in 1944 it was decided to establish a new monetary order
would expand international trade, promote international capital flows and contribute to
monetary stability. The IMF and the World Bank were borne out of this Conference of
the end of World War II.

INTERNATIONAL MONETARY FUND

The International Monetary Fund (IMF) came into official existence on December 27, 1945,
when 29 countries signed its Articles of Agreement (its Charter) agreed at a conference
held in Bretton Woods, New Hampshire, USA, from July 1-22, 1944. The IMF
commenced financial operations on March 1, 1947.

IMF is a cooperative institution that 182 countries have voluntarily joined because they see the
advantage of consulting with one another on this forum to maintain a stable system of
buying and selling their currencies so that payments in foreign currency can take place
between countries smoothly and without delay. Its policies and activities are guided by its
Charter known as the Articles of Agreement.

Statutory purposes (Objectives`)

The purposes of the International Monetary Fund are:

• To promote international monetary cooperation through a permanent institution that provides

the machinery for consultation and collaboration on international monetary

problems.

• To facilitate the expansion and balanced growth of international trade and to contribute,
thereby, to the promotion and maintenance of high levels of employment and real income
and to the development of the productive resources of all members as primary objectives
of economic policy.

• To promote exchange stability, to maintain orderly exchange arrangements among members

and to avoid competitive exchange depreciation.

• To assist in the establishment of a multilateral system of payments in respect of current

transactions between members and in the elimination of foreign exchange restrictions
which hamper the growth of world trade.

• To give confidence to members by making the general resources of the Fund temporarily
available to them under FM-305 492 adequate safeguards, thus providing them with

49
opportunity to correct maladjustment in their balance of payments without resorting to measures
destructive to national or international prosperity.

• In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in
the international balances of payments of members.

Functions of IMF

1Exchange arrangements

2 Surveillance :IMF produces reports on member countries economies and suggest areas of
weakness / possible danger. The idea is to work on crisis prevention by highlighting areas
of economic imbalance.

3Exchange restrictions –

4Consultation & technical assistance

5 Lending for BOP difficulties -The IMF has $300 billion of loanable funds. This comes from
member countries who deposit a certain amount on joining. In times of financial / economic
crisis, the IMF may be willing to make available loans as part of a financial readjustment.

Criticism of IMF

1.Conditions of Loans

2. Exchange rate refoms

3 Devaluation

4 Neo Liberal criticism

5 Free market criticism of IMF

6 Lack of transparency and involvement

7 Supporting military dictatorships

SPECIAL DRAWING RIGHTS

As time passed, it became evident that the Fund‟s resources for providing short-term
accommodation to countries in monetary difficulties were not sufficient. To resolve the situation,
the Fund, after much debate and long deliberations, created new drawing rights in1969. Special

50
Drawing Rights (SDRs), sometimes called paper gold, are special account entries on the IMF
books designed to provide additional liquidity to support growing world commerce. Although
SDRs are a form of money not convertible to gold, their gold value is guaranteed, which helps to
ensure their acceptability. Initially, SDRs

worth $9.5 billion were created.Participant nations may use SDRs as a source of currency in a
spot transaction, as a loan for clearing a financial obligation, as a security for a loan, as a Swap
against currency, or in a forward exchange operation. A nation with a balance of payments need
may use its SDRs to obtain usable currency from another nation designated by the fund. A
participant also may use SDRs to make payments to the Fund, such as repurchases. The Fund
itself may transfer SDRs to a participant for various purposes including the transfer of SDRs
instead of currency to a member using the Fund‟s resources.

The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the
freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in
exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges
between members; and second, by the IMF designating members with strong external positions
to purchase SDRs from members with weak external positions. In addition to its role as a
supplementary reserve asset, the SDR serves as the unit of account of the IMF and some other
international organizations.

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT(WORLD

BANK )

The World Bank group is a multinational financial institution established at the end of World
War II (1944) to help provide long-term capital for the reconstruction and development
of member countries. The group is important to multinational corporations because it
provides much of the planning and financing for economic development projects
involving billions of dollars for which private businesses can act as contractors and
suppliers of goods and engineering related services.

The purpose for the setting up of the Bank are

- To assist in the reconstruction and development of territories of members

- To promote private foreign investment by means of guarantees or participation in loans

- To promote the long-range balanced growth ofinternational trade

51
- To arrange the loans made or guaranteed by it in relation to international loans

-To conduct its operations with due regard to the effect of international investment

The World Bank is the International Bank for Reconstruction and Development (IBRD) and the
International Development Association (IDA). The IBRD has two affiliates, the
International Finance Corporation (IFC) and the Multilateral Investment Guarantee
Agency (MIGA). The Bank, the IFC and the MIGA are sometimes referred to as the
“World Bank Group”

The International Bank for Reconstruction and Development (IBRD), commonly referred to as
the World Bank, is an international financial institution whose purposes include assisting the
development of its member nation‟s territories, promoting and supplementing private foreign
investment and promoting long-range balance growth in international trade.

The World Bank was established in December 1945 at the United Nations Monetary and
Financial Conference in Bretton Woods, New Hampshire. It opened for business in June 1946
and helped in the reconstruction of nations devastated by World War II. Since 1960s the World
Bank has shifted its focus from the advanced industrialized nations to developing third-world
countries.

Organization and Structure:

The organization of the bank consists of the Board of Governors, the Board of Executive
Directors and the Advisory Committee, the Loan Committee and the president and other staff
members. All the powers of the bank are vested in the Board of Governors which is the supreme
policy making body of the bank.

The board consists of one Governor and one Alternative Governor appointed for five years by
each member country. Each Governor has the voting power which is related to the financial
contribution of the Government which he represents.

The Board of Executive Directors consists of 21 members, 6 of them are appointed by the six
largest shareholders, namely the USA, the UK, West Germany, France, Japan and India. The rest
of the 15 members are elected by the remaining countries.

Each Executive Director holds voting power in proportion to the shares held by his Government.
The board of Executive Directors meets regularly once a month to carry on the routine working
of the bank.

The president of the bank is pointed by the Board of Executive Directors. He is the Chief
Executive of the Bank and he is responsible for the conduct of the day-to-day business of the
bank. The Advisory committees appointed by the Board of Directors.

52
It consists of 7 members who are expects in different branches of banking. There is also another
body known as the Loan Committee. This committee is consulted by the bank before any loan is
extended to a member country.

Capital Resources of World Bank:

The initial authorized capital of the World Bank was $ 10,000 million, which was divided in 1
lakh shares of $ 1 lakh each. The authorized capital of the Bank has been increased from time to
time with the approval of member countries.

On June 30, 1996, the authorized capital of the Bank was $ 188 billion out of which $ 180.6
billion (96% of total authorized capital) was issued to member countries in the form of shares.

Member countries repay the share amount to the World Bank in the following ways:
1. 2% of allotted share are repaid in gold, US dollar or Special Drawing Rights (SDR).

2. Every member country is free to repay 18% of its capital share in its own currency.

3. The remaining 80% share deposited by the member country only on demand by the World
Bank.

Objectives:
The following objectives are assigned by the World Bank:
1. To provide long-run capital to member countries for economic reconstruction and
development.

2. To induce long-run capital investment for assuring Balance of Payments (BoP) equilibrium
and balanced development of international trade.

3. To provide guarantee for loans granted to small and large units and other projects of member
countries.

4. To ensure the implementation of development projects so as to bring about a smooth

transference from a war-time to peace economy.

5. To promote capital investment in member countries by the following ways;

(a) To provide guarantee on private loans or capital investment.

(b) If private capital is not available even after providing guarantee, then IBRD provides loans
for productive activities on considerate conditions.

Functions:

53
World Bank is playing main role of providing loans for development works to member countries,
especially to underdeveloped countries. The World Bank provides long-term loans for various
development projects of 5 to 20 years duration.

The main functions can be explained with the help of the following points:
1. World Bank provides various technical services to the member countries. For this purpose, the
Bank has established “The Economic Development Institute” and a Staff College in Washington.

2. Bank can grant loans to a member country up to 20% of its share in the paid-up capital.

3. The quantities of loans, interest rate and terms and conditions are determined by the Bank
itself.

4. Generally, Bank grants loans for a particular project duly submitted to the Bank by the
member country.

5. The debtor nation has to repay either in reserve currencies or in the currency in which the loan
was sanctioned.

6. Bank also provides loan to private investors belonging to member countries on its own
guarantee, but for this loan private investors have to seek prior permission from those counties
where this amount will be collected.

International Development Association

The IDA was formed in 1960 as a part of the World Bank Group to provide financial support to
LDCs on a more liberal basis than could be offered by the IBRD. The IDA has 137
member countries, although all members of the IBRD are free to join the IDA. IDA‟s
funds come from subscriptions from its developed members and from the earnings of the
IBRD.

Functions :

1. Aims to reduce poverty by providing loans and grants for programs that boost
economic growth.
2. IDA complements the IBRD
3. Lend money on concessional terms to the needy countries
4. To co-ordinate with the World Bank in c0-financing
5. Provide long term credit to poor countries at soft terms
6. Create supplementary sources of capital for member countries
7. To increase productivity
8. To promote economic growth of member developing countries.

54
MULTILATERAL INVESTMENT GUARANTEE AGENCY (MIGA)

Established in 1988 to help developing countries attract and retain private investment, it
furnishes private enterprises investing in developing countries with non-commercial risk
insurance and provides developing country members with technical assistance regarding
investment promotion. MIGA guarantees protected investors against loss resulting from
expropriation, breach of contract, war and civil disturbance including insurrection, coups d‟état,
revolution, sabotage and terrorism. In addition to offering insurance to private companies, MIGA
mobilizes additional guarantees for investors and assists host governments with legal services
and strategic advice regarding investment.

By September 2008, MIGA had issued 922 guarantees for over 96 developing countries
cumulatively worth over $19.5 billion since 1990.

In addition to providing political risk insurance to corporations that want to invest in developing
countries, MIGA offers advisory services to developing country governments. The organization
advises on the policies and procedures these governments should follow and the best ways these
countries can attract foreign investment. Other services by the MIGA include licensing
arrangements, franchising and technology support.

INTERNATIONAL LIQUIDITY

The term 'international liquidity' includes all those assets which are internationally acceptable
without loss of value in discharge of debts .

In its simplest form, international liquidity comprises of all reserves that are available to the
monetary authorities of different countries for meeting their international disbursement. In short,
the term 'international liquidity' connotes the world supply of reserves of gold and currencies
which are freely usable internationally, such as dollars and sterling, plus facilities for borrowing
these. Thus, international liquidity comprises two elements, viz., owned reserves and borrowing
facilities.

Components of International Liquidity

Under the present international monetary order, among the member countries of the IMF, the
chief components of international liquidity structure are taken to be:

1. Gold reserves with the national monetary authorities - central banks and with the IMF.

2. Dollar reserves of countries other than the U.S.A.

55
3. £-Sterling reserves of countries other than U.K.

It should be noted that items (2) and (3) are regarded as 'key currencies' of the world and their
reserves held by member countries constitute the respective liabilities of the U.S. and U.K. More
recently Swiss francs and German marks also have been regarded as 'key currencies.

4. IMF tranche position which represents the 'drawing potential' of the IMF members; and

5. Credit arrangements (bilateral and multilateral credit) between countries such as 'swap
agreements' and the 'Ten' of the Paris Club.

Of all these components, however gold and key currencies like dollar today entail greater
significance in determining the international liquidity of the world.

However, it is difficult to measure international liquidity and assess its adequacy. This depends
on gold and the foreign exchange holdings of a country, and also on the country's ability to
borrow from other countries and from international organisations. Thus, it is not easy to
determine the adequacy of international liquidity whose composition is heterogeneous.

Moreover, there is no exact relationship between the volume of international transactions and the
amount of necessary reserves In fact, foreign exchange reserves (international liquidity) are
necessary to finance imbalances between international receipts and payments. International
liquidity is needed to service the regular How of payments among countries, to finance the
shortfall when any particular country's out payments temporarily exceed its in-payments, and to
meet large withdrawals caused by outflows of capital.

Thus, external or internal liquidity serves the same purpose as domestic liquidity, viz., to provide
a medium of exchange and a store of value. And the primary function of external liquidity is to
meet short-term fluctuations in the balance of payments.

Questions:

2 marks:

 What is IMF?
 What is IBRD?
 What is IDA
 What is MIGA
 What are SDRs?
 What is International Liquidity?

8 marks:

 What are the activities of IMF?

56
  Difference between IMF & World Bank.
 Discuss criticism of IMF
 Explain the role of SDRs?
 What are the functions of IDA?

16 marks:

 Explain the structure, objectives and functions of IMF.

 Explain the role of World Bank.
 Discuss the components and problems of International Liquidity.

57