PREFACE

Global Financial Analysis is very wide in its scope of theory and

applications. Lessons on the topics take the overview of each topic. In depth
study is not possible without reading suggested books under different units. Also
it is suggested that, the terms can be rightly appreciated only when the students
shall establish the rapport with the firm which is engaged in import and export on
a large scale or bank or financial institution having Foreign Exchange Division.

This study material shall induce the students to obtain right feel of
the subject.
The students are recommended to read the details from the
suggested books and also involve in completion of projects and field work.
On completion of filed/project work and with the suggested
readings they can develop excellent insights, even at Diploma level.

Similarly, since the International Financial System has become

extremely dynamic and complex after 1991, globalization; the glossary of key
terms has been given so as to have a proper interpretation of the subject.
This material in brief, gives very comprehensive perspective of
International Financial World.
Orientation to the subject can be fairly attained from the same.

The subject is little complex than other units and therefore needs
more efforts for the preparation of the subject from both academic as well as
practice point of view.
The students are made aware to be proactive and take proper
assistance of the material.

xxxxxx

1
In order to understand the subject in detail following summary should be
given proper attention, which is very specific.
Sr.No. Name of Topic Ref. Book Pg.From Pg.To
International
Financial
01 International Financial System 85 90
Management. By-
V.K.Bhalla
02 Rise & Fall of Bretton Woods ---------do--------- 27 32
Globalization & Growth of ---------do---------
03 97 98
derivatives.
04 The crash of 1994-96 & beyond ----------do--------- 105 122
-----------do--------
International 08 09
05 Euro currency issues Financial
Management By- 100 101
P.G.Apte
Euro Currency Futures & ----------do--------- 240 241
06
Options 289 290
International
Financial
07 Syndicated Euro Credits 531 533
Management By-
P.G.Apte
08 International Bonds Market ----------do--------- 547 548
The Journal of
Institute of Chartered
09 Swaps & Markets 12 20
Accountants of India
Dec 1999 issue
International
Financial
10 Pricing options 290 323
Management. By-
V.K.Bhalla
International
Financial
11 Features of International Bonds 525 539
Management By-
P.G.Apte
Central Bank & Balance of -----------do--------
12 54 63
Payment.
13 European Monetary System & ------------do--------- 87 87
International
other regional artificial currency

2
 Financial
areas. Management. By- 345 345
Avdhani.
IFM By- V.K.Bhalla 507 509
14 International Capital Market - P.G.Apte
648 650
International Banking & Country IFM By- V.K.Bhalla
15 805 811
risk
International portfolio IFM By- P.G.Apte
16 497 500
diversification.
17 International Transfer Pricing IFM By- P.G.Apte 574 574

Other Books for References : Refer the Bibliography on Page Number 154.

*****

UNIT : 1 : International Financial System

CONTENTS
________________________________________________________________
Lesson Number Lesson Starting Ending

3
 Page Page
________________________________________________________________

1. Evolution of International
Financial System 5 11

2. Rise and Fall of Bretton Woods 12 15

3. Globalisation and Growth

Of Derivatives 16 24

4. The crash of 1994-96

And Beyond 25 29

Unit No. 1
International Financial System

Learning objectives: - To study the important milestones, which framed the

current financial system at international level and to learn about the overall
financial environment in which the multinational corporations operate.

4
Lesson No. 1. :
Evolution of international financial systems:

Introduction: To study the evolution of international Financial System; pattern in

which the recent international financial system got gradually moulded into a
comprehensive mechanism of international trade settlement and its effective
management is required to be closely looked at.. The important landmark
incidents which gave shape to the present day international financial system
focuses the need of having a global market wherein there becomes possible a
free flow of transactions across various countries of the world. The impact of
these landmark incidents as present day economic order is also an interesting
aspect, which is required to be looked at.

Gold Standard : The Gold Standard means fixing the price of gold in terms of
the currency of a nation . Before the emergence of currencies of the countries ;
the gold was used as the only mechanism to settle the trade and financial
transactions. Before the first World War ; this methodology was being widely
practiced. But as the trade expanded ; it became very inconvenient to settle the
value of the transactions in terms of gold. It was also very difficult and risky to
possess and carry the stock of gold. A need was felt to bring in place a more
safe , secure and accurate system whereby the transactions could be settled
effectively , easily and accurately .

With this need in mind ; currency of each nation got evolved.

Because of this ; the arbitrariness could be avoided and the transactions could
be effectively settled. However it gave rise to exchange rates in between these
currencies. The exchange rate refers to the quantity of a currency which is
required to be given for purchasing one unit of another currency. For example
US $ 1 = Rs. 45. This is the exchange rate between the US Dollar and the Indian

5
Rupee which denotes that for purchasing one US $ ; Rs. 45 in Indian Rupees are
required to be paid.

The days of fixed exchange rate regime is a thing of the past. The
companies are required to function in a turbulent environment wherein there are
constant fluctuations in the exchange rates of the currencies. The trade between
the various countries as well as the aspect of capital and technology transfer has
never been so complicated earlier. This situation makes it very much necessary
on the part of the multinational corporations to effectively devise the ways and
the means to hedge their positions against the possible adverse movement in
the exchange rates and their repercussions on their revenue and cash flow
positions. For the reason of having a stable exchange rate regime ; in order to
facilitate the trade easily ; many European countries have adopted a common
currency known as Euro whereby the intra-European trade and investment has
become less skeptical to exchange rate risk.

International Financial System is thus a framework within which

international payments are made by accomodating movement of capital and
determination of exchange rates.

The origin and emergence of international financial system can

be traced to the sectoral and national interdependence leading to international
economic , commercial , and financial relations between the countries. It results
in an exchange of goods and services involving payments and receipts between
various countries and exchange of currency. These transactions and trading in
foreign currencies and foreign assets or liabilities and foreign claims constitutes
the international financial system.

Following three types of transactions lead to the emergence of

international finance :

6
• Economic and commercial transactions involving exchange of goods for
money abroad constituting the merchandise trade the worldwide.

• Trade in invisible items in the form of export of services like banking and
insurance , technical consultancy , emigrant labour services etc. The country
can also get remittances in the form of profits , dividends , interest on the
capital invested abroad, royalties on patents , trademarks , copyrights ,
technical know-how exported abroad.

• Inflow of funds involving unilateral transfers in the form of charities ,

donations , gifts , free samples to the residents or companies in the country
from abroad.

These categories of export of goods and services constitute the

current items of the Balance of Payments of a country. The outflows in the form
of import of merchandise and services to the foreign countries constitute the
supply of domestic funds in the international markets. Because of these
transactions in the international system of trade ; there involves an exchange of
currencies . This constitutes the foreign exchange market where one currency
is exchanges for another.

Each country is a sovereign and has got its own national

currency . But the international transactions are to be settled by exchange of
one currency with the currencies of other countries. These transactions in foreign
currencies results in various forms of financial claims in the form of assets and
liabilities denominated in foreign currencies.

The management of international finance has assumed

tremendous significance in the light of integration of the global financial markets.
The management of international finance requires special precautions to be
exercised along with a high degree of vigilance and a deeper understanding of

7
the practices , strategies and instruments as opposed to that in the domestic
financial environment.

An important aspect of international financial system is the

international trade which accounts for the largest chunk of international
commercial and financial relations and payments . Another aspect is the
institutions and the organisations in it under which the banks , national , and
international financial institutions represents the institutional framework. The sub-
markets in the financial system like foreign currency , flow of investments and
capital , foreign claims etc. constitutes the financial flows between the countries.
Thus ; both the international trade and international currency and exchange
markets are closely connected with each other. International financial institutions
plays a crucial role in directing the flow of funds in various countries through their
settlement systems.

The finance manager of a multinational company in a liberalised

set up is required to be very vigilant in so far as it relates to the play of crucial
market forces which are ever changing. He has to ensure an optimum utilization
of finance in order to maximize the wealth of the shareholders. He has to take a
systemic view of the organisation as a whole and has to judge the impact of his
decisions on other functional areas like production , personnel , marketing etc.

The peculiar features of international finance which separates it

from the domestic finance can be summarised as follows :

i. The presence of Foreign exchange and Political risk

ii. The inherent imperfections in the market
iii. A wide range of techniques , practices and the instruments which are
used to hedge against the likely fallout of an array of risks.

8
 Now ; let us see these aspects in brief. The transactions
between two or more nations necessarily involves the presence of the different
currencies. The individuals , firms and multinational corporations involved in
cross border transactions are necessarily exposed to the foreign exchange risk.
The situation becomes complex in view of the fact that the exchange rates
between the various currencies of the world changes continuously.

The exchange rates among the various major currencies like US

Dollar , French Franc , Japanese Yen , British Pound and Euro fluctuates
continuously and as such is very difficult to predict . Since 1970 ; when the fixed
exchange rates has been abandoned ; that such a situation is being encountered
with at the international level of finance.

The political risk manifests itself in the form of changes in the

respective government policies , tax laws , rules and regulations , political
uncertainty , international obligations, internal unrest and the overall economic
and financial policies .It has the potential of changing the “rules of the game”
against which the affected parties may not be having a lasting recourse.

The market imperfections in the form of entry barriers , legal

restrictions , huge transaction costs , lack of proper infrastructural facilities ,
discriminatory taxation policies etc. are still present in the world markets which
has added a new dimension in the management of the international finance.

These impediments causes frictions and thus a smooth flow of

the transactions may get hampered. This fact does also put restrictions on the
international portfolio diversification and before taking the decision of such a
diversification ; the pros and cons of the likely fallout of such an action are
required to be examined in the minute details. However when the firm (s ) enter
the global financial markets ; a wide range of opportunities are also open to it.
Only thing is that with a judicious mix of strategies , policies , techniques and

9
application of available and latest instruments these opportunities are required to
be converted into profitable ventures.

The aim of any financial management ; whether domestic or

global ; is the maximization of the wealth of the shareholders by optimizing the
returns through the effective management of risks. In this respect the firms and
the multinationals are also required to maintain the highest standards of
transparency , and Corporate Governance. The corporate Governance is the
legal and financial framework for regulating the relationship between the
company and the shareholders. It ensures the shareholders are properly
informed and they get fair returns on their investments.

Key Words : Corporate Governance , Foreign Exchange Risk , Exchange Rate ,

Globalized and integrated world economy , Market imperfections , Multinational
corporations ( MNCs ) , Political Risk , Maximization of shareholders’ wealth.

Reference Sites : i. www.cia.gov

ii. www.imf.org
iii. www.unctad.org

Self Study Questions :

1. Explain how will you co-relate the international financial system and the
management of international finance.
2. Explain in detail how the international financial management is different from
the domestic financial management ?
3. What do you mean by the term Multinational Corporations ? Explain their role
in the international financial system.
4.With the specific case of Indian economy ; explain how the economic well
being of a country gets enhanced through the free trade of goods and services
in the international trade. Explain with suitable examples.

10
Project / Field Work : Visit the site of Sony Corporation and study the scope
of the geographical diversification and the impact of the Corporate Governance
on the financial and operating performance of the company.

Additional / Suggested Reading :

1. International Finance and Open Economy Macroeconomics : 2 nd Edition .
Upper Saddle River , N.J. : Prentice Hall , 1994. Authored by : Rivers- Batiz ,
Fransisco L. , and Luis Rivera – Batiz.

**********

Lesson No. 2.
The rise and fall of Bretton woods

Study Objective : The study objective in this lesson is to have the knowledge of
the forces which led to the fall of Bretton Woods and lessons to be learnt
therefrom.

11
 During the World War II, the most economies of the various
nations of the world went haywire. The balance of payment position deteriorated
to an all time low. The foreign exchange reserves position also got the worst
ever. Inflation gripped the economies of the nations, which was not easily
controllable.

Towards the end of World War II the governments of the leading trading
nations of the free trade decided that such a chaotic financial condition can not
be tolerated in the future after the end of war. In order to create a financially
disciplined atmosphere and to bring in element of change, which will qualitatively
improve the economic conditions; an International Monetary and Financial
Conference of the United and Associated Nations was convened at Bretton
Woods on 1st July 1944. It was attended by 44 nations. It is famously known as
Bretton Woods.

It established the liberal international economic regime of the

post-war era. The urgent task before this fund was to restructure the post war
economic positions of the countries. Rise of economic nationalism, competitive
devaluations and lack of international economic cooperation were identified as
the main reasons for economic crisis and chaos. The same was also contributed
by the political instability, as the economy and political stability are the factors,
which are very closely related with each other and has got interaction with each
other.

The object of Bretton woods: To establish an international economic system that

would prevent another political and economic collapse. In order to achieve these
objective, a multi pronged strategy was adopted. It included :

• Provision of adequate liquidity so as to counter the short-term balance of

payments problems.

12
• To create an adequate mechanism wherein international adjustment can be
made. There was a commitment to free trade and an open international
economy spreading its tentacles across various countries of the world not
being limited by their respective national boundaries. This fund, which was
established in Bretton woods, is known as International Monetary Fund (IMF).
It tried to keep in place an orderly expansion of international trade. Thus
Bretton woods created an institutional mechanism in the form of IMF to
supervise and promote an open and stable international monetary system by
promoting international monetary cooperation to promote and maintain a high
level of employment, to develop the productive resources for the economic
development, to promote exchange arrangements, to avoid competitive
exchange depreciation, to establish the multilateral system of payments and
thereby to eliminate foreign exchange restrictions.

The fund is to regulate the financial relations of its members. It

shall also provide financial assistance to member countries, which faces a
balance of payments problem. The fund also provides consultation services to its
member nations. Among 44 nations represented at Bretton woods conference;
28 nations were underdeveloped. Their influence was minimum. These
underdeveloped and developing nations were at a subordinate position vis-à-vis
the developed nations. The developed countries rejected the request of
developing countries in respect of the development of resources and productive
power of all members countries with due regard to underdeveloped nations. This
created an impression that IMF is anti-development. The contention of IMF is that
a stable economic environment is a necessary pre-requisite for the attainment of
economic development. Economic development was not a prime goal of the
international regime established at Bretton woods. The concerted efforts by the
developing countries for a recognition of their particular interest has obtained
limited success.

13
 The IMF has rarely been able to exercise an effective degree of
control over advanced industrial countries. However, it has kept increasing
control over the Third World, which is dependent upon the financial resources
provided by IMF. The hegemony of the United States in the global political
economy enabled it to exercise a dominant role in the IMF. US successfully
initiated policy changes and controlled access to the funds resources. The
absence of an effective coalition of developing countries led to the
marginalisation of their interests.

In 1960s there was an unprecedented economic growth for the

major capitalist economies. As trade increased; severe liquidity problem became
apparent. Even the US ran into severe balance of payment problem and it could
not continue indefinitely providing resources to the rest of the world. This was the
result of inherent contradictions of Bretton woods system and US misuse of the
dollar’s hegemonic position. This resulted in diminishing the confidence in dollar
denominated assets and the dollar holding got converted into gold. Declining
American competitiveness was matched by increasing European and Japanese
efficiency. It was the adjustment problem rather than the liquidity issue which led
to the fall of Bretton woods system.

Key words : Bretton Woods, Conference, economic system, IMF,Euro.

Self Study Questions :

1. Elaborate the objectives of global economic system ?
2. Explain the features of Balance of Payment ?
3. Write a note on the rise & fall of Bretton Woods ?
4. What were the main objectives of Bretton Woods System ?

Field/Project work :-
Visit the site of I.M.F.and list down its areas of functions.

14
Reference Sites :
1. www.imf.org
2. www.pacific.commerce

Suggested Readings :
1.International Finance – Prof.V.A.Avadhani & V.A.Ghosh – Himalaya Publishing
House.
2.International financial management – Text & Cases – Prof.B.K.Bhalla – Anmol
Publication. New Delhi.
3.International Finance – Prof. A.K.Seth – Gargotia Publications.
4.International Financial Management – Prof. P.K.Jain, S.S.Yadav & Prof.
Peyard.
5.International Finance – Prof.P.G.Apte Tata McGrawhill – Delhi.
6.International Finance – M.Agarwal - Institute of Finance New Delhi
7.International Finance – Prof. C.S.Nagpal & A.C.Mittal
8.Case problems in International Finance – Prof.W.C.Kester and
Prof.T.A.Luehrman McGrawhill – Newyork.
*******

Lesson No. 3.
Globalization and Growth of Derivatives

Learning Objectives : The objective of the study in this lesson is to study the
aspect of globalization and the important of the derivative products in
international financial along with mechanism of derivative.

15
 At the very early stages of trade, it was predominantly a
barter exchange i.e. exchange of goods for goods. No currency was there in
which price of a particular commodity can be expressed and exchanged. As the
trade increased, a need was felt to designate a currency in which the settlement
of transaction can be made. At that time, the gold got recognition as a currency
for settlement of transactions and gold standard was established. It envisaged
exchange of a specific quantity of gold for a particular quantity of commodity.
Thus as the trade increased, a genuine need for common currency was felt as
the gold may not always be available in required quantity and is always risky to
carry the same.

After industrial revolution, there was an advent of new

technology and machinery. In developed countries; technology machinery driven
production was being carried out, as the labour was costly in those countries.
However, in developing countries, the labour was in huge supply and it was also
cheap. These developing countries started importing the goods produced by
developed countries. Gradually, import was also effected by these developing
countries of technology and machinery. Thus the trade between various
countries increased very rapidly. Each country at that time was having its own
currency, which was used as a mechanism of trade settlement.

Due to increase in trade in between various countries,

there arose the problem of settlement of the transaction because of different
currencies of various nations. At that point, US $ was designated as the currency
in which the majority of the transactions got settled. However, the problem
continued in respect of exchange rates, which was determined partly by interplay
of demand and supply and partly by the intervention of the Reserve Bank of the
respective country. This led to the advent of management of international finance
for minimizing the risk of losses due to adverse fluctuations in exchange rates

16
and maximization of profit by taking the benefit of any favourable movement in
exchange rates.

As the trade between various countries increased, the

national geographical boundaries in terms of trade became blurred. For the
purpose of trade, the globe just became a village wherein there became free
movement of goods and services from one country to another without any
barriers. The trade became globalised trade. The economies of the world opened
up and the approach of liberalization started taking the roots. The establishment
of GATT was a main incidence, which tried to remove all the tariff and no-tariff
barriers in the international trade.

Because of liberalization of economies and globalization of

trade, there was a free flow of capital among various countries, which increased
the interest of the stakeholders. Multinational companies came into existence
with huge capital being contributed by institutional and individual investors.
Concept of the maximization of wealth of shareholders became more crucial as
the consumer became the king of the market-oriented economy. Equity markets
played a crucial role for sale and purchase of corporate equity.

Changing interest rates and exchange rate expectations,

new highs reached by equity markets and the sharp reversal of leveraged
positions in the late 1998 stimulated the activity in derivatives market. Investors
withdrew from risky assets and shifted their exposure towards highly rated and
liquid government securities. In the field of Globalization, cross-currency
derivatives and credit derivatives used to occupy important places. A derivative is
an instrument the value of which depends upon the value of the asset underlying
such an instrument. Any change in the value of underlying asset will result in a
corresponding change in the value of derivative product.

17
 In cross-currency derivatives, the steady appreciation of
the dollar against the Yen increased the activity in related options, which to
some extent negatived the impact of the decline in intra-European business and
currencies of emerging markets. Then there was unwinding up of short yen
positions & the deleverage in dollar denominated securities. It led to high volatility
in major exchange rates. However, partial resumption of forward contracts took
place once there was some improvement in Asian business environment.

Globalization is the integration of financial markets of the world

into an international financial market. The restrictions on issuers and investors
regarding confinement to their respective national boundaries has been
eliminated. This has been influenced by deregulation and liberalisation of the
markets and the activities of the market participants in various financial
locations. Technological advancement has given a huge phillip and screen based
trading has become the order of the day with very fast settlement of the
transactions with the clinical accuracy , transparency and saving in the
transaction costs. The advancement in the computer technology coupled with
effective telecommunications systems has made it possible to use and transmit
the real time information on exchange rates , share price quotations , and other
important variables to many market participants across the world at a very high
speed.

The restrictions on movement of capital , technology has been

removed and the initiatives for liberalising the working of financial markets has
been taken on a war footing.

In respect of credit derivatives, the Asian crisis; which stem from

banks’ exposure to highly borrowed/leveraged institutions and emerging market
countries ; developed a broad interest in securities and instruments which offered
cushion against the counter-party risk. Inadequacy and loopholes in loan
documentation created liquidity problems. Exposure to changes in interest rates

18
in OTC markets of derivatives was nearly four times than in exchange traded
markets which was the major source of risk in derivative industry.

The growth and globalisation of the major stock exchanges along

with the introduction of new and complex variables therein ; has led to the
creation of wide range of the instruments. These instruments are tailor made to
address the concerns of the risk-return profile in a highly complex and turbulent
environment. This gave rise to the concept of Hedging Instruments which are
used to protect the firm from any adverse movement in the exchange rate
movement or adverse fluctuations in the interest rates. Over-the counter
instruments like Interest rate swaps , Currency swaps , Caps , Collars and
Swaptions were introduced to hedge against the adverse fluctuations in the
market variables. These various swaps are known as Derivatives. These are
traded on the exchanges thus providing for the liquidity . These are the
standardised contracts . The multinational corporations use these derivative
products to hedge against the changes in interest rates , foreign exchange rates
and commodity prices. Mutual funds and Pension funds use them to protect their
stock and bond investments.

Derivative is a security or a financial asset which derives its value

from specified underlying asset. It exists due to a contract between the two
parties. It does not have any physical existence. It however does not have its
own value. The underlying assets on which the value of derivative instruments
depend are shares , bonds , debentures and other financial securities. The value
of derivatives fluctuates in accordance with the fluctuations in the price of
underlying assets. Both forward and futures contracts are classified as Derivative
because their values are derived from the value of underlying securities. For a
derivative market to function ; two types of economic agents namely hedgers and
speculators are needed.

19
 On the basis of above discussions ; we can enlist the following
characteristic features of derivatives. :
• It provides hedging against price risk of transactions over a period.
• It is a contract which is to be settled in the future by making the payment of
price difference.
• Derivatives are secondary market securities and as
such an initial public offer of derivatives can not be made by a company.
• Derivative markets are computerised exchanges.
• As the derivatives are not the physical assets ; the settlement is done by
offsetting the transaction and the price differentials are settled by making or
receiving the payment.

Generally ; various types of derivative instruments are there like :

1. Commodity derivatives: These are the derivatives for which the

underlying asset is commodity like gold , silver , sugar etc.
2. Financial derivatives : These are the derivatives for which the underlying
asset is shares , bonds , debentures etc.
3. Basic derivatives : These are the derivatives on underlying assets .
Futures and options are the two basic derivatives.
4. Complex derivatives : Swaps are the examples of complex derivatives. It
involves an exchange of one set of predetermined payments for another.

Derivative financial instruments includes financial options , futures

and forwards , interest rate swaps and the currency swaps. These derivative
financial instruments create rights and obligations that have the effect of
transferring between the parties to the instrument one or more financial risks
inherent in an underlying primary financial instrument.

On inception ; derivative financial instruments give one party a

contractual right to exchange financial assets or financial liabilities with another

20
party under conditions that are potentially favourable , or a contractual obligation
to exchange financial assets or financial liabilities with another party under the
conditions that are potentially unfavourable. However , they generally do not
result in a transfer of the underlying primary financial instrument on the inception
of contract , nor does such a transfer necessarily take place on maturity of the
contract. Some instruments embody both a right and an obligation to make an
exchange. Because the terms of the exchange are determined on the inception
of the derivative instrument ; as the prices in the financial markets change ;
those terms may become favourable or unfavourable.

Let us have an example of a derivative financial instrument

wherein it is a forward contract to be settled in six months’ time in which one
party ( the purchaser ) promises to deliver Rs.50,00,000 cash in exchange for
Rs. 50,00,000 face value of fixed rate government bonds . During the six months;
both parties have a contractual right and a contractual obligation to exchange
financial instruments. If the market price of the government bonds rises above
Rs. 50,00,000 ; the conditions will be favourable to the purchaser and
unfavourable to the seller. If the market price falls below Rs. 50,00,000 ; the
situation will be exactly reverse.

The purchaser has a contractual right i.e. a financial asset

similar to the right under a call option held and a contractual obligation i.e. a
financial liability similar to a put option written ; the seller has a contractual right
i.e. the financial asset similar to the right under the put option held and a
contractual obligation i.e. a financial liability similar to the obligation under a call
option written. As with options , these contractual rights and obligations
constitute financial assets and financial liabilities separate and distinct from the
underlying financial instruments i.e. the bonds and cash to be exchanged in this
case . Both the parties under the forward contract have an obligation to perform
at the agreed time , whereas performance under an option contract occurs only
if and when the holder of the option chooses to exercise it.

21
 Many other types of derivative instruments embody a right or
obligation to make a future exchange , including the interest rate currency swap ,
interest rate caps , collars and floors , loan commitments , and letters of credit.
An interest rate swap contract may be viewed as a variation of a forward
contract in which the parties agree to make a series of future exchange of cash
amounts , one amount calculated with reference to a floating interest rate and
the other with reference to a fixed interest rate . Futures contract are another
variation of forward contracts , differing primarily in that the contracts are
standardised and traded on an exchange.

Meaning of important Terms: -

OTC: - Financial instruments traded off organized exchanges. Transactions are

negotiated over the telephone on a bilateral basis. Generally, the parties must
negotiate all the details of the transactions or agree to certain market conditions.
NASDAQ is one of the important OTC markets in the United States.

Arbitrageurs : These are the agencies in the market which earn profits in the
market by taking the benefit of price or rate differentials existing in the different
markets. They make profits by discovering the price discrepancies which allows
them to buy cheap and sell dear. Their transactions are risk-free. They act on
their own in undertaking the currency arbitrage and the interest arbitrage
transactions.

The currency arbitrage arises from the opportunities to buy

currencies at a cheaper rate than the rate at which they can be sold . In a free
market ; the scope for the currency arbitrage tends to be very brief.

22
 Interest arbitrage arises from the dis-equilibrium between two
exchange rate variables. It is carried out by the dealer banks .Interest rate
arbitrage ultimately leads to the interest rate parity.

Ultimately ; the opportunity and exercise of arbitrage leads to

the elimination of the price differentials in the long run . It is a sort of bringing
price parity in the market by the exercise of the arbitrage .

Key Terms : Derivative security , Underlying assets , OTC , Exchange traded ,

Standardised contract , Globalisation , Swaps , Interest Rate Arbitrage ,
Currency Arbitrage , Arbitrageurs.

Reference Sites : i. www.numa.com

ii ii. www.cme.com
iii. www.phlx.com
iv. www.simex.com.sg
v. www.isda.org
vi. www.bis.org

Self Study Questions :-

1. Explain the growth of Derivatives on account of globalisation.?

2. Explain in detail the concept of derivatives.
3. Discuss the role of various derivative instruments in hedging the risk in
the post liberalised and integrated financial markets.
4. Write a detailed note on different types of arbitrage.

Suggested Reading :
1.International Finance – Prof.V.A.Avadhani & V.A.Ghosh – Himalaya Publishing
House.
2.International financial management – Text & Cases – Prof.B.K.Bhalla – Anmol

23
 Publication. New Delhi.
3.International Finance – Prof. A.K.Seth – Gargotia Publications.
4.International Financial Management – Prof. P.K.Jain, S.S.Yadav & Prof.
Peyard.
5.International Finance – Prof.P.G.Apte Tata McGrawhill – Delhi.
6.International Finance – M.Agarwal - Institute of Finance New Delhi
7.International Finance – Prof. C.S.Nagpal & A.C.Mittal
8.Case problems in International Finance – Prof.W.C.Kester and
Prof.T.A.Luehrman McGrawhill – Newyork.

*******

24
Lesson No. 4.
The Crash of 1994-96 & beyond
.
Learning Objectives : The objective of this lesson is to study the factors and the
reasons which contributed the crash of 1994-96 and beyond.

Economies of countries are subject to cycles of ups and downs.

One phase precedes the other in rotational fashion. Boom and recession are the
phases of this trade cycle.

The cumulative effect of all these individual trade cycle of each

country in effect influences the trade cycle of the commercial world of all the
countries taken together.

The recession in the economy is the result of high supply and very
low demand. As such the investment declines, turnover declines and the excess
capacities are created and whereby, there is idle capacity. This ultimately results
in reduction in level of employment, retrenchment, lay-offs. Disposable income
level goes down. This definitely adversely affect the stock valuations in Equity
markets. A general atmosphere of pessimism prevails. Financial institutions are
flooded with funds but the atmosphere in recession is not conducive to
investment. Creditor banks and other investors scale back drastically their
financial exposures.

Until 1998, the financial crisis, which erupted in emerging market

economies, had contained mainly within Asia. However, it spread its tentacles
subsequently to Russia and parts of USA. At the root of the crisis, were a number
of major economic and financial weaknesses. The crisis has gone through series
of stages, which were linked by several complex channels of transmission. Weak
public finances, widening current account deficit, inconsistent policy,
unfavourable balance of positions has generally been the basic causes of
difficulties.

25
 The aspect of integration of emerging market economies into the
global financial system triggered and increased the domestic problems in case of
any reversal of capital flows. All this contributed to deep recessions and sharp fall
in exchange rates. It affected the international trade prices and flow of goods and
services. Volatility was also reflected in the prices of international securities.

By mid 1998, confidence crisis erupted in respect of servicing

debts and repayment of corporate and bank debt. There was a general
realignment of the spreads paid by borrowers with different risk profiles reflecting
a reduction in premium charges to high risk borrowers. The Asian crisis brought
this narrowing of relative spreads to a half.

After the massive depreciations of the local currencies ; financial

institutions and corporations with foreign currency debts in the afflicted countries
were driven to extreme financial distress and a large number of defaults took
place. The currency crisis led to an unprecedentedly deep and long lasting
recession in Asia. Nearly at the same point of time ; many lenders and investors
from the developed nations also suffered huge capital losses from their
investments in the emerging market securities.

Several reasons are behind this currency crisis in Asia. The

crucial among them are : weak domestic financial system , inconsistent economic
policies , free international flows of capital etc. Because of liberalisation of
capital markets ; the firms and financial corporations in Asia borrowed heavily in
the foreign currencies from U.S. , Japan etc. Many Asian countries like
Indonesia , Thailand etc. tapped new infusion of capital in foreign currencies.
Such a large infusion created a credit boom in the Asia which found its directions
towards real estate, stock market investments. The aspect of risk taking has
already been clearly exceeded beyond its limit and the factor of exchange risk
was not given the level of consideration which it deserved.

26
 Damage control exercises on the part of the domestic
governments of the developing countries in the Asian region resulted in a
continuous fall in the prices of assets. This also created problems for the banks
and financial institutions which had advanced huge amount of funds on the
security and mortgages of these assets. Banks and financial institutions failed to
adhere to the degree of financial prudence and risk management .This resulted
in huge defaults and an unprecedented rise in the Non Performing Assets
( NPAs ) of these banks and financial institutions.

An appreciation in the real exchange rate was effected resulting in

a fall in the exports of these Asian countries. Added to that recession in Japan
and depreciation of Yen acted as oil in the fire. This weakened the trade
balances of the Asian developing countries. Because of the fixed exchange rate
regime being followed at that point of time ; the Asian currencies could not be
depreciated to their real terms. With this situation ; the lenders withdrew their
capital . The earlier credit boom gave its place to the credit crunch. The crisis
unfolded ; International Monetary Fund ( IMF ) came to the rescue of the worst
hit countries in Asia with bail out plans.

The crisis is clearly the manifestation of the combination of

liberalisation of financial markets alongwith underdeveloped domestic financial
institutions and services. The structural adjustments which are required to be
carried out in domestic institutions were not fully carried out resulting in
mismatch . It prevented from coming into force a well tuned system of liberalised
economy coupled with strong and very well developed financial systems and
institutional set up. It also brought to light that a fixed exchange rate regime is
not working in view of integrated international financial markets. Fixed exchange
rate regimes without effective capital controls are useless.

The basic causes of difficulties were vulnerable corporate and

financial sectors , weak public finances , widening current account deficits and

27
inconsistent policy framework .The financial systems in the countries affected
during this crash were weak , poorly supervised , inadequately regulated and the
exchange rate regimes were inappropriate. Once the crisis struck ; the reaction
of the integrated and interconnected markets was vehement and contagious.

Effect of crisis on China and India :

Because of high degree of insulation from global financial

markets, these two most popular Asian countries were less affected by this crisis
of recession. However, it exposed vulnerability areas, which worsened economic
and financial conditions. Various indicators pointed out the slowing trend in
activities increase in unemployment, growing inventories of unsold goods, fall in
energy production etc. to tackle this problem, public sector spending was
boosted in later part of 1998. Spending an infrastructure was accelerated. State
owned enterprises were induced to increase investment and lending on the
sector of infrastructure and housing was promoted. Monetary policy became
more expansionary and reduction in interest rate was effected.

Russian financial collapse and its impact as Eastern Europe:

Difficulties in controlling public finances, rising pace of short-term government

debt, falling commodity prices put a question mark as Russia’s debt servicing
capabilities in the late 1997 and early 1998. Exchange rate suffered repeatedly.
Real interest rates increased substantially and government debt servicing costs
increased upto 50 % of budget revenue. In order to tackle this, the Russian
Authorities suspended trading in treasury bills, mandated restructuring of
government debt was undertaken, a 90 day moratorium was kept as repayment
of corporate debt and bank debt to foreign creditors. By end of 1998, Russia was
failing to meet the payments above a particular level. Public finances were in
doldrums.

28
 Russian default had a deep impact as Brazil. Its capital outflows
accelerated towards high yield international bonds. Internal debt/GDP ratio
increased drastically in Brazil. A policy of tightening of monetary policy was
followed to restore confidence.

Thus various countries of the world got affected by this crisis,

which spread like a chain reaction. It spread its tentacles even in Chile,
Columbia, Mexico etc. Each country adopted its own fiscal and monetary
measures to come out of the crisis situation successfully.

Self study questions:

1. Write a note on rise and fall of Bretton Woods.
2. Which factors contributed to the crash of 1994-96 and beyond? Explain in
detail.
3. What do you mean the term derivative product? Explain different types of
derivatives with suitable examples.
4. In an integrated world financial market ; a financial crisis in a country can
be quickly transmitted to other countries , causing a global crisis. What
kind of measures would you propose to prevent the recurrence of an
Asia type crisis?

Reference Sites :
1. www.adb.org

Suggested Reading : (As per Lesson No. 1 & 2 )

**********

UNIT : 2 : Euro Currency Issues

29
 CONTENTS
________________________________________________________________
Lesson Number Lesson Starting Ending
Page Page
________________________________________________________________
1. Euro Currency Market 31 40

2. Euro Banking and

iii Euro Currency Centres 41 42

3. Deposit Dealing and

iv Term Structure of Euro
Currency Rates 43 44

4. Euro Currency Futures 45 51

And Options
5. Syndicated Euro Credits 52 56

Unit No. 2 Euro Currency Issues

30
Learning Objectives :Objective of the study in this unit is to have the working
knowledge in respect of various matters and structure of Euro Currency
Market and mechanism of various products available in Euro Currency.

Lesson No. 1 Euro Currency Market

Keywords: -

1.Euro Currency Market : Euro Currency Market is at the core of

International Money Market. Euro currency markets are however not the
currency markets, where the foreign exchange is traded. They are short
term money markets for short term deposits and loans. They refer to any
off-shore transactions and are thus off-shore money and capital markets.
It denotes that the currency denomination is not the official currency of
the country where the transaction takes place.

Euro dollar market is followed by the Euro bonds market .

The term Euro dollar market was generalised to Euro currency where with
the emergence of off-shore centres for other currencies. A market for
Euro commercial paper has also come into existence. Euro equity markets
to trade the corporate stocks outside the home countries of issue have
also emerged. The Euro market is regulated than the US market. The
absence of reserve requirements , deposit insurance and transaction
costs and tax provisions makes the Euro transactions cheaper than the
domestic transactions in the USA.

There also exists a Collection of banks that accept deposits

and provide loans in large denominations and in a variety of currencies.

Euro markets are the markets on which Euro currencies ,

Euro bonds , Euro shares , Euro bills are traded or exchanged.

31
2. Euro Currency : It is the currency held by non-residents and placed as
deposit with banks outside the country of the currency e.g. US dollars owned
by a middle East country and deposited in London. Thus Euro currency
deposits are the deposits made in a bank , situated outside the territory of the
origin of that currency. Euro dollars is a deposit made in US Dollars in a bank
located outside the USA.

3.Euro-dollars: - US dollars held by any one who is not a resident of United

States. Thus these are the deposits of US Dollars in the banks located
outside the United States. Likewise Eurosterlings are the deposits of British
Pounds outside the United Kingdom.

4.Euro banks: - Commercial banks that participate as financial

intermediaries in the Euro currency market. Thus ; they have term deposits in
Euro currencies and offer credits in a currency other than that of the country
in which they are located . Euro banks are the banks in which Euro currencies
are deposited.

5.Eurobond: - Bond sold in countries other than the country represented by

the currency denominating them. There is a growing tendency among the
multinationals to borrow in the form of issue of security .This is the process of
securitisation of borrowing. Euro bond is thus a part of this process of
securitisation of borrowing wherein the corporates issue the bonds for raising
the finance. The borrowers in the Euro bond markets are well known parties
and do have an impeccable credit standing and as such the borrowers are
developed countries , multinational corporations , international institutions,
Central banks etc. The US Dollar remains the most used currency for Euro
bond issues. These bonds helps in raising very large amounts. They also
offer very high liquidity as they are quoted on various exchanges. The

32
process of clearing of Euro bonds is ensured by EUROCLEAR and CEDEL
in Europe and by FEDWIRE in the USA.

There are different types of Euro Bonds like Straight bonds ,

Floating rate bonds , Reverse Floating rate bonds , Zero coupon bonds ,
Convertible bonds.
The investors in Euro bonds are specially the institutional
investors such as insurance companies , mutual funds and pension funds.

6.Euro credit loans: - Loans of one year or longer extended by Euro banks.
Euro debt or Euro credit are the medium term loans . The major participating
banks in this are Euro banks , American , French , German , Japanese ,
Singapore , JP Morgan , Citicorp , etc. When a borrower approaches the
bank for Euro credit ; a document is required to be prepared which contains in
details principal terms and conditions of the loan.

The decision of syndication is taken along with the strategy to

be adopted for the same. Each of the bank in the syndicate lends a part of the
amount of the loan. The syndicate is done as the amount involved is large to
the tune of $ 50 million or more. The rate of interest on Euro debts is
calculated with reference to LIBOR.

However there are certain differences in Euro bonds and Euro

currency loans. Euro currency loans have variable rates; Eurobonds are of
both fixed and floating rate . Euro bonds have longer maturities than that of
the Euro currency loans . Euro bond financing however takes more time than
that of Euro currency loans.

7.Eurodollars: - These are the US dollars deposited in European banks.

33
 8.Euronote: - A short-term note issued under Euro commercial paper facility.
These are of a hybrid class and contains the features of Euro bonds and
Foreign bonds. These can be Renewable Euro Notes , Euro Commercial
Paper , and Euro Medium Term Notes. These notes carry maturity period of
three months to one year in the Euro bonds market.

The interest rate is calculated from a reference rate say

LIBOR. Cost of Euro Notes is less than that of Euro Credit or Euro Debt.
Euro Commercial Paper are the notes in Euro Currency having a maturity of
three to six months. They are directly placed by the dealers with the
investors.

The main advantage of Euro Notes is the inbuilt flexibility and

the choice of the date of maturity. For example a borrower having committed
to a rate which may be fixed or variable suffers a loss if the rate decreases
afterwards. But the enterprise that has taken recourse to Euro Notes can wait
before borrowing if it is of the opinion that the rate is likely to go down in the
future.

The major factor about the Euro Currency market is that they
have the potential to create credit and yet remain unregulated. The fast
growth in depth and breadth in Euro currency markets coincided with a rise
in the level of inflation in the developed countries .The growth of Euro
currency markets had an effect of expansion of money supply in the
economies of the countries ; i.e. expansion in the monetisation of the
economy in a loose sense ; which created a situation of inflation .The
situation like too much money chasing too few goods had been created.

The Euro dollar market has the effect of raising the base
multiplier because a part of the newly created base gets deposited with the Euro
currency markets causing a greater impact on liquidity in the domestic banking .

34
The growth of Euro dollar market fuelled the supply of US Dollars causing a rise
in the level of inflation in the developed countries.

Euro currencies represent the separation of currency of

denomination from the country of jurisdiction. This separation becomes possible
by locating the market for a credit denominated in particular currency outside the
country where that currency is the legal tender.
These markets are generally referred to as “Euro” or External
markets in order to indicate that they are not part of the domestic or national
financial system. Differences in interest rates, practices in domestic and external
markets arise mainly from the extent to which the regulatory constraints are
different.
EURO-NOTES
|
_______________________________________________________
| | |

Renewable Euro Notes Euro Commercial Paper Euro-medium term Notes

|
_____________________________________________________
| | | |

Revolving Underwriting Note Issuance S.N.I.F. Multiple

Facilities ( RUF ) Facilities ( NIF ) Option
Facility (MOF)

Euro market consists of intermediated funds and direct funds. The

former in channel through banks is called as the ‘Euro currency market’. External
market is characterized by having a different political jurisdiction. Various
external markets have more common features with each other. So they are
called as common, integrated market where claims denominated in different
currencies are exchanged.

35
 Thus the Euro currency markets are the international
currency markets where the currencies are borrowed or lent. Each currency has
demand and supply in the markets. International banks , foreign branches of the
domestic banks , merchant banks , private banks are the main dealers in this
market .The market is of a wholesale nature highly flexible and competitive
connected in the world over by a wide network of brokers and dealers. London is
the focal centre for the Euro dollar.
The mechanics of issue can broadly be depicted by the
following chart :

Mechanics of issue
|
Issuers Loan Syndications
_________________________________|_______________________________
| |
| |
Lead Manager ( 1 ) Lead Manager etc. ( 2 )
| |
| |
Co-manager ( 1 ) Co-manager etc. ( 2 )
|
Underwriters (Bought Out Deals )

36
Medium Term Euro Notes : These medium term notes have a maturity period
ranging from 9 months to 20 years. Generally ; longer the maturity ; more the
liquidity problem. Therefore an arrangement for the liquidity is made through
the commitments from the dealers to buy back paper before the maturity at
the prices assuring them of their spreads.

The multicurrency options are also used .It helps in enhancing the
competitiveness of funding. The role played by Medium Term Euro Notes is
that of bridging the maturity gap between short term Euro Notes and the
Euro Bonds. It has evolved as a general fund raising instrument . it also
provides substantial flexibility in the aspects of maturity period , currency ,
size and the structure as it offers very competitive terms.

The short term Euro Notes consist of commercial paper and

certificates of deposit. The Commercial Paper consists of unsecured , short-
term notes sold on a discount either through the dealers or directly to the
investors. The investors hold the commercial paper till the time of its maturity
. The dealers make markets by standing ready to buy at substantial discount
; any of the commercial paper which the investors desires to sell before the
time of its maturity. Commercial paper is also supported by the issuers
maintaining the lines of credit provided by the banks on the payment of
fees.

37
 Certificate of Deposits( CDs ) is just like a term deposit as usual. It
is negotiable and is traded on the secondary markets. It is a bearer security .
No interest is paid on CDs. Only a single payment comprising interest and
principal is made. Generally the CDs have a very short duration ranging
from one to six months. For the other CDs having a having a longer term ;
they carry a coupon or a floating coupon rate. For the CDs with the floating
rate coupons ; their duration is sub-divided into periods of six months and
interest rate is fixed for at the beginning of each of such period. Such
interest rate is generally fixed on the basis of the prevailing market rate like
LIBOR or the US Treasury Bill rate.

38
Euro Issues : The Indian corporate sector has been allowed to access global
markets through the issue of Global Depository Receipts ( GDRs ) , Foreign
Currency Convertible Bonds ( FCCBs ).

Huge amount of finance is required for the corporates for their

expansion , diversification plans. The finance can be raised from various
sources. Each source of finance has its own cost structure. The aim of any
financial management is to maximise the wealth of shareholders. In order to
ensure this ; the finance manager is required to ensure that the Earnings Per
Share of the company is improved so as to pass on the benefits to the
shareholders of the company.

In order to maximise the wealth of shareholders ; the company is

required to ensure that the cost of its capital i.e. the weighted average cost of
capital is minimum and the funds so raised are properly invested which
gives a rate of return which is comfortably more than the cost of funds. This
is the optimum utilization of the funds which is necessarily required to be
ensured in any effective financial planning whether at the domestic level or
at the international level.

The cost of raising the funds at international level may be low on

account of lower rates of interest. As such many Indian corporates have
already raised finance by issue of GDR. The GDR issue of Reliance
Industries Ltd. , Infosys Ltd. are the benchmarks for the Indian corporate
world of successful fund raising abroad.

These GDRs are the instruments created by the overseas

depository banks ,These depository banks are authorised by the issuing
companies to issue GDRs outside the country. The GDRs are issued to the
non-residents investors against the shares of issuing company. These
shares resembles a fixed ratio to the GDRs e.g. 1 GDR for 10 Shares.

39
 They are negotiable certificates denominated in US Dollars .The
price of GDRs reflects the price performance of the underlying assets namely
the equity shares of the issuing company. Thus the price of GDR changes in
consonance with the changes in the price levels of the underlying shares.

GDRs is treated as the Foreign Direct Investment in the issuing

company. These types of Euro issues also costs less than the domestic
rights issues. It also enhances the image of the company globally. The Indian
companies does not bear any foreign exchange risk. The Indian companies
get the proceeds of Euro issue in foreign currency.

Key Terms : Euro credit , Euro currency , Euro note , LIBOR ( London Inter Bank
Offered Rate ) , Syndicate.

Reference Sites : 1. www.euribor.org

Self study questions: -

1. Explain in brief the concept of Euro currency market along with the
important terminology.
2. Discuss various factors responsible for emergence and growth of Euro
currency market.
3. “The Euro currency markets have permitted countries to avoid monetary
discipline and put off connective action to address their BOP problems”
Comment.
4. What do you mean by the term Securitisation? How does it affect
financing of Multinationals?
5. Explain the role of Euro Currency Markets in the International Financial set
up.
6. What are the distinguishing features between a Euro Currency Loan and
a Euro Bond ?

40
 7. Write a note on : i. Euro Bond
ii Foreign Bond
iii. LIBOR
v iv. Euro Notes
8. Write a detailed note on various types of Euro Issues that may be
undertaken by the Indian companies. Explain this specifically with the help of
issue of GDRs by the Indian corporates along with the merits and the limitations
thereof.

Project: Prepare a list of destinations wherein Euro market exists.

Additional reading: -
Johnston R. B. – “The Economics of the Euro market: History, Theory & Policy,
Macmillan, London.
*********

Lesson No. 2
Euro Banking & Euro Currency Centres
Objective of the lesson is to have working knowledge through self study the
mechanism of Euro banking and Euro currency centres and its importance.

41
Introduction and elaboration :

Euro banks: - Commercial banks that participate as financial intermediaries in

the Euro currency market.

Now let us see the details of the concept. The liberalization and
globalization of world economy have developed under the influence of Euro
market, which has been made possible by revolution in communication and
information processing system. As the volume of globalised financial transactions
increased, the risk involved in transaction settlement also increased drastically.

Euro banks are financial intermediaries in Euro currency market. Federal

Reserve Communication System (FEDWIRE) and Clearing House Interbank
Payment System (CHIPS) form the number of US fund settlements.

CHIPS is a settlement system operated in New York Clearing House

Association and was established as an efficient means of settlement of Euro
dollar transactions. It is presently a centralized system. In CHIPS transaction,
cancellation is possible. If for same reason, the final settlement is not carried out,
all transactions for the day with that bank will be cancelled. Settlements done by
CHIPS are basically Euro dollar transactions, there is a good chance that the
paying receiving bank will be a non-American bank.

The core of foreign exchange market is the inter bank market

which is closely linked to the Euro dollar inter bank market. The link between the
foreign exchange market and the Euro dollar market is derived from interest rate
parity hypothesis . This law states that there is a single price in the securities
market for the identical securities which are quoted in a common currency . Thus
the price differentials in respect of the identical securities are ruled out and that

42
such identical securities denominated in the same currency shall have identical
price in all the markets.

The transaction costs in the Euro dollar markets are negligible.

Euro dollars are used for purchasing foreign currency. The Euro dollar market
acts as a depository for keeping the proceeds of sales realised in foreign
currency. The foreign currency markets and the Euro dollar markets are
integrated which helps in determination of the forward cross rates.

Key Words : Euro dollar , settlement system , interest rate parity , depository ,
forward cross rate.

Self Study Questions :

1. Write a note on Foreign exchange market and Euro currency market and
comment on their integration.

2. What do you mean by interest rate parity hypothesis?

Additional Readings :
1. Grabbe , J. Orlin , International Financial Markets ,
Third Edition , 1996 ,Prentice Hall , New Jersey.
2. Annual Reports of International Banking and Financial
Markets Developments , Bank for International
Settlements.

Lesson No. 3

43
 Deposit Dealing and the term structure of Euro currency rates

Meaning of Important Terms :

Forward rate: Rate at which a bank is willing to exchange one currency for
another at some specified date in the future.

Exchange rate:- Value of one currency with respect to another.

Dealer or trader: - He is specialist in a bank or corporation who is authorized to

effect exchange transactions. He usually attempts to keep his book in balance
but may be allowed to take a position.

Hedging in the action taken to insulate a firm from exposure to exchange rate
fluctuations.

Now let us see concept in detail.

To keep track of its various transactions and the risks they entail,
the foreign exchange dealing room maintains a ‘Book’ or accounting of
outstanding positions. “Long” position is like an asset and “short” position is like a
liability when you own something you gain if its price rises. When you owe
something, you gain when its price falls.

Any short position can be used to offset any long position of equal
amount to provide a rough hedge. The relative movements of different long or
short positions depending in large part as interest rates movements. Matching
hedges the gross movements in the spot value of currency.

44
 Profit profile diagram helps to look at the dealers position in any
particular instrument. If the market forward rate is above the contracted forward
rate, the dealer has a profit, if below, a loss.

The long position means a net asset, net revenue and / or net
cash inflow position in a currency. If the currency appreciates, a foreign
exchange gain is generated. If it depreciates, a loss is incurred. The opposite is
true of short position. The advent of Euro is likely to cause Structural changes in
Foreign exchange markets. Euro has caused shrinkage of foreign exchange
markets. Euro banks can generate multiple expansion of Euro deposits on
receiving a fresh injection of cash.

Self study questions: -

1. Describe in detail the concept of deposit dealing and its mechanism.

2. Explain the concept of term structure of Euro currency rates.

Project: - Prepare a simplified position book representing dealers position in

respect of dealing in securities denominated in French-Franc.

Additional Readings: -
“International Finance”: Levi M.; New York.
*********

45
Lesson No. 4
Euro Currency Futures and Options

The object of study in this lesson, is to have basic knowledge about the
mechanism of futures and options.

Meaning of Important Terms : -

Options as future contract: - Contract that provides the right to purchase or sell
the future contract of a specified currency at a specified price by a specified
expiration date. The option is thus a contract giving the owner the right to , but
not the obligation , to buy or sell a given quantity of an asset at a specified price
in the future. Option is a derivative. Its value is derived from its underlying assets
like foreign currency or Euro in this case.

Currency futures: - The market of currency futures is the best-developed market

for hedging exchange rate risk. These are widely used by corporations, banks
and securities firms.

Futures contract: - A future contract may be defined as a standardized

agreement with an organized exchange to buy or sell something such as a
currency or commodity at a fixed price at a certain date in the future. It permits
the price risk to be separated from the reliability risk. These are standard form
contracts with only one negotiable term i.e. price. This contract standardization

46
eliminates the cost of bargaining over non-price terms. It also reduces the
monitoring costs. Futures contract is similar to a forward contract . However there
are differences between the two contracts. A forward contract is tailor made for a
client by the international bank while a futures contract is has standardised
features and is exchange traded. The main difference between the two is the way
in which the underlying asset is priced for future purchase or sale.

Currency futures offer advantages over forward contracts in terms

of liquidity , speculation and transaction size. They are traded only on organised
exchanges .The largest exchanges wherein the futures contracts for commodities
and treasury bills are traded are Chicago Board of Trade and Chicago Mercantile
Exchange. A short position on the foreign currency can be covered with a
futures contract . Currency futures are an effective hedging instruments than the
forward contracts. Majority of futures contracts do not lead to delivery .The
currency futures are highly liquid and the margins are small.

As the futures contracts are used for hedging purposes ; it is of

paramount importance for us to discuss the concept of hedging. Hedging means
securing against the loss from various risks which arises out of an exposure or
transaction undertaken in the international financial markets. The concept of
hedging is applied mostly in cases of exchange risks. It helps to alter the
composition of the assets and liabilities with a view to fully or partially offset an
existing or potential exposure to the exchange risk.

Foreign currency exposure is generally classified into following

categories.: Transaction Exposure , Translation Exposure and Economic
Exposure. The foreign exchange risk arises out of the fluctuations in the value of
assets , liabilities ,income or expenditure in the light of occurrence of
unanticipated changes in foreign exchange rates. An open foreign exchange
position implies a foreign exchange risk. When a firm owns an uncovered claim
in foreign currency ; it is called as Long and when it has an uncovered liability in

47
foreign currency ; it is said to be short. Hedging protects the value of receipts in
domestic currency.

Futures contract has a single price at a given point of time. The

pricing of futures contract is done by reference to an arbitrage portfolio which
combines a long position on the security underlying the contract with financing at
the risk free rate. In futures contract ; its rate is constantly changing . The initial
rate is different from the rate at which the contract is settled. With the changes in
the rates ; the resulting difference becomes realised gains or losses through
daily settlement process.

Futures Options : These are the options written on Futures Contracts. Here the
option gives the right to buy or sell the standard futures contract , in a currency
other than its currency. When exercised ; the holder receives a short or long
position in a currency futures contract that expires one week after the
expiration of the options contract.

The futures contract is delivered exactly like the delivery of the

currency , if the option is exercised. If it is not exercised ; trading is done on a
daily basis and the profit or loss is booked from time to time. The introduction of
the futures options has been an important milestone in the development of
financial markets and provides the trader , investors and speculators a wider
variety of instruments to reduce the risks or to take the risks . Thus these types
of a wide variety of instruments has added an additional impetus to the fast
growing field of international finance.

Currency option: - In respect of foreign exchange option, the right but not the
obligation to exchange currency at a predetermined rate is the speciality. A
foreign exchange option is a contract for future delivery of a specific currency in
exchange for another in which the option holder has the right to buy or sell the

48
currency at an agreed price which is strike price or exercise price but is not
obliged or required to do so. The right to buy is a call and the right to sell is put.
For such a right, the buyer pays a price called option premium.

The option seller receives the premium and is oblige to make or

take delivery at the agreed upon price if the buyer exercises his option. The value
of any option depends crucially upon the probability of the option being
exercised. A foreign currency option contract is an agreement between the buyer
and the seller where the seller grants the buyer the right to buy or sell a
currency under certain conditions. There are American and European options. An
American option gives holder the right to exercise at any time before maturity
while the European option allows the holder to exercise the right only at maturity.

The foreign currency option is a right to buy or sell a currency at

an agreed and predetermined exchange rate on or before an agreed maturity
period. The right to buy is a call option while the right to sell is a put option. A
foreign currency option holder will exercise his right only if it is advantageous to
do so. The currency futures protect the holder against the risk of adverse
exchange rate changes. One can hedge against the possible loss , but there is
always the avenue open for the risk taker to earn profit. An option would be
profitable to be exercised in certain situations when the option is in the money
at the current exchange rate.

Let us take an example to crystallize the concept.

A limited company buys a 6 months call option at Rs. 43.40
plus a premium of 5 % for purchasing the option. The company has to make a
payment of US $ 40 Lakhs after 6 months against the import of the plant.

In this case ; the maximum cost to the company if it chooses

to purchase the option will be Rs. 43.40 * 40 Lakhs * 1.05 = Rs. 1,822.80 Lakhs.
( Inclusive of the cost of the premium. ).

49
 In this case ; if at the end of 6 months period ; the exchange
rate is Rs.45 ; the company will exercise its call option as it will be
required to pay only Rs. 43.40 which is the exercise price to obtain one US $.
However in the open market ; it shall be required to cough up Rs. 45 per
one US $.

Now ; let us see the reverse case wherein at the end of 6

months ; the exchange rate is Rs. 42 per US $. In this case; the company will not
exercise the option as it can obtain in the open market one US $ at Rs. 42
only instead of the exercise price of Rs. 43.40 per US $. But it has already paid
the option premium. If the company does not exercise the option ; its total cost
will be
( Rs.42 * 40 Lakhs) + Rs. 86.80 Lakhs premium already paid = Rs. 1,766.80
Lakhs. Thus overall ; the company will save Rs. 56 Lakhs ( Rs.1822.80 Lakhs –
Rs.1766.80 Lakhs. ).

Thus the foreign currency option hedges against the adverse

fluctuations in the exchange rates. One can avoid the loss by exercising the
option and can maximize the profit from favourable exchange rate fluctuations .
The only thing is that the cost of option premium is nevertheless required to be
paid in any case.

Euro dollar currency futures were introduced as a vehicle for

hedging the short term rate risk.

Now let us see in brief the aspects which bifurcates futures and
options. As already seen ; futures and options are the basic types of derivatives
which are used for hedging purposes.

• Maturity period of options is generally shorter than that of futures.

50
• In futures ; both the parties are exposed to an unlimited profit or loss ;
however ; in case of options ; the loss of the option holder is limited up to the
amount of premium paid upfront . However the profit is unlimited.
• The profit of the option writer is restricted to the premium received but is
exposed to unlimited risk.
• An option holder is required to pay the premium to buy the option. But in
futures ; no premium is payable .
• Futures involves obligations while options involves right.

Now let us see in detail the concept of futures contract.

The parties to the futures contract are required to buy or sell the asset regardless
of its price or valuation during the interregnum. Futures are transferable futures
delivery contracts and the parties have got the right to transfer the contract by
entering into an offsetting futures contract. Futures are traded on exchanges.
Futures can also be of commodities like gold , silver , agricultural products ,
shares , bonds etc. Futures contracts are designed to provide for the physical
delivery of the asset however they get settled by offsetting futures contract. The
basic objective of the futures is the hedging for future risk and speculation and
not the actual delivery.

Futures are traded on organised exchanges only. The

exchanges provides the counter party guarantee through its clearing house and
various margin systems. Tokyo Stock Exchange , Chicago Board of Trade etc.
are the few centres where the futures are traded. Thus futures being a technique
of risk management also helps in indicating the future price movement in the
market and provides arbitrage opportunity to the speculators.

Reference Sites : i. www.castletrading.com

ii. www.cme.com

51
Summary: -
The futures and options contract which are denominated in US dollars but
are traded in non-US markets are the Euro currency options and futures.

Self study questions: -

1. What are the major differences between options and futures contract?
2. Why is the price of an option always greater than its intrinsic value?
3. What are currency future options?

Additional Readings: -

1. “Foreign currency option values”, journal of internationa money andfinance

by Mark German.
2. “Futures and Options: Theory & Applications”.Stoll, H.R. & R. E. Whaley,
Ohio.

*********

52
Lesson No. 5
Syndicated Euro Credits

Objective of this lesson is to study the nature and usefulness of syndicated

Euro credits.

Meaning of Important Terms : -

i Syndicate is a Group of banks that participate in loans.

ii Syndicated Euro credit loans: Loans provided by a group or syndicate of

banks in the Euro credit market Euro credit loans are of one year or longer
period extended by Euro banks. It is generally a floating rate loan with
fixed maturity between 5 to 10 years.

Euro credits are short to medium term loans of Eurocurrency

extended by Eurobanks to the corporations , sovereign governments , non
prime banks or the international organisations. The loans are denominated in
a currency other than the home currency of the Eurobank . Because these
loans are frequently very large for a single bank to handle ; Eurobanks
comes together to form a bank lending syndicate to share the risk. The
credit risks on these loans is greater as compared to other loans .

The interest rate on Eurocredits must compensate the

banking syndicate because of the increased level of risk . On the Eurocredits
originating in London ; the base lending rate is LIBOR. The lending rate on
these credits is stated as LIBOR + a specified percentage. This percentage is
the lending margin charged which depends upon the creditworthiness of the
borrower. Roll over pricing on Eurocredit was created so as to ensure that
the Eurobanks earn more on Eurocredits than what they pay on
Eurocurrency time deposits . Thus ; here Eurocredit may be seen as the

53
series of short term loans where at the end of each time period ; the loan is
rolled over and the base lending rate is recalculated with reference to the
current LIBOR . Let us see an example of Rollover Pricing of Eurocredit .

P. Ltd. ; a multinational company can borrow $ 60,00,000 at

LIBOR plus a lending margin of 0.75 % per annum on a three month roll over
basis from a London bank. Assume that the three month LIBOR is currently
177/32 %. Also assume that over the second three month interval ;
LIBOR falls to 41/8 %. How much will P.Ltd. pay in interest to the bank in
London over the six month period for the Eurodollar loan ?

Solution : $60,00,000*(0.0553125+0.0075)/4+$60,00,000*(0.05125+0.0075)/4

= $ 94,218.76 + $ 88,125.00
= $ 1,82,343.76

Syndicated Euro Credits are availed by the corporations or

small firms as well. Government and the government related borrowers
resorted to medium Euro credit market for industrial and infrastructure
projects and also to finance the deficits in Balance of Payments.

World bank and its affiliates are its regular borrowers .The
Euro currency market is not constrained by the availability of funds . Euro
dollar credits takes the form of Term Loans and Revolving Credit Facility.
Loans can be tailor made to suit the specific requirements of borrowers.
The term loan is divided into various parts like the draw down period , grace
period and redemption period. Revolving facility permits the borrower to draw
down and repay at its discretion for a specified period of time.

Because of large size of the loans ; the technique of

Syndication came in vogue. It also enables the banks to diversify the risks

54
associated with financing at the international level. The lead bank assembles
the group of other banks . Generally ; three levels of banks i.e. the Lead
bank , Managing bank , and Participating banks are present in a syndicate.
The loan amount may range from $ 5,00,000 to several billions. Term loan
with a grace period before the commencement of repayment of principal is
a common type of syndicate loan. The factor of grace period is one of the
determinants of the cost of the loan.

As these loans are for a quite longer period ; the resulting

interest rate risk from the mismatch is covered by the technique of roll over
credit pricing. Interest on syndicated loans is altered every three to six
months in consonance with LIBOR. The spread beyond LIBOR is the
‘spread’ which is negotiated with the borrower before the loan is granted.
This spread remains constant over the life of the loan or a change in it is
effected after a certain number of years.

Project finance in the energy sector in Asian region is likely to

become a major business for the Syndicated Euro credits.

iii Euro credit market : Collection of banks that accept deposits and
provides loans in large denominations and in variety of currencies. The
banks that comprise this market are the same banks that comprise the
Euro currency market. The difference is that the Euro credit loans are
longer term than so-called Euro currency loans. Interest rate is reset every
3 to 6 months with reference to LIBOR.

Following is in brief a summary of the clauses found in a Euro Currency

Loan Agreement :

1. Description of the parties to the loan and the loan amount

55
2. Definitions clause : It includes the meaning of various crucial terminology
used in the loan agreement.
3. Copy of resolution approving the loan amount to be taken specifying the
signing authority who shall sign all the concerned documents by the order
of and on behalf of the borrower company. Proper and sufficient
disclosure of the signing authority is required to be mentioned specifically
along with the specimen signatures.
4. Legal searches and legal opinions so as to ensure that all the concerned
legal formalities are duly and properly complied with so as to avoid future
legal tangles.
5. Rate of interest linked to LIBOR including the percentage of the Spread.
6. Commitment fees plus legal charges for effective execution of the
documents along with the cost of mortgages if any and the amount of
stamp duties.
7. The insertion of a pari-passu clause requiring the borrower to treat all the
members of the loan syndicate equally without any sort of discrimination.
8. In respect of repayments : the clauses as to the manner and mode of
repayment , time duration of the loan and the clauses in respect of pre-
payments. The additional charges which are to be paid in case of pre-
payments etc.
9. Warranties and representations from the borrower in respect of the
required approvals , compliances with all the laws , rules and regulations .
A declaration is also required from the borrower’s end as to non-pending
of any legal suit against it along with bank guarantee.
10. A subordination clause requiring the borrower to the concerned loan and
not to allow the other loans to have prior ranking.
11. An undertaking of non disposal of assets from the borrower.
12. A clause containing the penalty provisions in case of default in making the
repayment of the loan as scheduled , non compliance of any of the loan
agreement clauses.

56
Summary:

Thus syndicated Euro credit is loan extended by a syndicate of banks,

which accepts deposits, and provide loans in large denominations. The term is
generally of one year but it may be extended by the banks. It can be structured to
have various options.

Important terms: LIBOR, Floating rate loan.

Self study questions:

1. Explain in detail the meaning of syndicated Euro credits.

2. Discuss the crucial aspects in negotiating syndicated Euro credits.

Additional Readings: -“Lending Decision & Spreads. Syndicated Euro currency

Market, K.M. Ahmad, Indian Economic Review.

*********

57
 UNIT : 3 : International Bond Markets

CONTENTS
________________________________________________________________
Lesson Number Lesson Starting Ending
Page Page
________________________________________________________________

1. Types of International Bonds 58 61

2. Types of Bond Markets 62 65

vi

3. Euro Bonds and the

Procedure of its Issue 66 68

58
Unit No. 3
International Bond Markets

Learning objective: To study the growth of bond markets and its importance in
international finance.

Lesson No. 1 : Types of Bonds

Introduction : The multinational companies ( MNCs ) requires huge amount of

finance for financing their activities world wide. For financing such a huge
requirement ; a number of financing options are available at their disposal. The
option of Equity finance through ADR or GDR issue, Project Loans ,
Participatory Notes , Bonds etc. Each of these financing alternatives involves the
detailed considerations of risk , cost and the control. The decision of the right
financing mix to be used in the capital structure also depends upon host of other
factors and as such this decision becomes a complex task especially in an
international set up.

The presence of differential taxation policies of various

governments , inflation rates , capital investment policies etc. plays a crucial role
in the decision of deploying the right financing mix . The objective in having the
right financing mix is to ensure that the cost of capital shall be reduced to the
minimum. The aspect of debt- equity ratio also plays a decisive role in this
respect along with the financial leverage. Bonds is a borrowed source of finance
wherein the borrower MNC is required to pay the interest at a specified date and
the amount of the principal is required to be repaid at the expiry of the bonds
period. In India ; the interest on the bonds is a tax deductible expenditure and
as such it helps in reducing to a considerable level the cost of bonds. But ; each
country has its own tax laws and the provisions thereof and the prevalent rate of
interest in that country are required to be taken into account before embarking
upon the issue of bonds for raising the funds. A prudent financial manager shall

59
have a judicious mix of various short term and long term sources of finance at the
minimum possible cost.

Now ; let us turn our attention to the bonds and its different types.
1. Bond : A bond is a debt security issued by the borrower purchased by the
investor, usually through underwriters.

2. Euro bond: Bonds sold in countries other than the country represented by
the currency denominating them e.g. US dollar denominated bond sold
otherwise than in USA are Euro bonds. This segment of Euro bonds of
the international bond market accounts for nearly 80 % of new offerings.
This is because US Dollar is the currency most frequently sought in the
international bond financing .The role of Lead Manager , Underwriting
Syndicate , Managing Group always plays a crucial role in the issue of
issue of Euro bonds in the primary market.

The secondary market for the Euro bonds is an

over- the – counter market . The principal trading do take place in London.
The other centres wherein trading is done are Luxemberg , Frankfurt ,
Amsterdam .This secondary market consists of Market makers and
brokers connected with telecommunication equipments. The market
makers and brokers are the members of International Securities Market
Association.

3. Hedging: Action taken to insulate a firm from exposure to exchange rate

fluctuations.

4. Parallel bonds: Bonds placed in different countries and denominated in

the respective currencies of the countries where they are placed are called
as parallel bonds.

60
 5. Convertible bonds: A bond which gives the holder the option to convert
the bond(s) into equity at a fixed conversion price are convertible bonds.

6. Currency cocktail bond: Bond denominated in a mixture or cocktail of

currencies.

7. Dual currency bonds: Long-term securities denominated in two

currencies e.g. initial and interim coupon payment on a bond in non-US
dollar currency and a fixed final payment in US dollars. This is a dual
currency bond. That is for example ; a straight fixed rate bond issued in
one currency say Deutsche Mark paying coupon interest in that same
currency. At maturity ; the principal amount is repaid in US Dollars.
Generally ; the coupon rate is higher than the comparable straight fixed-
rate bonds. It is in the nature of a long term forward contract from the
perspective of the investors.

8. Equity related bonds: Securities, which include bonds with equity

warrants and convertible bonds.

9. Foreign bond: Bond issued by a borrower foreign to the country where

the bond is placed is called as foreign bond e.g. bond issued by a US
national resident organization / company in France. These bonds must
meet the security regulations of the country in which they are issued.

10. Junk bonds: High-yield bonds that are below investment grade. These
assets have been used by for leveraged buy-outs and corporate take over.

11. Global bonds : It is an issue of a very large international bond offering

by a single borrower which is simultaneously sold in North America , Asia and
Europe . It helps the borrower to raise the finance at reduced costs .e.g. Global

61
bonds issue of $ 14.6 billion Deutsche Telekom in the form of multicurrency
offering.

12. Zero coupon bonds : These are sold at discount from face value and
do not pay any coupon interest over their life . At the time of maturity ; the
investors receives the full face value. These bonds are generally denominated in
US Dollar and Swiss Francs . Response of Japanese investors is attractive
because of their tax laws treat the difference between face value and the
discounted purchase price of the bond as tax free capital gain. Another form of
Zero bond is the Stripped Bond.

Foreign bonds issued on American markets are called as Yankee bonds while
those issued on Japanese markets are called as Samurai bonds.

Self Study Questions :

1. Write a detailed note on various types of bonds in the international market.

2. Write a detailed note on bonds as a source of finance.

Key Words : Capital structure , Financial leverage , long term and short
term source of finance , Yankee Bonds , Junk Bonds , Global Bonds .

62
 Lesson No. 2 :
Types of Bond Markets

International bond market consists of two basic segments :

Foreign Bonds and Euro Bonds. A foreign bond is offered by a foreign
borrower to the investors and is denominated in that nation’s currency.
e.g. An U.S. MNC issuing Franc –denominated bonds to French
investors. On the other hand ; a Euro bond issue is denominated in a
particular currency but sold to investors in the country other than that
issued the denominating currency. e.g. A Dutch borrower issuing Dollar-
denominated bonds to the investors in the U.K. , Switzerland etc.
Eurobonds are usually bearer bonds. However because of this ; they
enable tax evasion . But because of this fact ; these bearer bonds give a
lower yield which makes them less costly source of funds for the issuer.

Significant Features: - Financial markets everywhere serve to facilitate

transfer of resources from savers to the borrowers. An efficient financial market
achieves an optimum allocation of surplus funds between alternative uses and
also offers the savers a wide range of instruments enabling the diversification of
portfolios. Different types of instruments as markets respond to changing needs
of investor/borrower. For developing countries; in respect of debt finance;
external bonds and syndicated credits are the main sources of funds.

There are various International bond market indexes like Global

Government Bond Index , J.P.Morgan and Company Domestic Government
Bond Indices etc. which are widely referenced and used as standards of
International Bond Market performance.

63
 Now let us see meaning of the term hedging in relation to the bonds.
Interest rate risk can be minimized and eliminated in the
environment of volatile interest rates by using various techniques and
instruments. One of them is Hedging. Borrowers ensure that their borrowing cost
does not exceed some ceiling rate. Interest rate futures can be used to reduce
the risk. Hedging is thus an action taken to insulate a firm from exposure to
exchange rate fluctuations.

The theory of term structure of interest rates focuses on effect of

time on the interest rates. It enables us to find out the reason of different
maturities having different yields and thus helps in the valuation of the bonds.
The price of any financial instrument is equal to the present
value of the expected cash flows from it. To determine the price ; an estimate of
the expected cash flows and an estimate of the required yield are necessary. The
cash flow for a bond consists of periodic coupon interest payments to the
maturity date and the par value at maturity.
The required yield is based upon the aspect of required return on
which a financial instrument having a similar risk structure will have expressed
in the form of the interest rate. With the information of the cash flow of a bond
and the required yield ; the price of a bond is determined by totaling the present
values of six monthly coupon payments and the present value of par or maturity
value at the time of the bond maturity.
Thus ; generally the following formula is applied for calculating the price of the
bond . However ; at the international level it is required to be adjusted to take into
account the factors like exchange rates , levels of inflation , taxation effects etc.

C C C C M
P= ________ + ________ + _______ + ….….+ ________ + ________
1 2 3 n n
( 1+r ) (1+r) ( 1 +r ) (1 + r ) (1+r)

64
where P = Price of the bond
n = Number of years
c = Six monthly coupon payments
m = Maturity value
t = Time period when the payment is to be received i.e. the duration of
the bonds.
The basic theory of the bonds states that its price changes in the
opposite direction from the change in required yield. The price of the bond is the
present value of the future cash flows. With the increase in the required yield ;
there is a fall in the present value which causes the price of the bond to fall. On
the other hand ; a decrease in required yield ; there is an increase in the present
value of the bond which causes an increase in the price of the bond. When the
coupon rate equals the required yield ; the price of the bond matches with its par
value. In case of the yield rising above the coupon rate ; price of the bond will fall
below its par value.
Now let us formulate the current yield.
Current yield = Annual Coupon Interest / Price
The current yield considers only the coupon interest by ignoring the time
value of money.
The summarisation of the relationship between current yield , yield to
maturity , and bond price is as follows :
Coupon Rate = Current Yield = Yield to Maturity.
If the bond is selling at a discount ;
Coupon Rate < Current Yield < Yield to Maturity
If the bond is selling at a premium ;
Coupon Rate> Current Yield >Yield to Maturity.

Key Words : Foreign Bonds , Euro Bonds , Bond Market Indexes ,

Required Yield , Current Yield , Coupon Rate .

65
Self Study Questions :

1. Explain the concept of Hedging in relation to the bonds .

2. Briefly discuss the difference between the Foreign Bonds and Euro
Bonds .
3. Define and discuss each of the different types of international bond
market instruments.

Reference Sites :
1. www.bondmarkets.com
2. www.clearstream.comwww.fitchibca.com

Additional Reading :
• Dosoo ,George. The Euro Bond Market , 2 nd Edition ,New York ,
Woodhead, Faulkner , 1992.
• Lederman , , Jess , Keith K.H. Park , The Global Bond Markets ,
Chicago : Probus , 1991.

66
 Lesson No. 3 :
Euro bonds and its Issue Procedure

Now ; let us see the concept of Eurobond & its issue

procedure in brief.
Eurobonds are the bonds sold in countries other than the country
represented by the currency denominating them e.g. Bonds denominated in yen
sold in Britain. The procedure for issue of new Euro bonds has evolved over
time.
• It generally involves initial organizational meeting with the issuer company to
discuss terms and conditions. It fixes responsibilities, marketing and other
strategies, trustee selection etc.
• At second stage; Board approvals are obtained. Sales material, draft
documents are prepared and sent to printers.
• In third stage invitation is sent by lead managers to underwriters etc. &
listing application is made. Invitation so sent is accepted by concerned
agencies like underwriters.
• In next stage, the syndicate tours are arranged for in which price
information is prepared. After that allotments are fixed internally by lead
managers and communicated to syndicate. Final pricing meeting is held with
borrower.
• In next stage, all the agreements are signed and payments are made.
Thus there are three important stages in the issue of Euro bonds.

1. Sending of invitations after the lead manager has assembled the syndicate to
manage the distribution of bonds issue as the underwriters and sellers.
2. Making of a firm commitment by the syndicate to the borrower on various
terms like offering and pricing date. This is based upon the assessment of the
response.
3. Closing date wherein ; bonds are purchased from the issuer and are
distributed to the investors.

67
 Thus ; generally the aspect of issue and distribution of the bonds
goes through the various stages like Preliminary Negotiation and preparation ,
Pre-placement , Pricing , Offering Day , Placing the Issue , Closing the Issue.

Launch Day offering Offering Day syndicate Closing Day

D Day period stabilization D + (20 to 30)

This is the general flow chart for issue procedure.

The bonds are listed on Luxemberg and London Stock Exchange

during the course of issue in order to have an open access to the investors.
Prices are quoted bid-ask net of commission and the trades are effectively
settled with the help of EUROCLEAR or CEDEL .

Key Words : Bearer Bond , Convertible Bonds , Dual Currency bonds , Euro
bonds , Foreign Bonds ,Global Bond , Lead ,manager , Primary and Secondary
Market, Underwriters , Zero Coupon Bonds.

Self study questions:

1. Explain in detail the procedure of new issue of Euro bond.

2. Define Hedging and explain its importance and application.
3. What are the methods of Euro bond valuation? Explain in detail.
4. Write a short note on international bonds market.
5. Distinguish between Euro bons and Foreign Bonds
6. Define and discuss each of the types of bonds issued in the International
Bonds Market.
7. Explain the various factors which are to be taken into account by the
issuer and the investor of Dual Currency Bonds?

68
 Web sites for reference : For international bonds and their ratings
1. www.fitchibca.com
2.www.moodys.com
3.www.standardandpoors.com
4.www.jpmorgan.com
5. www.bondmarkets.com

Additional Readings:
1. “Euro bond”: F.G. Fisher, Economy publications, London.
2. “Measuring the Risk of Foreign Bonds”: Journal of portfolio management:
Dym S. I., New York.
***********

69
 UNIT : 4 : Swaps And Markets

CONTENTS
________________________________________________________________
Lesson Number Lesson Starting Ending
Page Page
________________________________________________________________

1. Interest Rates and

Currency Swaps 70 79

2. Pricing Options 80 90

vii

3. Features of International Bonds 91 94

70
Unit No. 4
Swaps and Markets

Learning Objectives : Objective of this unit, is to study the meaning of swap

products and its market structure.

Lesson No. 1
Interest rates & currency swaps.

Learning objectives: To study various swaps and analyze the methodology of

valuation of swaps.

Introduction : Swaps were introduced in 1981. In 1985 ; the International

Swap Dealers Association was established . Its aim was to standardise the
procedures , documentation etc. Swaps are used by various financial
institutions , commercial and investment banks , corporations , government
agencies etc.

Need for swaps : The need for swaps arose out of felt needs of the corporates
to hedge the underlying risks and uncertainties of financial outlays and outflows.
The risks may arise out of trade in merchandise items or invisible items of
balance of payments. Even in capital account ; foreign borrowings require both
the interest rate risk coverage and currency risk coverage.

In respect of domestic financial markets also ; all these risks sans

exchange rate risk are present. The swaps in the domestic markets are required
for risk coverage in interest rate changes , yield adjustments , timings of inflow ,
and of the outflows ,management of assets and liabilities and portfolio etc.
Swaps from fixed interest to floating interest rate loans are used for adjusting
the yield pattern. Portfolio adjustments require the change of portfolio

71
composition to tune the expected inflows to come at the timings of expected
outlays ; which is called as the portfolio duration adjustments.

The risk and uncertainty hedge is an objective of swaps. For

example ; a swap used between a fixed interest loan and floating interest loan for
risk hedging. It can also be used for shifting the basis of interest rate fixation
from LIBOR based to one based on Treasury Bill Rate or a Bank rate. The swaps
enable the parties to the contract in exchange of principals at maturity at the
current spot rate or the predetermined exchange rate . The presence of
imperfections in the market creates the differential risk – return relationships by
making the swaps as the required instruments of hedging.

Currency swaps saves in costs, promote liquidity by providing

hedge to the risk .Currency swaps are used for financing the long term
requirements of funds for the projects of multi national corporations ( MNCs ) .
Swaps are used as the vehicle of for meeting the financial needs of MNCs .

Important Terminology:

Swap: The simultaneous buying and selling of a currency for different maturities.
The two types of swaps are forward swaps and spot / few and swaps. Swaps
are private arrangements to exchange the cash flows in the future as per a
predetermined formula. The currency swaps involves an exchange of principal
and fixed rate interest payments on a loan in a particular currency for the
principal and interest payments on the roughly equivalent loan in an another
currency. Swaps is an agreement between the two or more counter parties to
exchange the obligations arising from two or more debt instruments.

Swaps are the off balance sheet items because of their zero
initial value and the presence of the right to offset the swap.

72
 Currency swaps involves larger and a comparatively more
volatile exposure than that of the interest rate swap since the former involves the
exchange of the principal. Swaps are generally arranged by the banks as they
helps the banks to provide loans and accept deposits in any currency.

Interest rate swap: It is an agreement to swap interest payments; whereby

interest payments based on a fixed interest rate are exchanged for interest rates
based on floating interest rates. The interest rate swaps are over the counter
contracts between the two counter parties for exchanging interest payments for
a specified period , based on a given principal amount. The amount of principal
remains unchanged or constant but the flows of interest payments are
exchanged ; for example from fixed rate to floating or vice- versa. Only the cash
flows are exchanged and not the principal.

Thus in interest rate swap financing ; two parties called

counterparties make a contractual agreement to exchange cash flows at periodic
intervals. There are two types of interest rate swaps. One is a single – currency
interest rate swap which is also referred to as interest rate swap . The second
one is called as a cross currency interest rate swap which is also called as the
currency swap.

These Interest Rate Swaps ( IRS ) offers following advantages :

• The banks can use swap transactions to hedge the existing assets and
liabilities.
• The swaps are useful to the bank and financial institutions as an effective
instrument in the management of the interest risk.
• Banks use swap instruments for hedging and trading activities.
• The swaps helps in converting the rate of return on assets from uncertainty to
certainty by taking care of interest rate fluctuations risk.

73
• Swaps helps in generating profits and avoiding losses from the interest rate
fluctuations . Swaps helps in altering the cost of cost of existing borrowing
from fixed to floating rate or vice – versa.
• The banks act as an intermediary for arranging IRS as between two different
parties.

The banks are required to follow the prudential norms in respect

of capital adequacy and asset base along with controlling the level of Non
Performing Assets. This activity of capital maintenance along with the prudent
financial management is accomplished with the help of an effective use of swap
instruments as the bank assets are exposed to risk. The swaps acts as a cover
for these risks which help in effective risk management and hedging in respect of
rise in the level of risk in any contingency.

Currency swap: An agreement to exchange one currency for another at a

specified exchange rate and date is a currency swap. Banks commonly serve as
intermediaries between two parties who wish to engage in a currency swap. Here
two payment streams denominated in two different currencies are exchanged.
Following the collapse of Bretton Woods ; fixed exchange rate agreement and
exchange rate volatility created the need amongst MNCs to hedge the long term
foreign exchange exposure. This gave rise to the Currency Swaps. The currency
swaps evolved from parallel and back – to – back loans. These parallel and back
– to – back loans were created to counter the Exchange Controls. Through the
mechanism of the parallel loans the taxes could be avoided.

Cross Currency Interest Rate Swap : It is the swap of both the currency and
interest rate . e.g. A company has borrowed in through a US Dollar denominated
fixed coupon rate bond but the company requires Deutsche Mark ( D.M. )
denominated floating rate bond to be used for its German undertaking. This fixed
rate US Dollar bond will be exchanged for the floating rate D.M. denominated
bond.

74
Pricing of Swap : Swaps acquire the values as soon as the interest rate
changes or the spot rate changes. Swap being the combination of loan and
investment ; its value is equal to the difference between loan and investment .
The swaps rates are close to the long term Euro loans to the borrowers.

In the secondary markets for swaps ; the transactions may take

the form of a swap reversal , a swap sale , or assignment. In a swap reversal ; a
new swap of equal maturity in respect of time remaining to maturity for the
original swap is substituted with the same reference rate and capital.

Let us see an example of Currency Swap. A.Ltd. ; a

multinational has borrowed in US $ at a fixed rate. It wants Japanese Yen for
its expansion programme in Japan . It can swap its exchange risk by entering
into a contract for giving Japanese Yen at a floating rate or fixed rate ; for US
$ ; it has the borrowing at the fixed rate. If it wants both the interest rate and
exchange risk hedge ; the company may surrender its loan taken in US $ at a
floating rate to a Japanese Yen loan at a fixed rate. The swap contract
behaves like a long dated forward exchange contract .

Thus the currency swaps is a series of future exchange of

amounts of one currency for other currency. It involves spot purchase or sell of
foreign currency and its simultaneous offsetting by forward sell or buy
respectively. The situation of excess in a particular currency and shortage in
another currency creates an ideal ground for the currency swap to work. In a
currency swap ; principal amounts are exchanged at the beginning and at the
end of the term of the swap and the interest payment is made periodically . The
currency swaps are used to reduce the cost of the loan and to access the
restricted markets.

75
 A cross currency swap is a contractual agreement between the
two parties in which one party promises to make the payment in one currency
and the other promises to make payment in another currency. It may take any of
the following form :
i. Floating Currency A into floating currency B
ii. Fixed Currency A into fixed currency B
iii. Floating Currency A into fixed currency B
iv. Fixed Currency A into floating currency B

Basic swap : It is also called as Plain Vanilla Swap. It is fixed – for – floating rate
interest rate swap . Both the debt obligations are denominated in the same
currency. In this one party exchanges the interest payments of a floating – rate
debt obligation for the fixed -rate interest payment of the other party.

Swap Bank : It is a term used to describe a financial institution that facilitates

swaps between the counterparties It is an international commercial bank , an
investment bank , a merchant bank. It serves either as a broker or a dealer. It
receives commission as remuneration for this service.

There are various types of basic currency and interest rate

swaps. Fixed –for- floating and floating –for- floating currency rate, zero coupon
– for- floating rate swaps are its variants.

Thus swaps offer counterparty benefits and has shown

tremendous growth. It has also become an important source of revenue for the
commercial banks.

Now let us see, in some detail ; the aspects of swap. The

essence of a swap contract is the binding of two counter parties to exchange two
different streams over time. Financial swap markets has its origin to the
exchange rate instability that followed by the fall of Bretton woods. Swaps are at

76
the centre of global financial revolution. They are having a major macro
economic impact forging the linkage between the Euro and domestic market.
Swap transactions are not executed in a physical market.

The majority of interest rate swap are driven by the cost savings to be
obtained by each of counter parties. It results from differentials in the credit
standing of counter parties. A greater premium is demanded of issuers of lesser
credit quality. Underlying source of funds remains unaffected. Interest rate swap
market is of two types – primary and secondary market. Banks must observe
capital adequacy norms in interest swap.
Let us see an example of Interest Rate Swap.

A.Ltd. and B.Ltd. ; both the companies want to borrow $

30,00,000. Fixed interest rate on loan is 8 % and 9 % for A.Ltd. and B.Ltd.
respectively. In case of floating rate ; the companies can obtain the loan at
LIBOR +1.00 % and LIBOR+4.00 %. A. Ltd.is having an advantage over B.Ltd.
in case of fixed rate and floating rate regimes . However ; comparatively ; BLtd. is
having an advantage over A. Ltd. in the fixed rate system as B.Ltd. has to apply
only 1 % (9%-8%) extra as compared to 3 % (4%-1%) in floating rate system .
Both A.Ltd. and B.Ltd. can benefit by arranging a swap to share the comparative
advantage.

Thus ; interest rate swap is an agreement between two parties to

exchange interest obligations or receipts over an agreed period of time . Interest
Rate swaps are generally used when two parties are able to borrow at different
interest rate systems.

Now let us see an example of Currency Swap :

P.Ltd. and Q. Ltd. desires to borrow in Dollars and Pounds
respectively. But P.Ltd. can borrow Pounds at a cheaper rate than Q.Ltd. while
Q.Ltd. can can borrow Dollars at a cheaper rate than P.Ltd..

77
 Here ; both the companies can enter into a Currency Swap to
share the advantage of the cheaper borrowing capacity of the other company.

On the basis of the above discussion ; we can formularise the

following uses of Swaps :

• Currency swaps are used when a firm finds that it has excess in one
currency and shortage in the another currency.
• Short term swaps are set up to secure two reciprocal loans.
• The swap enables to have future interest payments and amortisations to
have equal values.
• Flexibility of swaps allows perfect matching of cash flows . This extent of
perfection could not be achieved by forwards and futures.
• Fixed for fixed currency swaps offer advantages which reflects market
imperfections.
• The company uses the swapping of the domestic currency loan into a foreign
currency loan ; which ensures the payment of a risk free rate for foreign
currency plus the spread on it.

A swap bank familiar with the financing requirements of Bank A

and the Company B has the opportunity to set up a fixed – for – floating interest
rate swap that will benefit each counterparty and the swap bank.The essential
re-requisite for the swap is that a Quality Spread Differential ( QSD ) exists.

A QSD is the difference between default-risk premium

differential on the fixed – rate debt and the default-risk premium differential on
the floating-rate debt. Generally ; the former is greater than the later because
the yield – curve for the lower-quality debt funds is generally steeper than the
yield-curve for the good-quality debt. The lenders are not required to renew and
are least bothered about the lock in case of good – quality debt funds.

78
Summary: Swaps are used as hedging instruments in order to minimize the
losses in turbulent market.

Key Words: Plain vanilla swap, exchange rate, fixed interest rate, floating
interest rate , counterparty , cross-currency interest rate swaps, Swap bank ,
Swap Reversal , Euro Loans , Reciprocal Loans , Market imperfections , Swap
Sale , Parallel Loans.

Self study questions:

1. Explain in brief the concept of swaps.
2. Explain in detail various swap products available.
3. What are the benefits of swaps product?
4. In a currency swap, both the principal and the periodic coupons are
exchanged. Why is this unnecessary in an interest rate swap?
5. Explain the different types of interest rates and currency swaps.
6. Discuss the basic motives for a counterparty to enter into a currency
swap.
7. Write a note along with illustration on the Cross Currency Interest Rate
Swap .
8. Write in detail along with suitable illustrations the various uses for which
the swaps can be put to use.
9. Explain the methodology of pricing of swaps.

Project / Field work:

Study the methodology used for valuation of a currency swap, that is the
exchange of a floating rate in one currency for a fixed rate in another currency.

Reference Sites :
1.www.isda.org

79
2. www.bis.org

Additional Readings:
1. “Interest Rate Swaps”: Arak Estrella, Goodman & Silver in Financial
Management, US.
2. Pingle , John J. and Connoly , Robert A. : “The Nature and Causes of
Foreign Currency Exposure” in Kolb , Robert W. , The Corporate Finance
Reader , Second Edition , 1995, Blackwell , USA.

*********

80
Lesson No. 2
Pricing Options
Learning objective is to study the pattern and mechanism of pricing the options
and its application in day-to-day life.

Keywords:
1. Foreign exchange option: It is a contract for future delivery of a specific
currency in exchange for another. The holder of the option has the right to
buy or sell the currency at an agreed price but is not required or obliged to do
so.

2. Option premium: For getting such a right, the buyer pays a price which is
called as the option premium.

Important points:

 Options are purchased and traded on an organized exchange. They are

generally standardized contracts.
 Cross rate options are also available like DM/Y, £/DM, £/Y. US dollar is
out of the equation.
 Options are of various types like currency options, stock options,
commodity options, interest rate options.
 Provides the purchaser with downside protection and upside opportunity.
 Price of option depends crucially on the probability of the option being
exercised.
 In deep-out-of-the-money option; strike price for exceeds the current
market level index.
 In out-of-the-money options; market price is quite close to the strike price.
 Those options are at the money the strike price of which is equal or close
to the ongoing market price.

81
 Various models of pricing the options are available e.g. Fischer Black’s
option pricing model. For detailed reading refer page 299 of International
Financial Management by V. K. Bhalla.

Thus an option is a contract giving the owner the right , but

not the obligation to buy or sell a given quantity of an asset at a specified
price at some time in the future. Like a future or a forward contract ; an option
is also a derivative. Its value is derived from its underlying asset e.g. a
foreign currency. An option to buy an underlying asset is a call and an option
to sell the underlying asset is a put option. Buying or selling the underlying
asset through the medium of the option is called as the exercising the option.
The price at which the option is exercised is known as Exercise or the Strike
price.

In terminology which is used in reference to the option ; the

buyer of an option is referred to as the long while the seller of an option is
referred to as the short or the writer of the option. Because the option owner
does not have to exercise the option ; if it is to his disadvantage ; the option
has a price or premium. The options basically are of two types : American and
European. The European option can be exercised only at the maturity or
expiration of the date of the contract while the American Option can be
exercised at any time during the currency of the contract.
Still let us have a look at the aspect of Valuation of options as it occupies an
important position.

A put or a call option to exchange financial assets or financial

liabilities gives the holder the right to obtain potential future economic
benefits associated with the changes in the fair value of the financial
instruments underlying the contract. Conversely ; the writer of an option
assumes an obligation to forego potential future economic benefits or bear
potential losses of economic benefits associated with changes in the fair

82
 value of the underlying instrument. The contractual right of the holder and
obligation of the writer meet the definition of a financial asset and a financial
liability , respectively. The financial instrument underlying an option may be
any financial asset , including shares in other enterprises and interest
bearing instruments. A option may require the writer to issue a debt
instrument , rather than transfer a financial asset , but the instrument
underlying the option would constitute a financial asset of the holder if the
option were exercised.

The option holder’s right to exchange the financial asset

under potentially favourable conditions and the writer’s obligation to
exchange the financial asset under potentially unfavourable conditions are
distinct and separate from underlying financial asset to be exchanges upon
exercise of the option. The nature of the holder’s right and of the writer’s
obligation are not affected by the likelyhood that the option will be exercised.

Because of their altogether different nature ; the basis of

valuation of options is also different from that of the valuation of other
securities like Equity shares , Preference shares , Debentures etc.

The valuation of options depends upon a host of factors

relating to the underlying assets which can be seen in following manner :

• Current value of the underlying asset is crucial as the options are Financial
Derivatives . In case of Financial Options ; the value of the underlying assets
like shares , bonds etc. will determine the value of the option.
• Income generated from underlying assets like dividend or interest causes
fluctuations in the value of options.

83
• An increase in interest rate increases the value of call option and reduces the
value of put option because the option holder has to pay the option premium
in advance for buying an option.
• The expiry time of option also determines option value . The longer the time
to expiry ; the higher would be the value of the option.
• Any expected change in the value of the underlying asset also impacts the
value of the option . Higher the variation in the value of the underlying
asset ; ;the greater the value of the option.
• The exercise of the option depends upon the difference between the strike &
the actual price of the underlying asset.

The value of an option usually does not fall below the intrinsic value.
Now the question arises as to what is the intrinsic value of an option?

In general terms ; the intrinsic value of an option is the value

which the option holder has ; in respect of the choice of whether to exercise the
option or not ; depends on the interplay of the strike price and the market value
of the underlying asset . Intrinsic value in respect of call option and put option is
required to be separately taken into account. The presence of arbitrageurs in the
market ensures that the value of the option does not fall below the intrinsic value.

The most established model for valuation of options is Bionomial

model ( B.M. ). It simplifies and formularises the aspect of valuation of options.
This model provides an exact pricing formula for an American call or put.
Following is the formula used under this model.
C1 – C2
No. of units of underlying asset= ------------------
S1 – S2
Where ; C1 : Value of call option if the share price is S1.
C2 : Value of call option if the share price is S2.

84
 Here ; the basic assumption is that the current price of the share ( i.e. the asset
underlying the option ) is “ S”. It can take and oscillate between two values
namely S1 & S2 wherein S1>S>S2.

This model helps to create a portfolio which consists of the

underlying asset and riskless asset. The principle of the arbitrage also applies
here. However this model may not work if there are multiplicity of share prices
because this model considers only two share prices namely S1 & S2.

Another model is Black & Scholes Model ( B.S.M. ). This model

uses five variable namely :
1.Current value of share
2.Interest Rate
3.Strike price
4.Fluctuations in the price of underlying asset.
5.Time before expiry.

This is a mathematical model and enables one to take the

benefits of option mispricing by accumulating riskless profits. However the
formulation is quite complex . The formula in this model is :

Value of a call option = SN ( d1 ) – Ke N ( d2 ).

Where ; S : Current market price of underlying shares.
K : Strike price of the option
t : Time before expiry of the option.
r : Annual risk free rate.
N ( d1 ) : Normal distribution of d1.

This model is based on certain basic assumptions . Most of these

assumptions are practically not present in any given situation. These
assumptions are as follows :

85
 Strike price or exercise price is the price at which the owner of a
currency call option is allowed to buy a specified currency, or the price at which
the owner of a currency put option is allowed to sell a specified currency

1.No penalty is leviable for short selling in shares.

2.There is a continuous random movement in share prices.
3.The short term risk free rate is known and is constant during the option period.
4.There is an absence of taxes and transaction costs.
5.The call option is an European option.
6.No dividend is paid by the underlying shares during the option period.
Most of these assumptions are very impractical & do seldom exist.

B.S.M. is an extention of B.M. In case of payment of dividend by

the company during the option period ; the value of call option goes down while
that of put option will increase.

Let us have a illustration of the application of this Black & Scholes Model :

The equity shares of ABC Ltd. is presently selling at Rs. 50. A

call option with a period of 4 months and strike price Rs. 45 is available for Rs.
6 per share. Is the option correctly priced if :

i. A dividend of Rs. 2 is expected in 2 months’ time.

ii. The variance in log of share price is 0.06
iii. The risk free rate of interest is 3 %.

In this case ; the value of the call option may be found by

applying the Black & Scholes Model in the following manner.

Adjusted share price; Sa = Share Price – Present Value of Dividends.

86
 = Rs. 50 - ( Rs. 2)
________
2/12
( 1+0.03)

= Rs. 50 - Rs. 2
_______
1
(1+0.005)

Adjusted Share Price = Rs. 48.01

Values of d1 and d2 can be calculated by the following formula :

In ( Sa / K ) + ( r + 0.5 variance) t
d1 = d1 ______________________________
_____________
\ | Variance * t
\|

= In ( 48.01 / 45 ) + ( 0.03+0.5*.06 )4/12

________________________________
_________________
\ | ( 0.06 * ( 4 / 12 ) )
\|

= 0.0647+0.02
___________
0.1414

87
 d1 = 0.60

d2 = 0.60 – 0.1414

d2 = 0.4586

Therefore ; N ( d1 ) = N (0.6 ) = 0.7257 ( as per log )

N ( d2 ) = N( 0.4586 ) = 0.6760 ( as per log )

-rt
Value of the call = Sa * N ( d1 ) - Ke * N ( d2 )
=( Rs. 48.01 * 0.7257 ) - ( 45 * 0.99 * 0.6760 )
= 34.84 – 30.12
= Rs. 4.72

If the call is available for Rs. 6 per share ; then it is overpriced because the fair
value of the call is Rs. 4.72. At a price of Rs. 6 ; the call is not correctly priced.

Now let us give a cursory look at Straddle. Straddle is an

offsetting position taken by investor in the option market by simultaneous
holding of call and put option at the same strike price and same expiry period. It
can also be done by writing both the put and call options for the same strike price
for the same expiry period.

The investor is required to pay the premium on the call and put
option . He will definitely earn the profit irrespective of price going above or below
the strike price.
Option values are determined by the current spot rate, the
exercise price, time to maturity, domestic and foreign interest rates and
exchange rate volatility.

88
 Whenever an underlying exchange rate is more then the strike
price of a call or is less than the strike price of a put ; a currency option is said to
be in-the-money. The option premium in this case will be higher than that of the
at-the-money option ; which is an option for which the strike price is equal to the
current exchange rate.

The option has to be sufficiently in-the-money to cover the option

premium in its entirety which has been paid as an upfront. An option is said to be
out of the money when the strike price of a call is less than or when the strike
price of a put is more than the current exchange rate. The premium for an out-of-
money option is generally lower than that of the at-the-money option.

The intrinsic value of an option is the amount by which the option

is in-the-money. Thus only an in-the-money option can have intrinsic value. On
the other hand ; the time value of an option is the amount by which the price of
an option exceeds its intrinsic value.

For example ; the spot price of Deutsche Mark ( DM )is $0.55 ; a

DM 50 call can have intrinsic value of $0.05 per DM and a DM 50 put would
have no intrinsic value. An option having no intrinsic value expires worthless.

Usefulness of options: Currency options are useful for anyone who requires a
gain if the exchange rate goes one way but wants protection against the loss if
the rate goes the other way. Foreign exchange options represent an
asymmetrical risk profile. Most option trade at a price higher than the gain that
would be made from exercising the option. Arbitrage plays crucial role in option
price.

Key Words: Organized exchange, cross rate options, exercises of the option,
strike price, asymmetrical risk profile, arbitrage , American option , at-the money ,
in-the-money , out-of the-money , European option , Intrinsic value .

89
Self study questions:
1. What are the components of an option premium?
2. Why is the price of the option always greater than its intrinsic value?
3. Why can not the intrinsic value of the option be less than zero?
4. When should a company buy a call option for hedging?
5. When should speculators buy a put and call option(s)?
6. Discuss the Fischer Black’s option pricing model.
7. X Ltd. , an Indian company has to make payment of $ 5 million ( 50 lakhs )
after 6 months against import of plant & machinery. Discuss the different
alternatives to hedge against this foreign currency exposure.
8. B Ltd. is planning to import a multi-purpose machine from Japan at a cost
of 3,400 lakhs Yen.The company can avail loans @ 18% p.a. with
quarterly rests with which it can import the machine .But there is an offer
from the Tokyo branch of an Indian based bank extending credit of 180
days @ 2% p.a. against opening of an irrevocable letter of credit.
Other information is as follows :
Present exchange rate : Rs.100 = 340 Yen
180 days’ Forward rate : Rs. 100= 345 Yen
Rate of commission for letter of credit is @ 2% p.a.
Advise whether the offer from the foreign bank should be accepted?
(Solution: Total cash outflow under Option I = Rs.1,092.03 Lakhs & that
under Option II = Rs.1,005.23 Lakhs. As such Option II shall be selected. )
9. A company operating in a country having the $ as its unit of currency has
invoiced sales as on today to an Indian company . The credit period is of
3 months from the date of invoice. The invoice amount is $ 13,750 and at
today’s spot rate of $ 0.0275 is equivalent to Rs. 5,00,000.
It is anticipated that the exchange rate will decline by 5% over the 3 month
period and in order to protect the $ payments , the importer proposes to
take appropriate action in the foreign exchange market . The 3 month
forward rate is presently quoted as $ 0.0273. You are required to

90
 calculate the expected loss & to show how it can be hedged by a forward
contract. ( Solution : Rs. 26,316/-. )
10. Examine the relationship between the spot rate and forward rate.
11. What do you mean by foreign exchange risk management ? What are the
techniques to offset the foreign exchange risk?
12. Differentiate between forward contracts & future contracts.
13. The current market price of equity shares of R.Ltd. is Rs. 70/- per share . It
may be either Rs. 90/- or Rs. 50/- after a year. A call option with a strike
price of Rs. 66/-(time period = 1 year ) is available. The rate of interest
applicable to the investor is 10 %. He wants to create a replicating
portfolio in order to maintain his pay off on the call option for 100 shares.
Find out the hedge ratio . ( Solution : Hedge Ratio : 0.60 ).

14.Write short notes on :

i. Strike price
ii. Forward contracts
iii. Straddle
iv. Underlying asset.
15. What are the Futures and options contracts ?
16.Write a note on call option and a put option.
17. Explain in detail the factors determining the value of an option.
18. Explain with the formulation the concept of hedge ratio.
19.State along with your comments the basic assumptions of Black and
Scholes Model.
20. Explain the terminology that an option is in-,at-,or out-of-the-money?

Additional Readings: “Option Pricing: A Simplified Approach”: Journal of

Financial Economics, Ross & Rubinstein.
***********

91
Lesson No. 3
Features of International Bonds:

Learning objectives in this lesson to study various types of bonds, which are
used to raise finance in international markets and to analyze its characteristics.

Important Terminology :

Bond: It is an instrument through the mechanism of which the funds are

borrowed in international markets. It is a debt security issued by the borrower,
purchased by the investor, usually through the intermediation of a group of
underwriters.

Elaboration: The funding avenues open to a borrower in the global capital

markets can be categorized as: straight bonds, Floating Rate Notes (FRNs), zero
coupon and deep discount bonds and the bonds with a variety of option features
embedded in them.
Let us have a brief discussion on some of the bonds :

The straight bonds have finite maturities and interest payments

are at the intervals of one year. Straight bonds are also issued on perpetual
basis . Bullet bonds provides for the repayment of entire principal on a single
maturity date. Full or partial redemption before the date of maturity can also take
place.

Floating rate notes are the bonds carrying interest based on a

reference rate such as LIBOR or stock market index. Zero Coupon Bonds are
sold at a discount and no interest is paid and hence are preferred by the issuers.

Some bonds are attached with Equity Warrants and thus confers
a right on the owner to purchase a specified and pre-determined number of

92
equity shares of the issuing company at the rice specified . Such bonds carry a
lower rate of interest and are sold at a discount. These bonds can also be used
as financial swaps if the warrants attached to them detachable. The obligation in
case of these bonds can not be reduced or eliminated.

There is an another type of bond which is used occasionally and

that is Putable Bonds . In this type of bonds ; the issuers can redeem the bonds
at a predetermined price after the stated period of time .

 A non-resident company issuing a dollar denominated bond in the US capital

market is called as a Foreign Dollar Bond. Whereas, a dollar bond issued
outside the US is Eurodollar Bond. It is also called as international dollar
bond.

 Straight Bond is a traditional bond having a fixed period of maturity and a

fixed coupon rate. Floating Rate Note is a bond with varying coupon and
interest rate payable for the next six months is set with reference to a market
to a market index such as LIBOR (London Inter Bank Offered Rate) FRNs
are of two types i.e. capped FRNs and Collared FRNs.

 Zero coupon bond is purchased at a substantial discount from the face value
and redeemed at face value as maturity. There are no interim interest
payments. In case of deep discount bonds the coupon rate is below the
market rate for a corresponding straight bond. Return to the investor is in the
form of capital gains.

 Convertible bonds are the bonds that can be exchanged for equity shares of
the issuing company or some other company. The conversion price
determines the number of shares for which the bond will be exchanged. The
conversion value is the market value of the shares, which is less than the

93
 face value of the bond at the time of issue. As the share price rises, the
conversion value rises.

 Warrants are an option sold with a bond, which gives the holder the right to
purchase a financial asset at a stated price. The asset may be further bond,
equity shares or foreign currency.

 A large number of variants have been brought to the market e.g. drop-lock
FRNs, convertible FRNs, dual currency bonds etc. The largest international
bond market is the Euro bond market. A formal credit rating as S & P or
Moody’s helps in placing the bond issue terms attractive to the borrower.

 Many Euro bonds are listed in stock exchange in Europe. Secondary market
trading in Euro bonds is entirely over the counter by telephone between the
dealers. Floatation costs of Euro bond issues are generally higher than
syndicated credit costs.

 Dollar denominated bonds issued by foreign borrowers are called as Yankee

Bonds. These are exempt from elaborate registration and disclosure
requirements but credit rating is useful.

References and additional readings:

1. “Measuring the risk of foreign bonds”: The Journal of Portfolio
Management, by Institutional Investor Inc. New York.
2. “Global Money & Capital Markets” by P. R. Joshi, shopping for finance,
2nd ed. Tata McGraw Hill Publishing Co. New Delhi.

Self study questions:

1. Explain in detail various types of international bonds.

94
 2. Explain the characteristic feature of the bonds issued in international
markets.
3. Whether raising the funds in international markets through international
bonds is the best way of tapping the funds. Explain with reasoning.

Project/Field work:

Analyze the instances of finance raised by Indian companies in the

last 2-3 years through the issue of international bonds and prepare a report on
the response it received and its impact a cost of capital of Indian companies.

*********

95
 UNIT : 5 : Central Banks And Balance Of Payments

CONTENTS
________________________________________________________________
Lesson Number Lesson Starting Ending
Page Page
________________________________________________________________

1. Central Banks And Balance of Payments 96 100

2. Reference Sites 98 98

3. Key Words 98 98

4.. Self Study Questions 98 99

5. Project / Field Work 100 100

8. Additional Reading 100 100

Unit No. 5

96
 Central Banks & the Balance of Payments

Learning Objectives : Learning objective in this unit is to study and get familiar
with the aspects of central bank and importance of maintaining balance of
payment position.

Introduction: Balance of Payment is the Collection of the Current Account, The

Capital Account & the Reserve Account. Balance of payment provides a detailed
information concerning the demand and supply of a country’s currency. For
example if the US imports more than it exports ;then that means the supply of
dollars is likely to exceed the demand in the foreign exchange market and vice-
versa. It will result in depreciation in the dollar vis-a vis the other currencies. In
case the US exports more than its imports ; then the value of dollar will
appreciate against the other currencies. The country’s balance of payment data
shows to the world its capacity to be a business partner. The data of balance of
payment is helpful in evaluating the performance of the country in the
international economic competition.
In the balance of payments ; any transaction yielding receipts
from other country is a credit item while a transaction yielding a payment to other
country is a debit. The former is accorded a positive sign while the later a
negative sign.

Important Terms & elaboration:

1. Central bank: It is the bank which supervises, controls and monitors all the
banks in a country e.g. in India, Central Bank is the Reserve Bank of India
(RBI). In US, it is the Federal Reserve.

2. Balance of payments: It is a comprehensive record of economic transactions

of the residents of a country with the rest of the world. It presents an account
of receipts and payments an account of goods exported, services rendered

97
 and capital received by the concerned country and goods imported, services
received and capital transferred by the concerned country.

Now let us see the concept of balance of payment.

Balance of payment records flow of economic transactions between one

country and another country. Certain transactions involving claims on and
liabilities to the rest of the world also get covered here even if they are between
two residents or two non-residents e.g. a sale of foreign exchange by the central
bank to a commercial bank; where both banks are resident banks in the same
country; would be recorded as a reduction in the foreign assets of official sector
matched by a corresponding increase in the banking sector’s foreign assets.

When a country is required to make a payment to other countries

because of a balance of payment deficit ; the central bank of that country runs
down its Official Reserve Assets like gold , foreign exchanges or borrow from
foreign central banks. In case of surplus in balance of payment ; central bank will
either retire some of its foreign debts or acquire additional reserve assets from
foreign countries.

When the balance of payments accounts are recorded correctly ;

the combined balance of current account , capital account ,and the reserves
account must be zero. This is known as the balance of payment identity. This can
be explained by way of the following equation :
BCA + BKA + BRA = 0
Wherein ; BCA : Balance on the current account
BKA : Balance on the capital account
BRA: Balance on the reserves account.

• Balance of payment is built up on the double entry system of book keeping.

98
• IMF has recommended in the ‘Balance of Payments Manual’ that “Market
Prices” be used for valuing transactions.
• In case of capital account transactions by convention, the change of
ownership takes place at the time when transactions are effected through
banking channels. The capital account consists of sub categories like direct
and portfolio investment and other investment.
• The current account is also called as income account showing country’s
receipts and payments on account of goods and services. The capital account
is its reflection. The current account includes the export and import of goods
and services while the capital account includes all purchases and sales of
assets such as stocks , bank accounts , bonds , businesses etc. The official
reserves account covers all purchases and sales of international reserves
assets such as dollars ,gold , foreign exchanges etc. A country can run a
balance of payments surplus or deficit by increasing or decreasing its official
reserves.
• The current account transactions are classified into ‘mercantile’ and
‘invisibles’. While capital account transactions into ‘private’, ‘banking’ and
‘official’.
• Balance of payments offers precision to a country’s external transactions. It
acts as a guide to fiscal, monetary, trade and other policies. A decision to
raise bank rate which is done by central bank inevitably involves an
examination of balance of payments position. Taxation policy on import and
exports may affect balance of payments. Similar is the impact in relation to
public investment policies, development of tourism facilities. It also has an
impact on the exchange rates.

Reference Sites :
1. www.bea.doc.gov
2. www.ecb.int
3. www.imf.org

99
Key Words : Balance of payments , Capital Account , Current Account , Invisible
Trade, Official Reserve Account ,Portfolio Investment.

Self study questions:

1. Describe in detail the interlinkages in central bank and the balance of
payments.
2. Discuss the concept of balance of payments and critically examine various
methods of compiling the same.
3. Discuss the recent trends in balance of payments in India in the light of
Asian Crisis of recession.
4. Describe in detail the uses of balance of payments in the light of economic
enquiry.
5. Why should a corporate finance manager monitor BOP development?
6. Explain Official reserve assets and its major components.
7. Explain how a country can run a overall balance of payments deficit or
surplus.
8. Describe the balance of payment identity.
9. Explain how each of the following transactions will be classified and
recorded in the debit and credit of the French balance of payments:
i. A British insurance company purchases French Treasury
bonds and pays out of its bank account maintained in
Paris city.
ii. A French professional is hired by a British company for
consulting and gets paid from French bank account kept
by the British company.
iii. An Indian resident in France sends a cheque drawn on
his Paris bank account as a gift to his parents residing
in Pune.
iv. A French citizen taking a meal at a Paris restaurant and
pays with French card.

100
Project: 1. Analyze for the past 2-3 years, the balance of payments position of
India and its impact as the policies of Reserve Bank of India.
2. Study the website of IMF and discuss the role of IMF in dealing with
the balance of payments and currency crises.

Additional Readings: 1. RBI: “Balance of Payments Compilation Manual”,

Bombay.
2. Kemp and Donald. Balance of payments concepts – What do they really
mean ? Federal Reserve Bank of St. Louis Review , July , 1975 , pp 14-23
**********

101
 UNIT:6: The European Monetary System
And
Other Regional Artificial Currency Areas

CONTENTS
________________________________________________________________
Lesson Number Lesson Starting Ending
Page Page
________________________________________________________________

1. The European Monetary

System And Other Regional Artificial
Currency Areas. 101 105

2. Reference Sites 105 105

3. Key Words 105 105

4. Self Study Questions 106 106

5. Project / Field Work 106 106

Unit No. 6

102
 The European Monetary System & Other
Regional Artificial Currency Areas

Learning Objectives : Learning objective in this unit is to study European

Monetary system, the emergence of Euro vis-à-vis dollar.

Important terms and elaboration:

1.European Monetary System: All the countries in European Economic

Community except that of Britain joined the club and created European
monetary system. The member countries declared their bilateral parties. The
EMS had operating mechanisms which guided member countries intervention in
foreign exchange markets to maintain the bilateral rates within permissible
bands. The European Economic Community ( EEC ) countries thought it fit to
have stable exchange rates among the EEC countries so as to promote intra –
EEC trade and deepening economic integration. With this objective in mind ;
the European Monetary System was established in 1979. Among its objectives ;
the major objectives are :
1.Creation of monetary stability in Europe.
2.Proper co-ordination of exchange rate policies.

The main objective for creation of EMS was to create a

single economic zone in Europe with complete freedom of resource mobility
within the zone, a single currency and a single central bank. Finally the single
currency “Euro” came into existence in early 1999. During first three years of
transition, Euro co-existed with the national currencies of the eleven countries
which have decided to join single currency from the beginning. After this
transition period, the individual currencies ceased to exist.

103
 Thus ; EEC countries launched EMS to establish ‘ Zone of
Economic Stability’ in Europe. The two main instruments of EMS are
European Currency Unit ( ECU ) and Exchange Rate Mechanism ( ERM ).
ECU is the basket currency of EMS members and serves as an accounting
unit of EMS. On January 1 , 1999 ; eleven European countries adopted a
common currency called as the” Euro” .

Once a country adopts the common currency ; it obviously

cannot have its own monetary policy. The common monetary policy for the
Euro zone is framed by the European Central Bank. ( ECB ) . It is located in
Frankfurt. Euro has a strong potential of becoming another global currency
rivaling the US Dollar in the matter of the dominance in the international trade
and finance.

The companies all over the world can benefit from this
development as they can raise capital more easily on favourable terms in
Europe. The cross border alliances among financial exchanges , growing
independence from the banking sector and the European Mergers and
Acquisitions has created a salutory impact on the Euro. The transaction
domain of Euro may become larger than that of the US Dollar in the near
future.

Until now the US Dollar has played a major role as a global

currency . Because of this , foreign exchange rates of the currencies are
being quoted against the US Dollar . Also the majority of the transactions are
settled in US Dollars only. Because of this ; the central banks located world
over maintain a huge portion of their external reserves in US Dollars. This has
naturally put the US in a commanding position in various respects at the
world stage by conferring upon it he various privileges and benefits.

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 The increasing use of the Euro is likely to shift this power
equilibrium in its favour and require the US Dollar to share the
aforementioned privileges with it.

2. Other regional artificial currency areas: The Euro currency market is a

market principally located in Europe for lending and borrowing the world’s
most important convertible currencies i.e. Dollar, Sterling, Deutsche Mark,
French Frank, Yen etc. On the same basis, the Asian currency market or
African currency market can also be defined which are artificial regional
currency areas.

3. Asian currency markets: This market facilitates the use of dollar balances in
Asian Continent for the balance of payment purpose as well as investment in
projects. It has imparted greater liquidity to Asian economies. Singapore acts
as a bridge between Asian market in Tokyo and Hong Kong and the western
market in London, Paris and Frankfurt. Asian dollars are a separate entity.

Now ; let us study the linkages between the Euro dollar market
and Off-shore centres. The Euro dollar markets and other off-shore centres are
linked through a network of international transactions. The arbitrage transactions
shows the extent of linkages which are used to take the advantage of
differentials in interest rates . Revolution in electronics and communications has
ensured the integration and interlinking of the scattered markets around the
world.

The Euro Dollar market has influenced to a considerable extent

the policy framework of the European nations. A system of flexible exchange rate
regime has been brought in with the advent of Euro followed by the fall of
Bretton Woods wherein there was the system of fixed exchange rates. Euro
dollar market is based on the free mobility of the capital across all the countries.
The funds from Europe has moved to the United States because of a rise in the

105
rates of interest in the US. This sort of flight of capital from one country to
another has its on effects on the exchange rates and its mechanism across a
number of nations.

This type of instability in the exchange rate regime affects the

valuation and quality of assets and liabilities denominated in foreign currencies.
As a result of these effects ; the inter bank transactions which are entered to
nullify this effect may not be settled in a year thereby causing a structural
change in the Euro dollar denominated assets liabilities composition .

Petro Dollar market: Many petroleum producing countries started accumulating

foreign funds due to current account surpluses in their balance of payments.
These off-shore funds of the oil producing countries have been designated as
petroleum dollars and the market. These funds were kept with foreign banks or
national banks as off-shore funds and have given rise to the Petro dollars, which
are recycled for the purposes of re-lending, investment etc.

These oil producing countries are referred to as “OPEC

Countries” and includes Iran, Iraq, Nigeria, Bahrain, UAE, Qatar, Saudi Arabia,
Kuwait etc. Petro dollar market started developing since 1974. It like other Euro
currencies affect volume and geographical pattern of capital flows among
countries. These in turn influence the interest rates in the markets and exchange
rates as between the currencies.

Reference Sites :
1.www.ecb.int
2. www.pacific.commerce.ubc.ca/xr

Keywords: Euro, Petro Dollar.

106
Self study questions:
1. Explain in detail the European Monetary System (EMS) and the impact of
emergence of “Euro” currency as the international environment.
2. Explain various other regional artificial currency areas and position of
these currencies vis-à-vis Euro and US Dollar.
3. How the interlinking of the Euro dollar market and off-shore centres ahs
taken place and state its impact on the international finance.

Field/Project work: Visit the website of European countries Union as EURO and
report on Historical background for the emergence of EURO and its impact on
US dollar as the major currency of the world.

*********

107
 UNIT:7: International Capital Market

CONTENTS
________________________________________________________________
Lesson Number Lesson Starting Ending
Page Page
________________________________________________________________

1. New Instruments in
International Capital Markets 107 109

2. International Banking And

Country Risk 110 114

viii 3. International Portfolio Diversification 115 122

4. International Transfer Pricing 123 126

5. Forecasting And The Image

of The Future 127 132

6. GLOSSARY 133 138

7. QUESTION BANK 139 154

108
Unit No. 7
International Capital Market
Lesson No. 1
New Instruments in International Capital Markets

Learning objectives is to have knowledge about various instruments, which are

used in present day context to raise finance in international capital markets.

Important Terminology :

1. International capital markets: The markets which are spread internationally

i.e. in various countries of the world in which a company raises the capital for
the purposes of its business are generally known as international capital
markets. These extend beyond the geographical limits of a country in which
the concerned company is having its place(s) of business e.g. an Indian
company can tap US market for raising funds for its business by floating ADR
therein.

2. Instruments: Instruments are nothing but various modes of raising finance

e.g. capital may be raised by an Indian company by floating ADR, GDR issue
or by issue of the participatory Notes. Various instruments are available for
raising the funds in international capital markets.

Now let us have a glimpse of new instruments in international capital market.

The intention and objective of any financial management is to minimize

the cost of funds and maximization of wealth of the shareholders. In order to
reduce cost of capital, finance manager is in search of new markets in other

109
foreign countries especially in developed countries wherein the cost of capital
and rate of interest is lower.

By tapping such a market to raise the fund, the cost of capital can be
reduced down. It in effect, does have a contribution towards the maximization of
the wealth of shareholders. Brief elaboration in respect of some of the new
instruments in international capital markets.

American Depository Receipts: These are equity based instruments that are
publicly traded in the US securities market e.g. New York Stock Exchange,
NASDAQ, OTC. ADRs are US dollar denominated and can be issued and traded
only in the US. The equity shares represented by ADRs are thus offered in the
US markets. Dividend payment is made in US dollar.

Euro bond: Bonds sold in countries other than the country represented by the
currency denominating them.

Global Depository Receipts (GDR): These are equity-based instruments.

These have global market unlike in case of ADR. GDRs can be offered in US as
well as in non-US as well as in non US countries’ markets. It can be traded in
several currencies. The system of clearance is through global book entry clearing
through Global Depository. It is an easily and freely transferable instrument.

A reference can be taken from the Circular no. 52 dated

November 23,2002 under FEMA ; which gives the outline of the Operating
Guidelines for Divestment of shares by the Indian companies in the overseas
markets through the issue of ADRs , GDRs and the utilization of the proceeds of
ADRs , GDRs and Foreign Currency Convertible Bonds ( FCCBs ) in the first
stage of acquisition of shares in the divestment proceeds and also in the
mandatory second stage offer to the public in view of their stategic importance.

110
International Depository Receipts (IDR): These are equity-based instruments,
which are issued, traded and settled only in the European securities markets
through Euro clear and CEDEL.

Yankee stock offerings: This is the instrument, which is available to offer stocks
by non-US firms in the US markets.
Issue of equity through Participatory Notes (PNs).

Self study questions:

1. Explain in brief various new instruments in international capital markets.
2. Explain in detail, the mechanism of issue of ADRs and GDRs.
3. Explain in detail the mechanism of issue of Participatory Notes (PNs).

Field / Project work:

Study the procedural matters and aspects which go into making a GDR
and ADR issue a success and enlist the precautious to be undertaken with
reference to the grand success of issue of Equity of Reliance Industries Ltd. (RIL)
through ADR route.
**********

111
Lesson No. 2

International Banking and Country Risk.

Learning objective in this lesson, to study and analyze the role of international
banking system in international banking system in internationalization trade
regime and analyze the factors which are to be taken into account in order to
balance overall risk scenario of investment in other country/ies.

Important Terminology :

1. International Banking: It involves doing the business of banking across

the border through different forms of foreign bank organizations. It takes a
number of forms i.e. correspondent banking, foreign branch and
subsidiaries, consortium banks.
Let us see the meaning of International banking :

Solidity of international banking depends upon the solidity and

stability of the national economies. Economic growth has a positive influence on
it while recession and inflation causes negative impact.

International banking has been influenced by changes in

regulatory environment, technological change, financial innovation, growing
diversity in financial systems etc.

This has become possible because of advancement in science

and technology especially in the field of computer and communication and
information processing systems.

Because of the globalization of transactions through international

banking, the risk involved in the settlement of transactions has also increased
and as such, various settlement systems are in use e.g. in US, it is Federal

112
Reserve Settlement System (FEDWIRE) and Clearing House Inter Bank
Payment System (CHIPS). In UK, it is Clearing House Automated Payment
System (CHAPS), in France, it is SAGITTAIRE System, in Switzerland, it is
Bankers Clearing System and Swiss Inter Bank Clearing i.e. S/C.

Brief History: The Russian Debt Moratorium in August 1998 led to a dramatic
loss of market confidence. The Asian crisis which erupted in mid 1997 had
already rendered the environment much less favourable to the borrowers.
In first half of 1998, international banking activity was focused on borrowing
entities in Europe, North America. In mid 1998, abrupt swings in the credit
availability were noticed. Several cases of restructuring and recapitalisation
initiatives have been taken in Asia to tackle banking crisis. Changes in regulatory
framework were effected. Prudential regulations were tightened etc. bank
mergers and recapitalisation are being effected.

Let us see an example. International Finance Corporation (IFC ) , the

investment arm of World Bank is planning on increasing its exposure in the
Indian Banking industry .The corporation has evinced interest in investing in old-
generation private sector banks like Dhanalaxmi Bank ,Development Credit Bank
and Federal Bank. The process is not yet complete . But the intention is that
Indian banks would need large amount of capital infusion to adhere to the Basel
–II norms.

2. Country Risk: it constitutes the characteristics of the host country. It

covers a wide spectrum of political, socio-cultural, financial conditions,
which has a bearing and impact upon the cash flows of multinational
companies. Thus in short, it is exposure to a loss in cross-border lending
caused by events in a particular country. It is a broader concept than the
sovereign risk. The later means the risk of lending to the government of a
sovereign nation. Generally the country risk applies to assets and not to
the liabilities.

113
 All cross border lending in a country i.e. to the government, a
bank, a private enterprise or an individual is exposed to country risk. The most
frequent events that can lead to the materialization of country risk can be
classified as:
1. Political components: It includes war, riots, territorial claims, regionalism,
political polarization etc. are the critical factors in country risk analysis of
political nature.

2. Socio-cultural components: It includes unequal income distribution,

religious divisions, civil war etc. the spectrum of these components is to be
seen in relation to domestic level, national level and international level.

3. Economic components: Economic factors includes slow down in GNP

growth, inflation, strike, fall in export earnings etc. are to be examined in
depth.

Country risk assessment is a complex exercise. Those factors which are fairly
within the control of the government of a concerned nation are subject to country
risk.

The country risk assessment helps to determine whether the risk is tolerable.
In case, the risk is too high, then the company does not need to analyze the
feasibility of the proposed project any further. If the risk rating of the country is in
the tolerable range, any project related to that country deserves further
consideration. Country risk can also be incorporated in the capital budgeting
analysis of a proposed project by the adjustment of discount rate, cash flow
adjustment etc.

114
 The spread on Euro dollar loans which is negotiated with the
borrower depends on the assessment of the country risk by the lender bank or
the syndicate. Country risk is inherent in off-shore credit expansion having the
potentially favourable or adverse consequences as far as the recovery of debt is
taken into account. The risk in international lending is requires an in depth
analysis of the country risk. The essence of country risk analysis at the
international banks consists of an assessment of factors that would allow a
country to generate adequate hard currencies to repay external obligations as
and when they become due .These factors are both of the economic and political
nature.

Country risk is broadly divided into Sovereign Risk and

Transfer Risk. Sovereign risk occurs when a national government refuses to
permit loans to be repaid or effects the seizure of bank accounts without
sufficient compensation . Country risk analysis is made by Euromoney and JP
Morgan by using the following variables:

• Economic Performance : It involves global economic projections.

• Political Risk: It is non-payment or non-servicing of payments for goods and
services , loans etc. and the non-repatriation of capital.
• Re-schedulement of debt : It is based upon the default(s) in debt servicing .
• Credit ratings published by Standard and Poor’s , Moody ‘s etc.
• Access to capital markets and bank finance : It involves a study of
disbursement of loans as a percentage of GNP and also the level of access
to international bonds markets.

Let us take the example of Banking Industry . When a bank undertakes a

cross border lending and investment activities ; under foreign transactions route ;
it is faced with country risk consisting of Settlement Risk , Transfer Risk ,
sovereign and non-sovereign risk , cross border risk, currency risk etc.

115
 Country Risk Management involves aggregation of country
exposures and monitoring thereof against pre-defined limits on the basis of
rating framework.
In Currency Risk ; there involves a possibility that exchange
rate changes will alter the expected amount of principal and return investment or
lending.
Thus the banks shall put in place proper credit rating models
to evaluate the risk and to rate the counter party so as to fix the suitable
exposure limits.

Self study questions:

1. Discuss the motives that led to the growth of international banking.
2. Discuss various settlement systems of clearances that are used in
international banking.
3. Explain the characteristics of risks of international banking.
4. What are the various organizational factors of international banking and
explain the same.
5. Explain the recent trends in growth of international banking.
6. Identify and elaborate the common political factors for an MNC to consider
when assessing the country risk.
7. What are the various strategies available to a MNC in order to minimize
the incidence of country risk?

Field/ Project work:

As a country risk consultant, you are requested to conduct a country risk
analysis for MNC, which wants to develop a large sized subsidiary network in
various countries and submit a report.
Additional Readings: “Country Risk Assessment: Where to invest your money”,
Multinational Business by H. Cataquet, The Economist, London.

*******

116
Lesson No. 3
International Portfolio Diversification

Learning objective in this lesson, is to understand the meaning of portfolio

diversification and its importance in the vibrant and turbulent international
environment , the need to diversify the portfolio internationally and the gains from
such diversification , the impact of fluctuating exchange rates on these diversified
portfolios etc.

Important terms and elaboration:

Portfolio: It is a spectrum of investment strategies & modules wherein the

investment umbrella is generated in which the overall risk related to investment
reduces and optimum levels of return can be expected by balancing the risk and
return. “Not to put all the eggs in a single basket” is the guiding principle of
finance which underlines the necessity of creating an effective portfolio and its
diversification which covers differing spectrum of political, economic, financial
aspects relevant to various countries .

For example; a MNC has established a business of refinery in a

country in which there are heavy excise duties on production in refineries.
However, in the same country, there are substantial concessions from excise
duty in manufacture of textiles. Therefore, in order to reduce down the overall
cost of duty, the MNC could very well set up the textile manufacturing unit in that
country which will create diversification and built up effective portfolio of activities
so as to balance aspects of risk, cost and return. Its more projects are added, the
portfolio variance should decrease on an average. But when average reduction in
the variance becomes negligible, it means that the remaining risk cannot be
diversified.

117
Portfolio Management : The need for Portfolio Management arises from the
need to optimise the returns by balancing the risk level. Normally the principle is
that : Higher the risk ;Higher the return. If the rate of return expected from a
particular investment is high ; naturally the level of risk also rises.

Banks keep their foreign funds in various funds in the form

of cash in hand , balances with other banks , deposits with other banks having
differing maturities , foreign government bonds , treasury bills , short –term
commercial bills , treasury paper etc. These assets carry different maturity
periods and the risk levels.

The management of these assets involve the same principles of

risk and return which are applicable at the domestic level. Risk is at a higher level
in respect of foreign assets than in the domestic assets. The foreign currency
and fund managers have to plan to maximise the returns and minimise the
risks through the planned diversification into the country and currency
combinations and use Beta for long term assets so as to construct an effective
portfolio of the investment.

The currency manager has to choose a planned coverage of risk

and formulate strategies to reduce his risks in currency positions by utilizing
various instruments available for diversification and creation of an effective
portfolio.
For example let us take a case on an individual level. If a person
is not willing to take risk in respect of investment of his funds ; then he will have
to content with a relatively lower rate of return. He can invest the funds in Fixed
Deposits of a Nationalised Bank so that his principal amount remains safe &
secure & there will practically be no risk of loss of principal. But simultaneously ;
he will have to remain contended with a lower rate of interest as well.

118
 On the other hand ; a person willing to take risk & desirous of a
high rate of return on his investment may take the path of Mutual Funds or Stock
Market wherein he can earn a high rate of return by taking a high level of risk
under his belt which may also even cause in certain situations the erosion of his
capital . Thus rate of return is reward for risk taking.

The portfolio Manager has to balance risk & return so that to the
extent possible ; the risk can be minimised & return can be maximised. This is a
act of delicate balancing requiring a tight rope walk . For this purpose , the
portfolio manager shall be equipped with expert knowledge of all the investment
alternatives available along with their merits & limitations so far as it concerns
with risk & return.

Thus the delicate balancing of maximising the returns &

minimising the risk level leads to optimum returns. Portfolio Management enable
such optimum returns because of Diversification & helps in reducing the likely
adverse impacts of exposure concentration. Ultimately ; the Principle of Finance
advocates not to put all the eggs in a single basket.

Regular reviews of Portfolio is required to be carried out for

identification of strength & weaknesses well in advance so as to take remedial
action on the weaknesses before any calamity occurs. Steps are to be initiated to
maintain the desired quality of the portfolio along with the in built flexibility which
will take care of changes in ground realities so as to adjust the structure of
portfolio accordingly.

In respect of building of Portfolio for Corporate entities being

Multinationals ; additional precautions are to be taken . A high degree of alert is
required to be kept in respect of changes in international financial environment
involving policies of the concerned governments , new & emerging instruments
in the financial markets , trade cycle of recession & boom , performance of

119
various industries worldwide , mergers & demergers taking place etc. The
cumulative impact of all these on the rates of foreign exchange requires special
attention.

The economic , political , institutional , psychological factors do

tend to vary from country to country. This results in relatively low co-relations
among the international securities. This means that the investors are in a position
to reduce the portfolio risk to a great extent if they diversify internationally rather
than domestically. Various theories of Optimal International Portfolio Selection
are in place like Sharp Performance Measure which advocates the maximisation
of the Sharp Ratio of the portfolio weights.

Also the success of foreign investment by way of portfolio

diversification rests upon the performance of the foreign currency. Exchange rate
volatility is a major factor of close attention and vigilance .

The investors in The United States of America can have

international diversification by using American Depository Receipts ( ADRs ).
ADRs are traded on US exchanges resulting in savings in transaction costs and
speedy settlements. The British and European investors can have international
diversification by using Global Depository Receipts ( GDRs ). In the year 1996 ,
the American Stock Exchange introduced a class of securities namely World
Equity Benchmark Shares ( WEBS ) which are exchange – traded , open ended
country funds which keeps a close track of foreign stock market indexes. By
using the Exchange Traded Funds ( ETFs ) the investors can trade the entire
stock market index.

Thus due to deregulation of financial markets , introduction of

international mutual funds , internationally cross-listed stocks has caused a rapid
growth in international portfolio investment and diversification. The presence of

120
the risk of fluctuating exchange rates ; has acknowledged the importance of
hedging against this risk .

Now let us have a cursory look at the policies in corporate

investments. These are subject to constant revisions and the students are well
advised to keep a continuous track of these revisions , amendments and the
changes.
Investments made under the automatic route for Overseas Direct
Investment (O.D.I. ) ; Authorised Dealers are required to forward to R.B.I. ;Form
ODA along with the prescribed documents & a Report on remittance in form
ODR.
For streamlining the procedure for reporting O.D.I. in Joint
Ventures ; the requirement of forwarding form ODA along with prescribed
documents to R.B.I. for investment made under the Automatic route by Indian
parties has been dispensed with.

In terms of Regulation 4 of The Foreign Exchange Management

(Investment in Firm or Proprietory Concern in India ) Regulations ,2000 ; a non –
resident Indian or a person of Indian origin resident outside India may invest by
way of contribution to capital of a Firm or a Proprietory Concern in India.

The Regulation provides for certain conditions to be fulfilled in

investing such contribution as the capital of the firm or the Proprietory Concern
.These conditions are subject to constant amendments, changes & modifications
the track of which shall be kept by the students regularly.

Securities & Exchange Board of India ( SEBI ) has issued

circulars at different points of time regarding the modalities of Portfolio
Management by Foreign Institutional Investors. Let us have a look at the
summarised version of these modalities :

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 a. A system of reporting of transactions by Foreign Institutional
Investors ( FIIs) shall be in place.
b. Operating guidelines for reporting of transactions by FIIs.
c. Reporting of transactions in Equity on the basis of daily reports.
d. Uptodate reporting of Merger/Acquisitions , Amalgamation /
Splitting of the shares
e. Subscription in Public issues , Rights issues etc.
f. Cases of Amalgamations and Mergers.
g. Conversion of Debentures into Equity or Preference Share Capital.
h. Buy –back of shares and open offers.
i. Share Warrants issued .
j. Splitting of shares into shares of smaller face value.
k. Reporting of debt transactions.
l. Monthly reconciliation of Debt transactions.

 A greater riskiness of individual projects overseas could be offset by

beneficial portfolio. Multinationality alters firms perceived riskiness thereby
reducing its cost of capital.
 To maximize a portfolio is a decision, which requires important inputs like
expected returns and variance co-variance matrix. Returns, volatilities and
correlations should be forecasted.
 World Bank has defined portfolio flows as consisting of bonds, equity and
money market instruments and commercial paper.

Recently , Vodafone ; a British company has acquired a huge

stake in Bharati Tele Ventures Ltd. pursuant to the increase in threshold limit on
Foreign Direct Investment in Telecom sector to 74%.

The very recent example of diversion of portfolio at the

international level is of South Korea’s top mobile operator , SK Telecom’s
decision to invest upto $280 million in its Vietnam venture. The reason being that

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it faces slowing growth in an increasingly saturated local market. SK Telecom
controls half of South Korea’s mobile market . The company expects the changes
in regulations in Vietnam .The objective is to bolster the company’s
competitiveness & to grow as one of the major players in Vietnam.

Let us see another example . State Bank of India ( SBI ) is also

planning to acquire 76% stake in PT Bank IndoMonex, an Indonesian bank for
around $ 8-10 million.This will be SBI’s third overseas acquisition this year after
Indian Overseas International Bank of Mauritius for $ 8 million & Kenya’s Giro
Commercial Bank for $ 7 million. The acquisition aims at gaining an entry into
Indonesia .
Recently the Government of India has allowed 49 % Foreign
Direct Investment ( FDI ) in Asset Reconstruction Companies (ARCs.) It will give
a fillip to the activities of taking out distressed assets in the country. This will
enable the foreign companies to buy out Non –Performing Assets ( NPAs ) of
banks and Financial Institutions estimated at over Rs. 60,000 crores . The role of
ARCs is to take over bad loans from banks & financial institutions at a discounted
value and recover the bad debts. Allowing the foreign companies to invest upto
49 % in ARCs would also pave the way for entry of foreign banks and ARCs
which are keenly waiting to enter India.

It will open the floodgates for a number of banks and institutions

like GE , Citicorp , Merril Lynch , Morgan Stanley , ING , Standard Chartered
Bank , Actis etc. All these invest in Junk Bonds in the global market and as such
the entry of these players would help the growth of ARCs market in India. This
would help banks & financial institutions to unlock their funds from bad loans.

Thus ; Portfolio may be diversified in number of countries as well

so as to take benefit of different factors prevalent in various countries.

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Self study questions:
1. Explain in detail the concept and importance of international portfolio
diversification with suitable examples in present day context.
2. Discuss the various factors which has contributed to the emergence of
International Portfolio Diversification .
3. What are the different mechanisms which are available to a finance
manager to ensure a proper and planned creation of diversified portfolio ?

Key Terms : Variance, correlation, beneficial portfolio , FDI. Optimal International

Portfolios , WEBS , Exchange traded Funds , ADRs , GDRs.

Reference Sites :
1. www.themexicofund.com
2. www.ishares .com
3. www.adr.com
4. www.msci.com

********

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Lesson No. 4
International Transfer Pricing

Learning objective in this lesson, is to study the mechanism of transfer pricing

at international level and to analyze the methodology of the same.

Elaboration :

Pricing decisions are very much crucial in domestic market as

well as in international markets. On the pricing decisions are the various factors
dependent like profitability, tax and duty liability.

The pricing which is charged in respect of exchange of

goods and services between Head office and branch, parent company and
subsidiary company is known as transfer pricing as there is no sale of goods and
services involved to outside parties. There are the transactions in the same
group, which helps in determination and measurement of financial performance
of each activity within the group separately, which helps in managerial decision-
making.
Within a large business firm ; having a number of
divisions and departments; goods and services are frequently transferred from
one department to the other. This process of transfer brings forth the aspect of
the price at which such inter departmental transfers shall be recorded. Whether
each department shall be treated as a profit centre and if so what shall be the
transaction price of such transfer so that the transferring department can record
its profit on the concerned transfer ( s ). The pricing used by the transferring
department is the cost of the transferee department. Obviously ; larger the
transfer price ; larger will be the profits of the transferring division. But the
determination of this transfer price poses a number of problems at the domestic
level.

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 The same problems gets magnified at the level of the international
transfers. In case of a Multi National Corporation ( MNC ) , a large number of
factors and variables like exchange restrictions , exchange rates , discriminate
taxation rates , quotas and the import export duties makes this matter of
determination of transfer price a much more strenuous job.

Transfer pricing strategies may be beneficial when the host

country restricts the amount of foreign exchange that can be used for importing
specific goods. In this case ; a lower transfer price allows a greater quantity of
the goods to be imported under a quota restriction.

Transfer prices also have an impact on how the divisions of a

MNC are perceived locally. A high mark up on cost policy leaves little net income
to show in the affiliate’s books. If the parent company expects the affiliate to be
able to borrow short term funds locally in the event of shortage of cash ;say in
the form of working capital finance ; the later may be faced with the difficulties
with poor financial performance. On the other hand a low mark up over the cost
policy shows even if notionally that the contribution in the consolidated profits
has been brought out in a major proportion by the affiliates rather than the parent
company.
The strategy of the transfer pricing does have an impact on
international capital expenditure analysis.

The mechanism of transfer pricing is used by Multinational

Corporations to price intra-corporate exchange of goods and services. It is
designed in such a way so a to maximize overall after tax profit. It helps in
attainment of conflicting objectives.
 Legal constraints have been placed by many governments on the practice of
transfer pricing.
 Transfer price is different from arms length price.
 International Transfer Pricing serves as a tax planning measure.

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 It reduces exchange exposure and overcomes quota restrictions on imports. It
may sometimes be used as “window dressing” operations to improve the
reported financial position, which helps in improving credit rating.
 The devise of international transfer price is used to siphon profits away from a
high tax parent or affiliate to low tax affiliates and thereby to position the funds
in locations in strong currencies where there are virtually no exchange
controls.
 Tax codes and regulations of most of the countries acts as a dampener on
the employment of transfer pricing mechanism by MNCs. These regulations
enable tax authorities to reallocate and recomputed taxable income of
corporate entities ignoring or canceling the effect of transfer pricing.
 Very often; transfer pricing is characterized by exchange controls and
restrictions on profit repatriation. Tax minimization is a secondary objective.

Now let us see the actual application of international transfer pricing. A

parent company is situated in a country in which tax rates are low. While its
subsidiary company is situated in a country having high tax rates as it is in
developing country. In order to reduce the overall burden of tax liability; the
parent company may very well invoice the goods to its subsidiary at a price / rate
which is higher than the market price thereby booking more profit at the end of
parent company and simultaneously; lower profit at the end of subsidiary
company and as such, the overall tax burden can be reduced by employing the
mechanism of international transfer pricing effectively.

Now ; let us have an example of how the transfer pricing strategy

is actually used for tax planning purposes by MNCs.

A U.S. based company manufacturing cars and purchasing the

parts from its subsidiary located in a East Asian country wherein the tax rate is
low. The parent US company can reduce its reported US income and increase
the profits of its subsidiary by asking the subsidiary to charge more in the bill.

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The overall profit will be a good and healthy one still the company will
substantially save on the tax in the US by reporting a lower profit in the US
wherein the tax rates are on the higher side. Thus ; besides showing an overall
healthy profit ; the company also saves considerably on the tax payment through
the effective implementation of the transfer pricing mechanism at the
international level.

Key terms: Arms length price, window dressing , transfer price.

Self study questions:

1. Explain in detail the mechanism of international transfer pricing.
2. Explain the characteristic features and benefits which are offered by
international transfer pricing.

Reference Site : i. www.tpmba.com

Field / project work:

Prepare a report of analysis of mechanism of transfer pricing applied by MNCs in
Chemical industry during the last year and trace out the objectives fulfilled by it.

Additional Reading :

i. Prusa Thomas J.” An incentive compatible approach to Transfer Pricing “

Journal of International Economics 28 ( 1990 ).

ii. Tawfik, M. Sherih . An Optimal International Transfer Pricing System : A Non

Linear Multi Objective Approach . Ph.D. dissertation , Pennsylvania State
University , 1982.
*********

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Lesson No. 5
Forecasting and the Image of the Future

Study objective in this lesson, is to understand the nature and uses of futures
along with major characteristics of futures contracts.

Important terms:

Futures Contract: A futures contract is an agreement for future delivery of a

specified quantity of a commodity at a specified price.

Features of Future Contract:

Following are the important features of futures contract:
 Futures contracts are traded on organized futures exchanges.
 A futures contract is a standardized contract.
 The clearing House is the key institution in a futures market.
 Only the members of an exchange can trade in futures contract on the
exchange.
 In futures contract, actual delivery of commodity is rare.

Elaboration:

In futures market, there are two types of traders: Hedgers and

Speculators.

Hedgers use the futures to eliminate the price risk and the speculators
attempt to earn profit from price movements by taking a limited risk.

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 Thus Indian exporters , importers & their treasury managers do
generally require to reduce the risks of their exposure in the foreign exchange
markets.

But the actual experience upto the year 2004 has been that the Indian
exporters & importers have largely failed to exploit from the market scenario or
reduce their costs in the foreign exchange markets.

Indian corporate treasury & finance managers now have got following
solutions in view of changed circumstances & ground realities.
i.Entering into forward contracts with their respective banks.
ii.Enter into & execute Rupee based options
iii.Swap interest rates in different international currencies.

Still there appears to be a widespread ignorance in the market about

hedging activities.

Hedging activities come in handy for Indian exporters & importers ;

particularly when they cannot freely speculate & trade in international
currencies.

Also ; the exposure based hedging operations can particularly help in

cases where the international partners do not agree to change the currency in
which the billing is made.

Short position in foreign currency can be covered with a futures

contract with a maturity closest to it. To cover a long position in the foreign
currency ; a futures contract with the maturity closest to the maturity of long
position can be sold.

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 Hedging with the currency futures is more complex than the
hedging with the forward contracts ; but the currency futures are an effective
hedging instruments. However the futures contract are very useful only for long
term hedging and as such the same may not be useful for the short term
hedging purposes.

Delivery seldom takes place on a vast majority of the futures

contracts. The investors close out their positions before the specified date and
buy or sell the currency in a usual manner. The currency Futures are highly liquid
contracts having smaller margins.

The futures markets are auction markets and are traded on the
organized exchanges. Bids and offers are made through an open outcry
system wherein the offer is made to the public openly on location of the
exchange floor .

All trades are processed through the exchange clearing house . It

confirms trade and guarantees the fulfillment of the contracts. The defaults are
made good . It ensures that the all the trades are formally arranged through the
mechanism of the clearing members . Outside the US ; the trading of currency
futures is carried on electronically.

Because of the fact that the clearing house enters into the
reversing contract ; the futures contract offers greater liquidity .Majority of the
currency futures contracts are liquidated through reversal rather than delivery at
the time of the maturity. Currency Futures contracts are for a standard amount of
the currency .

The pricing of the futures contract is done by reference to an

arbitrage portfolio by combining the large position on the security underlying the
contract with financing at the risk free rate. The overall gain in a futures

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contract is the difference between the initial exchange rate and the rate in effect
when the contract gets closed out.

The futures prices of a currency are supposed to exceed its

forward price if the changes in the exchange value of that currency tend to be
positively related with the changes in the interest rate differentials between the
concerned countries. However ; in case of a negative relationship ; the future
prices of the currency are supposed to be less than the forward price.

The futures contracts are traded on many different underlying

assets. The particularly important contract in this segment is the Eurodollar
interest rate futures which are traded on Chicago Mercantile Exchange and
Singapore International Monetary Exchange ( SIMEX ). This Eurodollar contract
occupies a pivotal role in hedging the short term US Dollar interest rate risk
.Eurobanks can use it as an alternative to the Forward Rate Agreement ( FRA ) .

Reserve Bank of India ( R.B.I. ) has also granted General Permission

to the entities in Special Economic Zones for undertaking Hedging transactions in
the International Commodity Markets /Exchanges to hedge their commodity
price risks on imports & exports; provided such transactions are undertaken on
Stand –Alone basis .For further details ; the students can refer to the Circular in
this respect issued vide Notification No. FEMA66/2002-RB.

Summary:

The liberalization and globalization of economies across the world has

considerably changed the functional spectrum of finance manager from the
domestic level to the international level.

He is required to keep himself abreast with the changes taking place

domestically as well as internationally in respect of government policies,

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economic and taxation policies, inflation, exchange rates, introduction of new and
cost saving instruments of raising finance in international markets.

For that, he is required to develop the skills of analysis of financial

environment and design his strategy accordingly so as to ensure maximization of
shareholders wealth.

Key terms: Hedgers, speculators.

Self study questions:

1. Explain in detail the important features of futures contract.

List of web sites for additional reference:

1. IMF
2. EMU
3. Transfer Pricing.
4. RBI

****************

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 GLOSSARY

• American Depository Receipt : Negotiable certificates issued by

US banks to the investors in the foreign states certifying that a specific
number of shares of foreign company have been deposited with an
overseas branch of the bank or another financial institution that acts as a
custodian in the country of origin. These ADRs can be subscribed to only
by the resident investors in the US. These are not available for
subscription in any other foreign country.
• American Option : An option that can be exercised at any time
before its expiration date. Exchange traded currency options are generally
American style options.
• Arbitrage : Buying in a market where it is cheap and selling it in
the market where it is dear. The arbitrage exploits the price differentials
existing for a instrument or commodity in different markets. In International
Finance ; two types of arbitrages are in vogue i.e. interest arbitrage and
currency arbitrage.
• Asked Price : This is the price at which the securities are offered.
• Asian Currency / Dollar Market : The centre of Asian dollar
market is Singapore ; however it encompasses Hong Kong , Japan and
other locations.
• At The Money Option : A currency option the strike price of which
is equal to the prevailing Spot Rate ; or the prevailing rate corresponding
to the expiry date of the contract is said to be at-the –money option.
• Bearer Security : A security ; the ownership of which can be
claimed by mere delivery and possession for which no negotiation is
required is the Bearer Security.

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• Beta : It is the measure of Systematic Risk. It is the co-variance
between the returns on the assets and the returns on the market portfolio
divided by the variance of the returns on the market portfolio.
• Bid Price : It is the price which is offered for securities.
• Call Option : A currency option in which the holder has the right to
purchase or call a specific currency at a specific price on a specific
maturity date or within a specified period of time.
• CEDEL : It is the clearing system in Luxemberg in the Euro Bond
Market.
• Chicago Board of Trade : It is the exchange which specializes in
the trading of Futures and Options. It has the largest trading volume in the
world.
• Clearing House international Payments System ( CHIPS ) :
CHIPS processes and clears the interbank transfers of Dollars as a result
of foreign exchange transactions in New York. It is jointly operated by the
Federal Reserve and New York Clearing House Association.
• Collar : Collar is the strategy which is used in the currency options
wherein one option is sold and another is purchased. This results in the
creation of a range or the limit in which both the best price and the worst
price are defined . The collars minimise or eliminate the option premium.
• Commercial Paper : It is the unsecured short term note sold on a
discount ; through direct placement or through the dealers to the
investors. The guarantees are provided to the investors by the
commercial banks.
• Convertible Bonds : These are the bonds wherein an option is
given to the bond holder to convert the bonds held by him into a
predetermined number of equity shares of the issuing company at the time
of expiration of the bonds period.
• Country Risk : It is the risk which is associated with the lending ,
deposits or investments in a particular country. It covers a vast canvass of
the risks in respect of a proposed foreign investment .

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• Coupon Yield : It is the interest yield on a bond calculated as the
annual amount of money paid on coupons divided by the face value of the
bond.
• Covered Interest Arbitrage : A series of transactions in which a
currency is borrowed , converted into second currency and invested . the
second currency is sold forward for the first currency.
• Cross Rate of exchange : It is the exchange rate between the two
currencies which is derived from the exchange rate between these
currencies and the third currency.
• Cross Hedge : A hedge which uses the Futures Contract on an
asset that is different from the asset being hedged.
• Currency Option : It is the contract that gives the owner the right
to buy or sell a given amount of one currency for another currency at a
fixed price within a given period of time.
• Currency Swap : It is the exchange of a loan in one currency for a
loan in another currency wherein both the principal and interest payments
are exchanged.
• Debt-Equity Swap : Debt is purchased at a discount by the
investors and traded to the central bank at a discount for the domestic
currency necessary for the investment.
• Euro : Euro is the common currency of the countries in the
European Union. It was introduced so a to have a common currency for
the countries in the Europe and to eliminate the fluctuations in the
exchange rates which affects the trade and the financial transactions.
• Euro Dollar : Euro Dollar is the currency which is freely convertible
and deposited into the banks outside the country of the origin.
• Euro Bonds : The bonds issued in countries other than the one in
whose currency they are denominated.
• Exchange Risk : It is the risk which arises on account of
fluctuations in the rates of exchange between the two currencies. It
affects the financial values of the international transactions. It is thus the

136
fluctuations in the values of the assets and liabilities arising out of the
uncertainties about the changes in the exchange rates.
• Euroclear : It is one of the main clearing systems in the Euro
Bonds Market.
• Exposure : The potential for the gain or loss as a result of
movements in the foreign exchange rates . Three types of exposure are
there . viz : Economic Exposure , Transaction Exposure and Translation
or Accounting Exposure.
• Economic Exposure : It is the change in the value of the company
arising out of the change in change in the rate of exchange affecting the
cash flow and earnings.
• Transaction Exposure : A potential gain or loss arising from the
transactions that will definitely occur in the future , or currently in progress
or possibly completed.
• Translation or Accounting Exposure : The capacity for the
change in the reported earnings and the book values of the corporate
equity because of change in the rate of exchange.
• Floating Rate Notes ( FRNs ) : The interest rate on the bonds is
stated with reference to a reference rate like LIBOR . This interest rate is
adjusted in accordance with the changes in the LIBOR.
• Forward Exchange Rate : An exchange rate which is applicable
to the exchange of bank deposits which is to take place after a few days.
This rate is determined in advance .
• Forward Premium or Discount : It is the percentage difference
between a forward rate and the corresponding spot rate which is
expressed on the annual basis.
• Global Depository Receipts ( GDRs ) : These are the negotiable
instruments created by the overseas depository banks . These overseas
are authorised by the issuing companies in India to issue GDRs outside
the country. Unlike ADRs ; these are available for subscription by any

137
member of the public in the foreign country. A single GDR represents a
pre-determined number of equity shares of the issuing company.
• Hedging : It is a technique to offset the commitments in order to
minimise the impact of potential and probable unfavourable outcomes. A
number of Hedging instruments are available.
• In – The – Money Option : A currency option the strike price of
which would provide the option holder a rate which is superior than the
rate provided by the current spot rate or the forward rate corresponding to
the expiry date of the option.
• Intrinsic Value : The intrinsic value is the amount by which the
option is in the money. It represents the amount by which the strike price
is better than the current market exchange rate.
• Interest Rate Parity : It has got a theory which states that in the
perfect money markets ; the forward discount or the premium on the
foreign exchange market is equal to the relative difference between the
two interest rates.
• Interest Rate Swap : The exchange of fixed interest payment for
the floating rate payments . The swap necessarily involves two legs or
streams e.g. fixed and floating . In swaps ; there is an exchange of these
two streams i.e. fixed for floating and floating for fixed.
• LIBOR : London Inter Bank Offer Rate ( LIBOR ) is the interest
rate on interbank transactions in the Euro currency market quoted in
London.
• Long : It is the position involving excess of foreign currency
purchases over the sales or excess of foreign currency assets over the
liabilities or the excess of purchases of a particular futures contract over
the sales of the same contract.
• Offshore Banking : An off-shore banking centre is one where a
intentional attempt is made to have international banking business. It
involves reductions or the elimination of the restrictions of various types
and other financial and tax incentives.

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• Open Position : A net position of long or short in foreign currency
or the futures the value of which changes in accordance with the changes
in foreign exchange rate or the futures price.
• Out – of- The Money Option : A currency option the strike price of
which provide the option holder with an inferior rate to that provided by
the current spot rate or the current forward rate corresponding to the
option’s expiry date .
• Spot Exchange Rate : It is the rate of exchange for the closest
delivery date which is say after a gap of two working days.
• Spreads : Spreads are the difference between the Bid and Ask
price.
• Swap : Swap is a derivative instrument used for hedging purposes.
It has two legs or streams. It involves an exchange of one stream for the
other so as to protect against the likely fallout of adverse fluctuations in
the exchange rates or the interest rate . Thus it involves an exchange of
streams of payments between the two counterparties either directly or
through an intermediary.
• Swap Rate : It is the difference between the spot and forward
exchange rates expressed in the basis points.
• Syndication : It is a methodology of financing the huge amount to
multinational corporations etc. For this purpose a number of banks come
together. They pool their resources together. One of the bank in that group
is a Lead Bank.
• Zero Coupon Bond : These are the bonds on which no interest is
paid . These bonds do not carry coupon and are sold at a discount.

*****

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 QUESTION BANK

1. What do you mean by GOLD STANDARD ?

2. What is the difference fixed exchange rate regime and flexible exchange
rate regime?

3. Flexible exchange rate regime is one of the main causes of the evolution of
Euro as a currency. Comment on this statement.

4. What do you mean by International Financial System ? What are its

components ?

5. What are the different types of transactions which can be said to have made
the emergence of international finance ?

6. What is the nature of the transactions which involves an exchange of one

currency with another constituting the Foreign Exchange Markets ?

7. What do you mean by the term Integration of Global Financial Markets ?

8. Is there any change in the objectives of the Financial Management at the

Domestic level and at the International level ? Discuss.

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9. What are the peculiar features of international finance ?

10. What do you mean by Cross Border Transactions ? Explain with the help of
suitable example.

11. Explain the nature of Political Risk in International Finance.

12. What factors contribute to the Market Imperfections in the international

finance markets ?

13. What do you mean by the term Corporate Governance ? How it is useful in
effective management of international finance ?

14. What were the objectives of Bretton Woods ?

15. Explain the nature of environment which was there before the Bretton Woods
meet in the year 1944.

16. Explain in detail the multi-pronged strategy adopted at the Bretton Woods
meet.

17. Discuss the role of International Monetary Fund ( IMF ) as chalked out by the
Bretton Woods.

18. Discuss the various factors which contributed to the fall of Bretton Woods.

19. What do you mean by Derivatives Instrument ? Explain with suitable

examples.

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20. What are the effects of Industrial Revolution on the International Finance ?
How it gave boost to the import and export of goods and services ?

21. How the Industrial Revolution gave advent to the ‘Management ‘ of

international finance ?

22. State the role of GATT in promoting the international trade and international
finance.

23. Liberalisation and globalisation enabled to focus on the welfare of

shareholders along with the expanding framework of stock markets . Discuss
this statement with the help of suitable illustrations.

24. Write a note on Cross Currency Derivatives.

25. Which are the changes in the financial and settlement systems brought in by
the integration of worldwide financial markets ?

26. What was the major source of risk for the Derivative industry at the time of its
introduction?

27. What do you mean by the term Hedging Instruments ? Explain the uses for
which the hedging instruments can be put to .

28. What are the different types of Hedging Instruments ? Where they are
traded ?

29. What do you mean by OTC ?

30. Define the following terms : Derivatives and Underlying Asset.

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31. What are the various types of underlying assets ?

32. Which are the two types of economic agents that are required for the effective
performance of Derivatives market ?

33. Write in detail the various characteristics features of Derivatives .

34. What do you mean by the term Primary Market and Secondary Market ? Why
the Derivatives are not the primary market instruments ?

35. Explain in detail the various types of derivative instruments along with the
suitable illustrations .

36. How can the terms of exchange of the derivative instruments in the market
become favourable or unfavourable ? Explain with the help of a suitable
illustration.

37. Explain the meaning of the terms : Call Option and Put Option.

38. When does the performance under the options contract occur ?

39. An Interest Rate Swap may be viewed as a variation of the forward

contract . Elaborate this statement .

40. State the points of differences between the Futures Contract and
Forward Contract.

41. Explain the meaning of the terms Arbitrage and Arbitrageurs.

42. Explain in detail different types of Arbitrage.

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43. Why in case of a free market ; the scope for Currency Arbitrage is
very limited ?

44. How the Arbitrage ultimately leads to the Interest Rate Parity and
the Price Level Parity ?

45. How the recessionary trends in the economy a country leads to the
lowering of the investments ?

46. Which are the main factors which contributed to the emergence of
the Asian crisis ?

47. How the massive depreciation of the currencies led to the huge
capital losses in the Asia ?

48. Elaborate on the reasons of the eruption of the currency crisis in

the Asia.

49. What were the fallouts of uncontrolled capital infusion through the
mechanism of borrowings from the developed countries by some of the
Asian countries in the post liberalised era of global financial markets ?
How it ultimately led to the erosion of confidence of the investors and the
lenders ?

50. What were the damage control measures undertaken by the local
governments of the Asian countries ? What was its impact ?

51. What was the effect of an appreciation of the real exchange rate ?

52. Fixed Exchange rate regimes without effective capital controls are
useless. Discuss this statement.

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53. Explain the need of having a strong support of well developed
mechanism of institutional set up for the success of the liberalisation
policies in an economy.

54. Discuss in detail the impact of Asian crisis on India and China.

55. Explain how the Asian crisis affected various countries of the world
in a manner of a chain reaction.

56. Write short note on Euro Markets.

57. What do you mean by Euro Currency and Euro Dollars ?

58. Explain the process of securitisation of borrowing through the

mechanism of Euro Bonds and its reach .

59. Explain the role of Euro Banks .

60. Explain in detail various types of Euro Bonds.

61. What do you mean by Euro Credit Loans ? What are the different
participating institutions in these loans ?

62. The rate of interest on Euro Debt is calculated with reference to

which rate ?

63. What is the meaning of the term LOAN SYNDICATION ?

64. Explain the differences between Euro Bonds and Euro Currency
Loans .

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65. Euro Notes are of a hybrid class. Discuss this statement in detail .

66. Explain the mechanism of Euro Notes along with its advantages.

67. How the Euro Dollar Market has the effect of Base Multiplier ?

68. Explain the impact of growth of Euro Currency Market.

69. Explain the role of Multi Term Euro Notes as a mechanism of

raising the funds.

70. Discuss in detail the components of Short Term Euro Notes.

71. Write a note on Certificate of Deposit ( CD ) .

72. Explain in detail the role of Euro Issues in raising the capital in the
Indian context along with suitable illustrations.

73. State the peculiar features of Global Depository Receipts (GDR)

and American Depository Receipts (ADR).

74. Explain the mechanism of a GDR issue .

75. Discuss the emergence of Euro as a currency and its influence in

the International Financial Markets.

76. What do you mean by Euro Banks ? Explain the role played by
them.

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77. Explain the link between the Foreign Exchange Market and the
Euro Dollar Market.

78. What is the meaning of Long Position and Short Position ?

79. Write a note on Options and Futures .

80. Explain the differences between the Forward and Futures

Contract .

81. Explain in detail various types of Futures Contract.

82. What do you mean by the term Currency Futures ?

83. Discuss the concept of Hedging along with the suitable illustrations.

84. Explain the different types of Foreign Currency Exposures .

85. How the pricing of the Futures Contract is carried out ?

86. Write a detailed note on Futures Options .

87. Explain the mechanism of Currency Options .

88. What are the various types of Options ?

89. When the exercise of the option is profitable ? Explain with the help
of a suitable illustration .

90. Explain the role played by Foreign Currency instrument as a

Hedging instrument.

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 91. Distinguish between the Futures and the Options.

92. Write a detailed note on Futures Contract .

93. Explain in detail the meaning and purpose of Syndicated Euro

Credits.

94. Explain with the help of suitable illustration the mechanism of Roll
Over Pricing of Eurocredit . Why Roll Over Eurocredits are required ?

95. Generally by whom the Eurocredit is availed ?

96. What are the various types in which the Eurocredits are made
available as per the requirements of the borrowers ?

97. State the advantages of syndicated Eurocredits to the lending

institutions .

98. State the various clauses which are generally included in a Euro
Currency Loan Agreement .

99. What factors are required to be taken into account for designing an
optimum capital structure ?

100. Write a detailed note on Euro Bonds.

101.Explain in detail various types of the bonds in the international market.

102. What are the two basic segments in the International Bonds Market ?

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103. What are the various International Bond Market Indexes ?

104. What is the generally used basis for determination of price of financial
instruments ?

105. State the basic theory of the pricing of the Bond .

106. Write and explain the formula which is generally used in bond pricing
methodology .

107. Explain the relationship between the Current Yield , Yield to Maturity
and the Bond Price .

108. Explain in detail the concept of Euro Bonds.

109. Explain in detail the procedure of issue of Euro Bonds in the market .
110. Define and explain the need for Swaps .

111. State the different types of Swaps .

112. How the swaps helps in Hedging ?

113. What are the objectives of using a Swap ? Explain with the help of
suitable illustration .

114. Currency Swaps involves a larger and more volatile exposure than
the Interest Swaps. Discuss this statement.

115. Explain the importance of the counterparties in a Swap

arrangement.

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116. A Swap does necessarily involves two legs or streams of payments.
Discuss along with suitable illustrations .

117. Explain the different types of Interest Rate Swaps .

118. What are the various advantages of Interest Rate Swaps ?

119. What do you mean by the term Cross Currency Interest rate Swap ?

120. How the value or the price of a Swap instrument is derived ?

121. What are the different types of transactions entered in the

Secondary Markets for Swap ?

122. Explain the mechanism of Currency Swap along with a suitable

illustration .

123. What are the various forms which a Cross Currency Swap takes
place ?

124. Write a notes on : Plain Vanilla Swap , Swap Bank.

125. Which are the types of Interest Rate Swap Markets ?

126. Explain the various uses of Swaps.

127. What do you mean by Quality Spread Differential ? Elaborate .

128. Explain the terms : Foreign Exchange Option and Option Premium.

129. What is the meaning of options ?

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130. What are the various types of Options ?

131. What are the various factors on which the valuations of the Options
depend ? Explain in detail .

132. What do you mean by the Intrinsic Value of an Option ?

133. Explain in detail along with the formulation the Bionomial Model of
Valuation of the Options .

134. Explain along with the mathematical formulation the Black and
Scholes Model for Valuation of the options.

135. What are the various assumptions made in Black and Scholes
Model ?

136. What do you mean by the term Straddle ?

137. When an Option can be said to be In-the Money , At –the –Money

and Out – of – the Money ?

138. State the various uses for which an option can be put to .

139. What is the meaning of Floating Rate Notes ?

140. What are the Putable Bonds ?

141. Write Notes on the following :Foreign Dollar Bond , Euro Dollar
Bond , Straight Bond , Floating Rate Notes , Zero Coupon Bonds ,
Convertible Bonds .

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142. Define the term Balance of Payments .

143. What are the different components of Balance of Payments ?

144. Explain and elaborate the term : Central Bank .

145. What is the Surplus and Deficit in Balance of Payments .

146. Explain the concept of Balance of Payment identity .

147. What are the various items appearing in the Capital Account and
Current Account of Balance of Payments ?

148. Write a detailed note on European Monetary System .

149. Write a notes on : Zone of Economic Stability , Other Regional

Artificial Currency Areas .

150. Explain the linkages between the Euro Dollar Markets and Off- shore
centres.

151. How the Structural change in the Euro Dollar denominated assets
and liabilities composition get effected as to the fluctuations in the
exchange rate ?

152. Write short note on Petro Dollar Market .

153. Write a note International Capital Markets .

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154. What are the various instruments which are used in raising the
finance in International Capital Markets ?

155. Explain the logic for tapping the international markets for raising the
capital .

156. What do you mean by the term International Depository Receipts ?

157. Distinguish between Global Depository Receipts ( GDR ) AND

American Depository Receipts ( ADR ).

158. What do you mean by the term Participatory Notes ?

159. Explain in detail the concept of international banking and its

importance in the international financial market.

160. Define the term Country Risk.

161. What are the different factors of the Country Risk Analysis ?

162. How the Country Risk Analysis helps in risk level ascertainment so
as to take informed judgement in case of a proposed lending or
investment ?

163. What is the nature of the factors for which the Country Risk Analysis
can be carried out ?

164. How the Spread on the Euro Dollar Loan is determined on the basis
of Country Risk Analysis ?

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165. In which of the two parts the Country Risk can be sub- divided for
the purpose of in depth analysis ?

166. Explain in detail the various variables which are used in Country risk
Analysis .

167. What are the different types of risks in case of cross border lending
by the Banking Industry ? What sort of mechanisms are used for
tackling these risks ?

168. Define the term Portfolio. Explain the significance of Portfolio

Diversification in the context of International Finance.

169. Explain the concept of Portfolio Management .

170. Managing the aspects of Risk and Return is an act of delicate

balancing . Explain this statement.

171. What are the various precautions which are required to be taken
while building up a portfolio for the multinational corporate entities ?

172. International portfolio diversification results in minimising the overall

risks . Explain with the help of suitable examples .

173. State the various guidelines issued by SEBI in respect of modalities

of the portfolio management by the Foreign Institutional
Investors ( FIIs ) .

174. Define and explain the term Transfer Pricing and its relevance in the
international context .

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175. How the mechanism of Transfer pricing is utilized by the MNCs for
maximising the profits but minimising the tax outflow ?Explain with
the help of suitable examples .

176. Explain in detail the peculiar features of Transfer Price and the
various uses for which it can be put to .

177. Explain the features of Futures Contract .

178. What do you mean by Futures Contract.

179. Which are the two types of players in the Futures market ? Explain
their role in it .
180. Explain the usefulness of Futures Contracts.
181. Explain the role of markets in the success of Futures Contracts.
182. How the pricing of the Futures Contract is carried out ?
183. Explain the following terms : Euro Dollar Interest Rate Futures ,
SIMEX.

BIBLIOGRAPHY

1. International Financial Management , Third Edition : Eun /

Resnick. TATA McGRAW HILL Publication.
2. International Financial Management : P.K.Jain ,J. Peyrard ,
Surendra S. Yadav.
3. International Finance : V.A. Avadhani . Himalaya Publishing
House.
4. International Financial Markets and India : H.R.Machiraju . New
Age International Publishers.

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