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CONTENTS Chapterno. Section1:BalanceofPayments 1. TheBalanceofPayments Section2:InternationalMonetarySystem 2. ExchangeRateRegimes 3. InternationalMonetaryFund 4. EuropeanMonetarySystem Section3:ForeginExchangeMarket 5. ForeginExchangeMarket(Structure&Transactions) 6. ForexQuotations&Arbitrage 7. Forex&interestRates Section4:InternationalFinancialMarkets 8.
InternationalFinancialMarkets Section5:InternationalEquityMarket 9. InternationalEquityMarket Section6:MultilateralfinancialInstitutions 10. IntenationalFinance 11. TheWorldBank 12. IDA 13. IFC 14. MIGA Section7:Exposure&RiskinIF 15. Risk&Exposure 16. Futures&options CompiledbyMANAGEMENTPARADISETEAM. PageNo.
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SECTION1:BALANCEOFPAYMENTS THEBALANCEOFPAYMENTS
BALANCEOFPAYMENTS Thebalanceofpaymentsofacountryisasystematicrecordofalleconomictransactionsbetweenthe residentsofacountryandtherestoftheworld.Itpresentsaclassifiedrecordofallreceiptsonaccount ofgoodsexported,servicesrenderedandcapitalreceivedbyresidentsandpaymentsmadebythemeon account of goods imported and services received from the capital transferred to nonresidents or foreigners. ReserveBankofIndia Theabovedefinitioncanbesummedupasfollowing:BalanceofPaymentsisthesummaryofallthe transactions between the residents of one country and rest of the world for a given period of time, usuallyoneyear.ThedefinitiongivenbyRBIneedstobeclarifiedfurtherforthefollowingpoints: A. EconomicTransactions Aneconomictransactionisanexchangeofvalue,typicallyanactinwhichthereistransferoftitletoan economic good the rendering of an economic service, or the transfer of title to assets from one economic agent (individual, business, government, etc) to another. An international economic transactionevidentlyinvolvessuchtransferoftitleorrenderingofservicefromresidentsofonecountry toanother.Suchatransfermaybearequitedtransfer(thetransfereegivessomethingofaneconomic valuetothetransferorinreturn)oranunrequitedtransfer(aunilateralgift).Thefollowingarethebasic typesofeconomictransactionsthatcanbeeasilyidentified: 1. Purchaseorsaleofgoodsorserviceswithafinancialquidproquocashorapromisetopay.[One realandonefinancialtransfer]. 2. Purchaseor saleofgoodsorservicesinreturnfor goodsorservicesorabartertransaction.[Two realtransfers]. 3. An exchange of financial items e.g. purchase of foreign securities with payment in cash or by a chequedrawnonaforeigndeposit.[Twofinancialtransfers]. 4. Aunilateralgiftinkind[Onerealtransfer]. 5. Aunilateralfinancialgift.[Onefinancialtransfer]. B. Resident The term resident is not identical with citizen though normally there is a substantial overlap. As regardsindividuals,residentsarethoseindividualswhosegeneralcentreofinterestcanbesaidtorestin the given economy. They consume goods and services; participate in economic activity within the CompiledbyMANAGEMENTPARADISETEAM. Page2
territoryofthecountryonotherthantemporarybasis.Thisdefinitionmayturnouttobeambiguousin some cases. The Balance of Payments Manual published by the International Monetary Fund providesasetofrulestoresolvesuchambiguities.Asregardsnonindividuals,asetofconventionshave been evolved. E.g. government and non profit bodies serving resident individuals are residents of respectivecountries,forenterprises,therulesaresomewhatcomplex,particularlytothoseconcerning unincorporated branches of foreign multinationals. According to IMF rules these are considered to be residents of countries in which they operate, although they are not a separate legal entity from the parentlocatedabroad. InternationalorganisationsliketheUN,theWorldBank,andtheIMFarenotconsideredtoberesidents of any national economy although their offices are located within the territories of any number of countries. To certain economists, the term BOP seems to be somewhat obscure. Yeager, for example, draws attention to the word payments in the term BOP; this gives a false impression that the set of BOP accountsrecordsitemsthatinvolveonlypayments.ThetruthisthattheBOPstatementsrecordsboth payments and receipts by a country. It is, as Yeager says, more appropriate to regard the BOP as a balanceofinternationaltransactionsbyacountry.SimilarlythewordbalanceinthetermBOPdoes notimplythatasituationofcomfortableequilibrium;itmeansthatitisabalancesheetofreceiptsand paymentshavinganaccountingbalance. Likeotheraccounts,theBOPrecordseachtransactionaseitheraplusoraminus.Thegeneralrulein BOPaccountingisthefollowing: a) Ifatransactionearnsforeigncurrencyforthenation,itisacreditandisrecordedasaplusitem. b) Ifatransactioninvolvesspendingofforeigncurrencyitisadebitandisrecordedasanegativeitem. TheBOPisadoubleentryaccountingstatementbasedonrulesofdebitandcreditsimilartothoseof businessaccounting&bookkeeping,sinceitrecordsbothtransactionsandthemoneyflowsassociated with those transactions. Also in case of statistical discrepancy the difference amount is adjusted with errorsandomissionsaccountandthusinaccountingsensetheBOPstatementalwaysbalances. ThevariouscomponentsofaBOPstatementare: A. B. C. D. E. F. CurrentAccount CapitalAccount IMF SDRAllocation Errors&Omissions ReservesandMonetaryGold
BALANCEOFTRADE CompiledbyMANAGEMENTPARADISETEAM. Page3
Balanceoftrademaybedefinedasthedifferencebetweenthevalueofgoodsandservicessold to foreigners by the residents and firms of the home country and the value of goods and servicespurchasedbythemfromforeigners.Inotherwords,thedifferencebetweenthevalue ofgoodsandservicesexportedandimportedbyacountryisthemeasureofbalanceoftrade. If two sums (1) value of exports of goods and services and (2) value of imports of goods and services are exactly equal to each other, we say that there is balance of trade equilibrium or balance;iftheformerexceedsthelatter,wesaythatthereisabalanceoftradesurplus;andif thelaterexceedstheformer,thenwedescribethesituationasoneofbalanceoftradedeficit. Surplusisregardedasfavourablewhiledeficitisregardedasunfavourable. The above mentioned definition has been given by James. E. Meade a Nobel Prize British Economist. However, some economists define balance of trade as a difference between the valueofmerchandise(goods)exportsandthevalueofmerchandiseimports,makingitthesame as the Goods Balance or the Balance of Merchandise Trade. There is n doubt that the balanceofmerchandisetradeisofgreatsignificancetoexportingcountries,butstilltheBOTas definedbyJ.E.Meadehasgreatersignificance. Regardlessofwhichideaisadopted,onethingiscertaini.e.thatbalanceoftradeisanational injection and hence it is appropriate to regard an active balance (an excess of credits over debits) as a desirable state of affairs. Should this then be taken to imply that a passive trade balance(anexcessofdebitsovercredits)isnecessarilyasignofundesirablestateofaffairsina country?Theanswerisno.Because,takeforexample,thecaseofadevelopingcountry,which mightbeimportingvastquantitiesofcapitalgoodsandtechnologytobuildastrongagricultural or industrial base. Such a country in the course of doing that might be forced to experience passiveoradversebalanceoftradeandsuchasituationofpassivebalanceoftradecannotbe describedasoneofundesirablestateofaffairs.Thiswouldthereforeagainsuggestthatbefore drawingmeaningfulinferencesastowhetherpassivetradebalancesofacountryaredesirable orundesirable,wemustalsoknowthecompositionofimportswhicharecausingtheconditions ofadversetradebalance.
BALANCEOFCURRENTACCOUNT BOP on current account refers to the inclusion of three balances of namely Merchandise balance,ServicesbalanceandUnilateralTransferbalance.Inotherwordsitreflectsthenetflow ofgoods,servicesandunilateraltransfers(gifts).Thenetvalueofthebalancesofvisibletrade andofinvisibletradeandofunilateraltransfersdefinesthebalanceoncurrentaccount. BOP on current account is also referred to as Net Foreign Investment because the sum representsthecontributionofForeignTradetoGNP. ThustheBOPoncurrentaccountincludesimportsandexportsofmerchandise(tradebalances), military transactions and service transactions (invisibles). The service account includes investment income (interests and dividends), tourism, financial charges (banking and insurances) and transportation expenses (shipping and air travel). Unilateral transfers include pensions,remittancesandothertransfersforwhichnospecificservicesarerendered. Page4
CompiledbyMANAGEMENTPARADISETEAM.
ItisalsoworthrememberingthatBOPoncurrentaccountcoversallthereceiptsonaccountof earnings(oropposedtoborrowings)andallthepaymentsarisingoutofspending(asopposed tolending).ThereisnoreverseflowentailedintheBOPoncurrentaccounttransactions.
BASICBALANCE Thebasicbalancewasregardedasthebestindicatoroftheeconomyspositionvisvisother countriesinthe1950sandthe1960s.ItisdefinedasthesumoftheBOPoncurrentaccount andthenetbalanceonlongtermcapital,whichwereconsideredasthemoststableelementsin the balance of payments. A worsening of the basic balance [an increase in a deficit or a reductioninasurplusorevenamovefromthesurplustodeficit]wasseenasanindicationof deteriorationinthe[relative]stateoftheeconomy. Theshorttermcapitalaccountbalanceisnotincludedinthebasicbalance.Thisisperhapsfor twomainreasons: a) Short term capital movements unlike long term capital movements are relatively volatile and unpredictable.Theymoveinandoutofthecountryinaperiodoflessthanayearorevensooner than that. It would therefore be improper to treat short term capital movements on the same footing as current account BOP transactions which are extremely durable in nature. Long term capital flows are relatively more durable and therefore they qualify to be treated along side the currentaccounttransactionstoconstitutebasicbalance. b) Inmanycases,countriesdonthaveaseparateshorttermcapitalaccountastheyconstituteapart oftheErrorsandOmissionsAccount. A deficit on the basic balance could come about in various ways, which are not mutually equivalent.E.g.supposethatthebasicbalanceisindeficitbecauseacurrentaccountdeficitis accompaniedbyadeficitonthelongtermcapitalaccount.Thelongtermcapitaloutflowwill,in the future, generate profits, dividends and interest payments which will improve the current accountandso,ceterisparibus,willreduceorperhapsreducethedeficit.Ontheotherhand,a basic balance surplus consisting of a deficit on current account that is more than covered by longtermborrowingsfromabroadmayleadtoproblemsinfuture,whenprofits,dividendsetc arepaidtoforeigninvestors. THEOFFICIALSETTLEMENTCONCEPT An alternative approach for indicating, a deficit or surplus in the BOP is to consider the net monetary transfer that has been made by the monetary authorities is positive or negative, whichisthesocalledsettlementconcept. Ifthenettransferisnegative(i.e.thereisanoutflow)thentheBOPissaidtobeindeficit,butif thereisaninflowthenitissurplus.Thebasicpremiseisthatthemonetaryauthoritiesarethe ultimatefinancersofany deficitinthebalanceofpayments (or therecipientsofanysurplus). These official settlements are thus seemed as the accommodating item, all other being autonomous. Page5
Themonetaryauthoritiesmayfinanceadeficitbydepletingtheirreservesofforeigncurrencies, byborrowingfromtheIMForbyborrowingfromotherforeignmonetaryauthorities.Thelater sourceisofparticularimportancewhenothermonetaryauthoritiesholdthedomesticcurrency asapartoftheirownreserves.Acountrywhosecurrencyisusedasareservecurrency(suchas the dollars of US) may be able to run a deficit in its balance of payments without either depleting its own reserves or borrowing from the IMF since the foreign authorities might be ready to purchase that currency and add it to its own reserves. The settlements approach is more relevant under a system of pegged exchange rates than when the exchange rates are floating.
THECAPITALACCOUNT Thecapitalaccountrecordsallinternationaltransactionsthatinvolvearesidentofthecountry concerned changing either his assets with or his liabilities to a resident of another country. Transactionsinthecapitalaccountreflectachangeinastockeitherassetsorliabilities. Itisoftenusefultomakedistinctionsbetweenvariousformsofcapitalaccounttransactions.The basic distinctions are between private and official transactions, between portfolio and direct investmentandbythetermoftheinvestment(i.e.shortorlongterm).Thedistinctionbetween privateandofficialtransactionisfairlytransparent,andneednotconcernustoomuch,except fornotingthatthebulkofforeigninvestmentisprivate. Direct investment is the act of purchasing an asset and the same time acquiring control of it (otherthantheabilitytoresellit).Theacquisitionofafirmresidentinonecountrybyafirm resident in another is an example of such a transaction, as is the transfer of funds from the parent company in order that the subsidiary company may itself acquire assets in its own country. Such business transactions form the major part of private direct investment in other countries, multinational corporations being especially important. There are of course some examples of such transactions by individuals, the most obvious being the purchase of the secondhomeinanothercountry. Portfolioinvestmentbycontrastistheacquisitionofanassetthatdoesnotgivethepurchaser control.Anobviousexampleisthepurchaseofsharesinaforeigncompanyorofbondsissued by a foreign government. Loans made to foreign firms or governments come into the same broadcategory.Suchportfolioinvestmentisoftendistinguishedbytheperiodoftheloan(short, mediumorlongareconventionaldistinctions,althoughinmanycasesonlytheshortandlong categories are used). The distinction between short term and long term investment is often confusing,butusuallyrelatestothespecificationoftheassetratherthantothelengthoftime of which it is held. For example, a firm or individual that holds a bank account with another country and increases its balance in that account will be engaging in short term investment, evenifitsintentionistokeepthatmoneyinthataccountformanyyears.Ontheotherhand,an individualbuyingalongtermgovernmentbondinanothercountrywillbemakingalongterm investment, even if that bond has only one month to go before the maturity. Portfolio investments may also be identified as either private or official, according to the sector from whichtheyoriginate. Page6
Thepurchaseofanassetinanothercountry,whetheritisdirectorportfolioinvestment,would appear as a negative item in the capital account for the purchasing firms country, and as a positive item in the capital account for the other country. That capital outflows appear as a negative item in a countrys balance of payments, and capital inflows as positive items, often causesconfusions.Onewayofavoidingthisistoconsiderthatdirectioninwhichthepayment wouldgo(ifmadedirectly).Thepurchaseofaforeignassetwouldtheninvolvethetransferof money to the foreign country, as would the purchase of an (imported) good, and so must appear as a negative item in the balance of payments of the purchasers country (and as a positiveitemintheaccountsofthesellerscountry). Thenetvalueofthebalancesofdirectandportfolioinvestmentdefinesthebalanceoncapital account.
ACCOMMODATING&AUTONOMOUSCAPITALFLOWS Economistshaveoftenfounditusefultodistinguishbetweenautonomousandaccommodating capital flows in the BOP. Transactions are said to Autonomous if their value is determined independentlyoftheBOP.Accommodatingcapitalflowsontheotherhandaredeterminedby thenetconsequencesoftheautonomousitems.Anautonomoustransactionisoneundertaken foritsownsakeinresponsetothegivenconfigurationofprices,exchangerates,interestrates etc, usually in order to realise a profit or reduced costs. It does not take into account the situationelsewhereintheBOP.Anaccommodatingtransactionontheotherhandisundertaken with the motive of settling the imbalance arising out of other transactions. An alternative nomenclature is that capital flows are above the line (autonomous) or below the line (accommodating). Obviously the sum of the accommodating and autonomous items must be zero,sinceallentriesintheBOPaccountmustcomeunderoneofthetwoheadings.Whether the BOP is in surplus or deficit depends on the balance of the autonomous items. The BOP is saidtobeinsurplusifautonomousreceiptsaregreaterthantheautonomouspaymentsandin deficitifviceaversa. Essentially the distinction between both the capital flow lies in the motives underlying a transaction, which are almost impossible to determine. We cannot attach the labels to particular groups of items in the BOP accounts without giving the matter some thought. For example a short term capital movement could be a reaction to difference in interest rates betweentwocountries.Ifthoseinterestratesarelargelydeterminedbyinfluencesotherthan the BOP, then such a transaction should be labelled as autonomous. Other short term capital movementsmayoccurasapartofthefinancingofatransactionthatisitselfautonomous(say, theexportofsomegood),andassuchshouldbeclassifiedasaccommodating. There is nevertheless a great temptation to assign the labels autonomous and accommodatingtogroupsofitemintheBOP.i.e.toassume,thatthegreatmajorityoftradein goodsandoflongtermcapitalmovementsareautonomous,andthatmostshorttermcapital movementsareaccommodating,sothatweshallnotgofarwrongbyassigningthoselabelsto the various components of the BOP accounts. Whether that is a reasonable approximation to thetruthmaydependinpartonthepolicyregimethatisinoperation.Forexamplewhatisan Page7
autonomousitemunderasystemoffixedexchangeratesandlimitedcapitalmobilitymaynot be autonomous when the exchange rates are floating and capital may move freely between countries. BALANCEOFINVISIBLETRADE Justasacountryexportsgoodsandimportsgoodsacountryalsoexportsandimportswhatare calledasservices(invisibles).Theserviceaccountrecordsalltheserviceexportedandimported by a country in a year. Unlike goods which are tangible or visible services are intangible. AccordinglyservicestransactionsareregardedasinvisibleitemsintheBOP.Theyareinvisiblein thesensethatservicereceiptsandpaymentsarenotrecordedattheportofentryorexitasin the case with the merchandise imports and exports receipts. Except for this there is no meaningful difference between goods and services receipts and payments. Both constitute earningandspendingofforeignexchange.Goodsandservicesaccountstogetherconstitutethe largestandeconomicallythemostsignificantcomponentsintheBOPofanycountry. The service transactions take various forms. They basically include 1) transportation, banking, and insurance receipts and payments from and to the foreign countries, 2) tourism, travel services and tourist purchases of goods and services received from foreign visitors to home country and paid out in foreign countries by home country citizens, 3) expenses of students studyingabroadandreceiptsfromforeignstudentsstudyinginthehomecountry,4)expenses of diplomatic and military personnel stationed overseas as well as the receipts from similar personnel who are stationed in the home country and 5) interest, profits, dividends and royalties received from foreign countries and paid out to foreign countries. These items are generallytermedasinvestmentincomeorreceiptsandpaymentsarisingoutofwhatarecalled as capital services. Balance of Invisible Trade is a sum of all invisible service receipts and paymentsinwhichthesumcouldbepositiveornegativeorzero.Apositivesumisregardedas favourable to a country and a negative sum is considered as unfavourable. The terms are descriptiveaswellasprescriptive.
BALANCEOFVISIBLETRADE Balance of visible trade is also known as balance of merchandise trade, and it covers all transactionsrelatedtomovablegoodswheretheownershipofgoodschangesfromresidentsto nonresidents(exports)andfromnonresidentstoresidents(imports).Thevaluationshouldbe onF.O.Bbasissothatinternationalfreightandinsurancearetreatedasdistinctservicesandnot mergedwiththevalueofgoodsthemselves.ExportsvaluedonF.O.Bbasisarethecreditentries. Datafortheseitemsareobtainedfromthevariousformsthattheexportershavefillandsubmit to the designated authorities. Imports valued at C.I.F are the debit entries. Valuation at C.I.F. thoughinappropriate,isaforcedchoiceduetodatainadequacies.Thedifferencebetweenthe totalofdebitsandcreditsappearsintheNetcolumn.ThisistheBalanceofVisibleTrade. Invisibletradeifthereceiptsfromexportsofgoodshappentobeequaltothepaymentsforthe imports of goods, we describe the situation as one of zero goods balance. Otherwise there Page8
wouldbeeitherapositiveornegativegoodsbalance,dependingonwhetherwehavereceipts exceedingpayments(positive)orpaymentsexceedingreceipts(negative). ERRORSANDOMISSIONS Errors and omissions is a statistical residue. It is used to balance the statement because in practiceitisnotpossibletohavecompleteandaccuratedataforreporteditemsandbecause thesecannot,therefore,ordinarilyhaveequalentriesfordebitsandcredits. Theentryfornet errorsandomissionsoftenreflectsunreportedflowsofprivatecapital,althoughtheconclusions thatcanbedrawnfromthemvaryagreatdealfromcountrytocountry,andeveninthesame countryfromtimetotime,dependingonthereliabilityofthereportedinformation.Developing countries,inparticular,usuallyexperiencegreatdifficultyinprovidingreliableinformation. Errors and omissions (or the balancing item) reflect the difficulties involved in recording accurately,ifatall,awidevarietyoftransactionsthatoccurwithinagivenperiodof(usually12 months).Insomecasesthereissuchlargenumberoftransactionsthatasampleistakenrather thanrecordingeachtransaction,withtheinevitableerrorsthatoccurwhensamplesareused.In othersproblemsmayarisewhenoneorotherofthepartsofatransactiontakesmorethanone year: for example wit a large export contract covering several years some payment may be received by the exporter before any deliveries are made, but the last payment will not made until the contract has been completed. Dishonesty may also play a part, as when goods are smuggled, in which case the merchandise side of the transaction is unreported although paymentwillbemadesomehowandwillbereflectedsomewhereintheaccounts.Similarlythe desiretoavoidtaxesmayleadtounderreportingofsomeitemsinordertoreducetaxliabilities. Finally, there are changes in the reserves of the country whose balance of payments we are considering, and changes in that part of the reserves of other countries that is held in the countryconcerned.Reservesareheldinthreeforms:inforeigncurrency,usuallybutalwaysthe US dollar, as gold, and as Special Deposit Receipts (SDRs) borrowed from the IMF. Note that reservesdonothavetobeheldwithinthecountry.Indeedmostcountriesholdaproportionof theirreservesinaccountswithforeigncentralbanks. The changes in the countrys reserves must of course reflect the net value of all the other recorded items in the balance of payments. These changes will of course be recorded accurately,anditisthediscrepancybetweenthechangesinreservesandthenetvalueofthe otherrecorditemsthatallowsustoidentifytheerrorsandomissions.
UNILATERALTRANSFERS Unilateral transfers or unrequited receipts, are receipts which the residents of a country receive for free, without having to make any present or future payments in return. Receipts from abroad are entered as positive items, payments abroad as negative items. Thus the unilateral transfer account includes all gifts, grants and reparation receipts and payments to foreigncountries.Unilateraltransferconsistoftwotypesoftransfers:(a)governmenttransfers (b)privatetransfers. Page9
Foreigneconomicaidorassistanceandforeignmilitaryaidorassistancereceivedbythehome countrysgovernment (orgivenby the homegovernment toforeigngovernments) constitutes government to government transfers. The United States foreign aid to India, for BOP 9but a debit item in the US BOP). These are government to government donations or gifts. There no well worked out theory to explain the behaviour of this account because these flows depend uponpoliticalandinstitutionalfactors.Thegovernmentdonations(oraidorassistance)givento government of other countries is mixed bag given for either economic or political or humanitarianreasons.Privatetransfers,ontheotherhand,arefundsreceivedfromorremitted to foreign countries on person to person basis. A Malaysian settled in the United States remitting$100amonthtohisagedparentsinMalaysiaisaunilateraltransferinflowiteminthe MalaysianBOP.AnAmericanpensionerwhoissettledafterretirementinsayItalyandwhois receivingmonthlypensionfromAmericaisalsoaprivateunilateraltransfercausingadebitflow intheAmericanBOPbutacreditflowintheItalianBOP.Countriesthatattractretiredpeople fromothernationsmaythereforeexpecttoreceiveaninfluxofforeignreceiptsintheformof pensionpayments.Andcountrieswhichrenderforeigneconomicassistanceonamassivescale can expect huge deficits in their unilateral transfer account. Unilateral transfer receipts and payments are also called unrequited transfers because as the name itself suggests the flow is only in one direction with no automatic reverse flow in the other direction. There is no repaymentobligationattachedtothesetransfersbecausetheyarenotborrowingsandlendings but gifts and grants exchanged between government and people in one country with the governmentsandpeoplesintherestoftheworld. ITEMSWHICHFALLUNDERCAPITALACCOUNTANDCURRENTACCOUNTWITHEXAMPLES.
Credits CurrentAccount 1. MerchandiseExports(SaleofGoods) 2. InvisibleExports(SaleofServices) a. Transportservicessoldabroad b. Insuranceservicessoldabroad c. Foreigntouristexpenditureincountry d. Otherservicessoldabroad e. Incomes received on loans and investmentsabroad. 3. UnilateralTransfers a. Privateremittancesreceivedfromabroad b. Pensionpaymentsreceivedfromabroad c. Governmentgrantsreceivedfromabroad CapitalAccount 3. Foreign longterm investments in the home country(lessredemptionsandrepayments) a. Directinvestmentsinthehomecountry CompiledbyMANAGEMENTPARADISETEAM.
Debits CurrentAccount 1. MerchandiseImports(purchaseofGoods) 2. InvisibleImports(PurchaseofServices) a. Transportservicespurchasedfromabroad b. Insuranceservicespurchased c. Touristexpenditureabroad d. Otherservicespurchasedfromabroad e. Income paid on loans and investments in thehomecountry. 3. UnilateralTransfers a. Privateremittancesabroad b. Pensionpaymentsabroad c. Governmentgrantsabroad. CapitalAccount 3. Longterm investments abroad (less redemptionsandrepayments) a. DirectInvestmentsabroad Page10
b. Foreigninvestmentsindomesticsecurities c. Other investments of foreigners in the homecountry d. Foreign Governments loans to the home country. 4. Foreign shortterm investments in the home 4. country. IMPORTANCEOFTHEBOPSTATEMENTS? b. Investmentsinforeignsecurities c. Otherinvestmentsabroad d. Governmentloanstoforeigncountries Shortterminvestmentsabroad.
BOP statistics are regularly compiled, published and are continuously monitored by companies, banks andgovernmentagencies.AsetofBOPaccountsisusefulinthesamewayasamotionpicturecamera. Theaccountsdonottelluswhatisgoodorbad,nordotheytelluswhatiscausingwhat.Buttheydolet usseewhatishappeningsothatwecanreachourownconclusions.Beloware3instanceswherethe informationprovidedbyBOPaccountingisverynecessary: 1. JudgingthestabilityofafloatingexchangeratesystemiseasierwithBOPastherecordofexchanges that take place between nations help track the accumulation of currencies in the hands of those individualsmorewillingtoholdontothem. 2. Judging the stability of a fixed exchange rate system is also easier with the same record of internationalexchange.Theseexchangesagainshowtheextenttowhichacurrencyisaccumulating inforeignhands,raisingquestionsabouttheeaseofdefendingthefixedexchangerateinafuture crisis. 3. To spot whether it is becoming more difficult for debtor counties to repay foreign creditors, one needs a set of accounts that shows the accumulation of debts, the repayment of interest and principal and the countries ability to earn foreign exchange for future repayment. A set of BOP accountssuppliesthisinformation.Thispointisfurtherelaboratedbelow. TheBOPstatementcontainsusefulinformationforfinancialdecisionmakers.Intheshortrun, BOP deficit or surpluses may have an immediate impact on the exchange rate. Basically, BOP recordsalltransactionsthatcreatedemandforandsupplyofacurrency.Whenexchangerates aremarketdetermined,BOPfiguresindicateexcessdemandorsupplyforthecurrencyandthe possible impact on the exchange rate. Taken in conjunction with recent past data, they may conformorindicateareversalofperceivedtrends.Theyalsosignalapolicyshiftonthepartof themonetaryauthoritiesofthecountryunilaterallyorinconcertwithitstradingpartners.For instance, a country facing a current account deficit may raise interest to attract short term capitalinflowstopreventdepreciationofitscurrency.Countriessufferingfromchronicdeficits may find their credit ratings being downgraded because the markets interpret the data as evidencethatthecountrymayhavedifficultiesitsdebt. BOPaccountsareintimatelywiththeoverallsavinginvestmentbalanceinacountrysnational accounts.Continuingdeficitsorsurplusesmayleadtofiscalandmonetaryactionsdesignedto correcttheimbalancewhichinturnwillaffectexchangeratesandinterestratesinthecountry. In nutshell corporate finance managers must monitor the BOP data being put out by CompiledbyMANAGEMENTPARADISETEAM. Page11
government agencies on a regular basis because they have both short term and long term implications for a host of economic and financial variables affecting the fortunes of the company. INTHEACCOUNTINGSENSETHEBOPALWAYSBALANCES! The BOP is a double entry accounting statement based on rules of debit and credit similar to thoseofbusinessaccounting&bookkeeping,sinceitrecordsbothtransactionsandthemoney flows associated with those transactions. For instance, exports (like sales of a business) are credits,andimports(likethepurchasesofabusiness)aredebits.Asinbusinessaccountingthe BOP records increases in assets (direct investment abroad) and decreases in liabilities (repaymentofdebt)asdebits,anddecreasesinassets(saleofforeignsecurities)andincreases in liabilities (the utilisation of foreign goods) as credits. An elementary rule that may assist in understandingtheseconventionsisthatinsuchtransactionsitisthemovementofadocument, not of the money that is recorded. An investment made abroad involves the import of a documentary acknowledgement of the investment, it is therefore a debit. The BOP has one importantcategorythathasnocounterpartoratleastnosignificantcounterpartinbusiness accounting,i.e.internationalgiftsandgrantsandothersocalledtransferpayments. In general credits may be conceived as receipts and debits as payments. However this is not alwayspossible.Inparticularthechangeinacountrysinternationalreservesingoldandforeign exchangeistreatedasadebitifitisanincreaseandacreditifitisadecrease.Theprocedureis tooffsetchangesinreservesagainstchangesintheotheritemsinthetablesothatthegrand totalisalwayszero,(exceptforerrorsandomissions). AtransactionenteringtheBOPusuallyhastwoaspectsandinvariablygivesrisetotwoentries, one a debit and the other a credit. Often the two aspects fall in different categories. For instance, an export against cash payment may result in an increase in the exporting countrys official foreign exchange holdings. Such a transaction is entered in the BOP as a credit for exportsandasadebitforthecapitalaccount.Bothaspectsofatransactionmaysometimesbe appropriatetothesameaccount.Forinstancethepurchaseofaforeignsecuritymayhaveasits counterpartreductioninofficialforeignexchangeholdings. ThusitisclearthatifwerecordalltheentriesinBOPinaproperway,debitsandcreditswill alwaysbeequal.SothatinaccountingsensetheBOPwillbeinbalance.
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DETAILEDOUTLINEOFTHEBOPSTATEMENT&SUBACCOUNTS
BalanceofPaymentsisthesummaryofallthetransactionsbetweentheresidentsofonecountryand rest of the world fora given period oftime, usually one year. ABOP statement (revised) includes the followingsubaccounts,asshowninthetablebelow. Items G. CurrentAccount 1. Merchandise a. Private b. Government 2. Invisibles a. Travel b. Transportation c. Insurance d. InvestmentIncome e. Government(notincludedelsewhere) f. Miscellaneous Credits Debits Net
3. TransferPayments a. Official CompiledbyMANAGEMENTPARADISETEAM.
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b. Private TotalCurrentAccount(1+2+3) H. CapitalAccount 2. Private a. LongTerm b. ShortTerm 3. Banking 4. Official a. Loans b. Amortisation c. Miscellaneous TotalCapitalAccount(1+2+3) I. J. IMF SDRAllocation
K. CapitalAccount,IMF&SDRAllocation(B+C+D)
L. Total Current Account, Capital Account, IMF & SDR Allocation (A+E) M. Errors&Omissions N. ReservesandMonetaryGold CurrentAccount
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Thecurrentaccountincludesalltransactionswhichgiverisetooruseupnationalincome.The currentaccountconsistsoftwomajoritems,namely,(a)merchandiseexportandimportsand (b)invisibleimportsandexports. Merchandiseexportsi.e.saleofgoodsabroad,arecreditentriesbecausealltransactionsgiving rise to monetary claims on foreigners represent credits. On the other hand, merchandise imports,i.e.purchaseofgoodsabroad,aredebitentriesbecausealltransactionsgivingriseto foreignmoneyclaimsonthehomecountryrepresentdebits.Merchandiseexportsandimports formthemostimportantinternationaltransactionsofmostofthecountries. Invisible exports i.e. sale of services, are credit entries and invisible imports i.e. purchase of services are debit entries. Important invisible exports include sale abroad of services like insuranceandtransportetc.whileimportantinvisibleimportsareforeigntouristexpenditures in the home country and income received on loans and investment abroad (interests or dividends). Transferspaymentsrefertounrequitedreceiptsorunrequitedpaymentswhichmaybeincash orinkindandaredividedintoofficialandprivatetransactions.Privatetransferpaymentscover suchtransactionsascharitablecontributionsandremittancestorelativesinothercountries.The maincomponentofgovernmenttransferpaymentsiseconomicaidintheformofgrants.
CapitalAccount The capital account separates the non monetary sector from the monetary one, that is to say, the tradingorordinaryprivatebusinesselementintheeconomytogetherwiththeordinaryinstitutionsof centralorlocalgovernment,fromthecentralbankandthecommercialbank,whicharedirectlyinvolved inframingorimplementingmonetarypolicies.Thecapitalaccountconsistsoflongtermandshortterm capitaltransactions.Capitaloutflowrepresentsdebitandcapitalinflowrepresentcredit.Forinstance,if anAmericanfirminvestsrupees100millioninIndia,thistransactionwillberepresentedasadebitin theUSBOPandacreditintheBOPofIndia. OtherAccounts The IMF account contains purchases (credits) and repurchases (debits) from the IMF. SDRs Special Drawing Rights are a reserve asset created by the IMF and allocated from time to time to member countries.Withincertainlimitationsitcanbeusedtosettleinternationalpaymentsbetweenmonetary authoritiesofmembercountries.Anallocationisacreditwhileretirementisadebit.TheReserveand Monetary Gold account records increases (debits) and decreases (credits) in reserve assets. Reserve assets consist of RBIs holdings of gold and foreign exchange (in the form of balances with foreign central banks and investment in foreign government securities) and governments holding of SDRs. ErrorsandOmissionsisastatisticalresidue.Errorsandomissions(orthebalancingitem)reflectthe difficulties involved in recording accurately, if at all, a wide variety of transactions that occur within a given period of (usually 12 months). It is used to balance the statement because in practice it is not
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possibletohavecompleteandaccuratedataforreporteditemsandbecausethesecannot,therefore, ordinarilyhaveequalentriesfordebitsandcredits. HOW WILL YOU IDENTIFY A DEFICIT OR SURPLUS IN BALANCE OF PAYMENTS? / MEANING OF DEFICITANDSURPLUSINTHEBALANCEOFPAYMENTS. If the balance of payment is a double entry accounting record, then apart from errors and omissions,itmustalwaysbalance.Obviously,thetermsdeficitorsurpluscannotrefertothe entire BOP but must indicate imbalance on a subset of accounts included in the BOP. The imbalancemustbeinterpretedinsomesenseasaneconomicdisequilibrium. Since the notion of disequilibrium is usually associated within a situation that calls for policy intervention of some sort, it is important to decide what is the optimal way of grouping the various accounts within the BOIP so that an imbalance in one set of accounts will give the appropriate signals to the policy makers. In the language of an accountant e divide the entire BOPintoasetofaccountsabovethelineandanothersetbelowtheline.Ifthenetbalance (creditsdebits) is positive above the line we will say that there is a balance of payments surplus; if it is negative e will say there is a balance of payments deficit. The net balance belowthelineshouldbeequalinmagnitudeandoppositeinsigntothenetbalanceabovethe line. The items below the line can be said to be a compensatory nature they finance or settletheimbalanceabovetheline. ThecriticalquestionishowtomakethisdivisionsothatBOPstatistics,inparticularthedeficit and surplus figures, will be economically meaningful. Suggestions made by economist and incorporated into the IMF guidelines emphasis the purpose or motive a transaction, as a criterion to decide whether a transaction should go above or below the line. The principle distinction between autonomous transaction and accommodating or compensatory transactions.TransactionsaresaidtoAutonomousiftheirvalueisdeterminedindependentlyof the BOP. Accommodating capital flows on the other hand are determined by the net consequencesoftheautonomousitems.Anautonomoustransactionisoneundertakenforits own sake in response to the given configuration of prices, exchange rates, interest rates etc, usuallyinordertorealiseaprofitorreducedcosts.Itdoesnottakeintoaccountthesituation elsewhereintheBOP.Anaccommodatingtransactionontheotherhandisundertakenwiththe motiveofsettlingtheimbalancearisingoutofothertransactions.Analternativenomenclature isthatcapitalflowsareabovetheline(autonomous)orbelowtheline(accommodating).The termsbalanceofpaymentsdeficitandbalanceofpaymentssurpluswillthenbeunderstood tomeandeficitorsurplusonallautonomoustransactionstakentogether. TheothermeasuresofidentifyingadeficitorsurplusintheBOPstatementare: DeficitorSurplusintheCurrentAccountand/orTradeAccount. TheBasicBalancewhichshowstherelativedeficitorsurplusintheBOP.
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ADEFICITINTHEBASICBALANCEISDESIRABLEORUNDESIRABLE!
Thebasicbalancewasregardedasthebestindicatoroftheeconomyspositionvisvisother countriesinthe1950sandthe1960s.ItisdefinedasthesumoftheBOPoncurrentaccount andthenetbalanceonlongtermcapital,whichwereconsideredasthemoststableelementsin thebalanceofpayments. Aworseningofthebasicbalance[anincreaseinadeficitorareductioninasurplusorevena movefromthesurplustodeficit]isseenasanindicationofdeteriorationinthe[relative]state of the economy. Thus it is very much evident that a deficit in the basic balance is a clear indicator of worsening of the state of the countrys BOP position, and thus can be said to be undesirableattheveryoutset. However, on further thoughts, a deficit in the basic balance can also be understood to be desirable.Thiscanbeexplainedasfollows:Adeficitonthebasicbalancecouldcomeaboutin variousways,whicharenotmutuallyequivalent.E.g.supposethatthebasicbalanceisindeficit becauseacurrentaccountdeficitisaccompaniedbyadeficitonthelongtermcapitalaccount. This deficit in long term capital account could be clearly observed in a developing countrys which might be investing heavily on capital goods for advancement on the agricultural and industrialfields.Thislongtermcapitaloutflowwill,inthefuture,generateprofits,dividendsand interestpaymentswhichwillimprovethecurrentaccountandso,ceterisparibus,willreduceor perhapsreducethedeficit. Thusadeficitinbasicbalancecanbedesirableaswellasundesirable,asitclearlydependsupon whatisleadingtoadeficitinthelongtermcapitalaccount.
SECTION2:INTERNATIONALMONETARYSYSTEM EXCHANGERATEREGIMES
WhatIsanExchangeRate?
Anexchangerateistherateatwhichonecurrencycanbeexchangedforanother.Inotherwords,itis thevalueofanothercountry'scurrencycomparedtothatofyourown.Ifyouaretravelingtoanother country,youneedto"buy"thelocalcurrency.Justlikethepriceofanyasset,theexchangerateisthe priceatwhichyoucanbuythatcurrency.IfyouaretravelingtoEgypt,forexample,andtheexchange rateforUSD1.00isEGP5.50,thismeansthatforeveryU.S.dollar,youcanbuyfiveandahalfEgyptian pounds.Theoretically,identicalassetsshouldsellatthesamepriceindifferentcountries,becausethe exchangeratemustmaintaintheinherentvalueofonecurrencyagainsttheother. Fixed There are two ways the price of a currency can be determined against another. A fixed, or pegged,rateisaratethegovernment(centralbank)setsandmaintainsastheofficialexchange rate.Asetpricewillbedeterminedagainstamajorworldcurrency(usuallytheU.S.dollar,but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintainthelocalexchangerate,thecentralbankbuysandsellsitsowncurrencyontheforeign exchangemarketinreturnforthecurrencytowhichitispegged. If,forexample,itisdeterminedthatthevalueofasingleunitoflocalcurrencyisequaltoUSD 3.00, the central bank will have to ensure that it can supply the market with those dollars. In ordertomaintaintherate,thecentralbankmustkeepahighlevelofforeignreserves.Thisisa reserved amount of foreign currency held by the central bank which it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. Thecentralbankcanalsoadjusttheofficialexchangeratewhennecessary.
Floating Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "selfcorrecting", as any differences in supplyanddemandwillautomaticallybecorrectedinthemarket.Takealookatthissimplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and thus stimulating demand for local goods and services. This in turn will generate more jobs, and hence an autocorrection would occur in the market. A floating exchangerateisconstantlychanging. In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influencechangesintheexchangerate.Sometimes,whenalocalcurrencydoesreflectitstrue valueagainstitspeggedcurrency,a"blackmarket"whichismorereflectiveofactualsupplyand demandmaydevelop.Acentralbankwilloftenthenbeforcedtorevalueordevaluetheofficial Page18
ratesothattherateisin linewith theunofficialone,therebyhaltingtheactivityoftheblack market. Inafloatingregime,thecentralbankmayalsointervenewhenitisnecessarytoensurestability and to avoid inflation; however, it is less often that the central bank of a floating regime will interfere.
FIXED&SEMIFIXEDSYSTEMS TheGoldStandardsystem ThisistheoldestsystemwhichwasinoperationtillthebeginningoftheFirstWorldWarandaforfew yearsthereafterieitwasbasicallyfrom18701914.Theessentialfeatureofthissystemwasthatthe gouvernmentgaveanunconditionalguarenteetoconverttheirpapermoneytogoldataprefixedrate atanypointoftimeordemand. 1. TheGoldSpecieStandard: In this system, circulation was in the form of actual gold coins or coins with fixed content of gold.
2. GoldBullionStandard: The basis of money remains a fixed weight of gold but the currency in circulation consist of papernoteswiththeauthoritiesstandingreadytoconvertunlimitedamountsofpapercurrency intogoldandviceversa,ondemandatafixedconversionratio.Thusapoundsterlingnotecan beexchangedforsayxouncesofgoldwhileadollarnotecanbeconvertedintosayyounces ofgoldondemand. 3. GoldExchangeStandard: Gold Exchange Standard was established in order to create additional liquidity in the internationalmarkets.Hencethesomeofthecountriescommittedthemselvestoconverttheir currenciesintothecurrencyofsomeothercountryonthegoldstandardratherthanintogold. Theauthoritieswerereadytoconvertatafixedrate,thepapercurrencyissuedbythemintothe paper currency of another country, which is operating a gold specie or gold bullion standard. Thus,ifrupeesarefreelyconvertibleintodollarsanddollarsinturnintogold,rupeecanbesaid tobeonagoldexchangestandard.
BRETTONWOODSSYSTEM
Conference was held at Bretton Woods in USA in July, 1944, in order to put in place a new internationalmonetarysystem.ThemaincharacteristicsoftheInternationalMonetarySystem developedatBrettonWoodsaresummarizedbelow: Page19
1. Fixed Rates in terms of gold, but only the US $ was convertible into gold as the US ensured convertibilityofthedollarsintogoldatinternationallevel. 2. Aprocedureformutualinternationalcredits. 3. Creation of International Monetary Fund to supervise and ensure smooth functioning of the system.Countrieswereexpectedtopursuetheeconomicandmonetarypoliciesinamannerso that currency fluctuations remained within a permitted margin 11%. This cause meant the Central Bank of every country has to intervene to buy or sell foreign exchange, depending on theneed. 4. DevaluationorRevaluationofmorethan5%hadtobedonewiththepermissionofIMF. TheBretton WoodsSystemlastedfrom1944to1971.TheBrettonWoodsplannersexpected thatafterabrieftransition(5years)theinternationaleconomywouldrecoverandthesystem wouldenterintooperation.From1945to1947,theUSactivelypressedforimplementationof the Bretton Woods system as originally conceived (US provided resources to the IMF and the WorldBankandurgedothercountriestodolikewise)By1947,theUSconcludethattheBretton Woods system was not working and that the Western system was on the verge of collapse (WWII had destroyed the European economic system, and the IMFs modest credit facilities wereinsufficienttodealwithEuropeshugeneeds). In 1960s the US balance of payment deficits started mounting. In 1968, convertibility of privately held Dollar into Gold was abandoned and in 1971 convertibility was completely abandoned. The US managed the international monetary system by providing liquidity: gold productionwasinsufficient;thedollarwastheonlystrongcurrencytomeettherisingdemands forinternationalliquidity.ThestrengthoftheUSeconomy,thefixedrelationshipofthedollarto gold($35anounce),andthecommitmentoftheUSgovernmenttoconvertdollarsintogoldat that pricemadethedollarasgoodasgold.Buttherewasahugedollarshortage (the US was runningtradesurpluses);andinorderforthesystemtowork,itwouldbenecessaryfortheUS toreversethisflowandtorunapaymentdeficit,whichofcoursehappened TheprimaryfactorforthecollapseofthesystemwascurrencyconvertibilityintoGold.Thisidea can be explained with the Triffins Paradox. It is said that the entire monetary system depended on the Dollar performing its role as the key currency. Countries other than the US hadtoaccumulatedollarbalancesasthedollarwasthemeansofinternationalpayments.This meantthattheUShadtorunbalanceofpaymentdeficits(ForeignExchangeDeficits)sothatthe other countries could build up a stock of claims on the US. As long as US deficits were moderate,thisworkedfine,butwhentheystartedmountingitleadtocrisisofconfidenceviz. Other countries started losing faith in the ability of US to convert dollar into gold. Gold demandsforsuchconversionbegantobemadeintheearly60sbytheFrenchfollowedbyother countries in suit. Soon it was obvious that US did not possess enough gold to honour its convertibilitycommitmentifallholdersofdollarassetsdecidedtodemandgold.Thus,aseries ofeventsfinallyledtotheUSabdicatingitsroleasananchoroftheWorldMonetarySystem. Severalattemptstorevisethesystemtroughaseriesofparityrealignments,Dollarrevaluation
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(in terms of gold) and widening the brands of permissible variations around central parties, failedthusmakingtheBrettonWoodsSystemtotallyinvalidin1978. TriffinsParadox: TheBrettonWoodsSystemhadsomecontradictionswhichwerepointedoutbyProf.RTryffin which were : The system depended on the dollar performing and its role as a key currency. CountriesotherthantheU.Shadtoaccumulatedollarbalancesasthedollarwasthemeansof Internationalpayment.ThismeantthattheUShadtorunBOPdeficitssothatothercountries could build up a stock of claims on the US. When the US deficits started mounting, other countriesstartedlosingfaithintheabilityoftheUStoconverttheirdollarassetintogold.
SmithsonianAgreement A revision to the Bretton Woods Accord, signed at the Smithsonian Institution in Washington, D.C., in December 1971. This agreement aimed to maintain fixed exchange rates, but without usinggold,andtoallowgreaterfluctuationbetweencurrencies.WhileBrettonWoodsallowed thedollartofloatinarangeof1percent,theSmithsonianAgreementproposedarangeof2.25 percent.ThesystemsetoutbytheSmithsonianAgreementdidnotworktheforeignexchange markets were forced to close in 1972, and when they reopened in 1973 they were no longer boundbytheSmithsonianAgreement. FLOATINGEXCHANGERATESYSTEM
I.
FREEFLOATING Value of the currency is determined solely by market demand for and supply of the currencyintheforeignexchangemarket. Tradeflowsandcapitalflowsarethemainfactorsaffectingtheexchangerate Inthelongrunitisthemacroeconomicperformanceoftheeconomy(includingtrends incompetitiveness)thatdrivesthevalueofthecurrency NopredeterminedofficialtargetfortheexchangerateissetbytheGovernment.The governmentand/ormonetaryauthoritiescansetinterestratesfordomesticeconomic purposesratherthantoachieveagivenexchangeratetarget Itisrareforpurefreefloatingexchangeratestoexistmostgovernmentsatonetime or another seek to "manage" the value of their currency through changes in interest ratesandothercontrols UK sterling has floated on the foreign exchange markets since the UK suspended membershipoftheERMinSeptember1992
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II. III.
IV. CRAWLINGPEG: Acrawlingpegrateisahybridoffixedandflexibleexchangeratesystems. Underthissystem,whilethevalueofacurrencyisfixedintermsofareferencecurrency,this peg keeps on changing itself in accordance with the underlying economic fundamentals, thus lettingthemarketforcesplayaroleinthedeterminationofthechangeinexchangerate. There are several bases which could be used to determine the direction of change in the exchange rate for example the actual exchange rate ruling the market, t there is gradual modificationswithpermissablevariationsaroundtheparityrestrictedtoanarrowband.
MANAGEDFLOATINGEXCHANGERATES Valueofthepounddeterminedbymarketdemandforandsupplyofthecurrencywith nopredeterminedtargetfortheexchangerateissetbytheGovernment Governmentsnormallyengageinmanagedfloatingifnotpartofafixedexchangerate system. Policypursuedfrom197390andsincetheERMsuspensionfrom19931998
SEMIFIXEDEXCHANGERATES Exchangerateisgivenaspecifictarget Currencycanmovebetweenpermittedbandsoffluctuation Exchange rate is dominant target of economic policymaking (interest rates are set to meetthetarget) BankofEnglandmayhavetointervenetomaintainthevalueofthecurrencywithinthe settargets Revaluationspossiblebutseenaslastresort October1990September1992duringperiodofERMmembership
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The change in parity per unit period is subject to a ceiling with an additional short term constraint,e.g.paritychangeinamonthcannotbemorethan1/12thoftheyearlyceiling. Parity changes are carried out , based on a set of indicators. They may be discretionary, automaticorpresumptive. The indicators are : current account deficits, changes in reserves, relative inflation rates and movingaverageofpastspotrates. CountriessuchasPortugalandBrazilhaveinthepartadoptedvariantsofCrawlingPeg.
Advantagesoffloatingexchangerates Fluctuations in the exchange rate can provide an automatic adjustment for countries withalargebalanceofpaymentsdeficit.Ifaneconomyhasalargedeficit,thereisanet outflow of currency from the country. This puts downward pressure on the exchange rateandifadepreciationoccurs,therelativepriceofexportsinoverseasmarketsfalls (making exports more competitive) whilst the relative price of imports in the home marketsgoesup(makingimportsappearmoreexpensive). Thisshouldhelpreducetheoveralldeficitinthebalanceoftradeprovidedthattheprice elasticity of demand for exports and the price elasticity of demand for imports is sufficientlyhigh. A second key advantage of floating exchange rates is that it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre determinedbands. For example when the UK came out of the Exchange Rate Mechanism in September 1992,thisallowedasharpcutininterestrateswhichhelpedtodragtheeconomyoutof aprolongedrecession. AdvantagesofFixedExchangeRates(disadvantagesoffloatingrates) Fixed rates provide greater certainty for exporters and importers and under normally circumstancesthereislessspeculativeactivityalthoughthisdependsonwhetherthe dealers in the foreign exchange markets regard a given fixed exchange rate as appropriate and credible. Sterling came under intensive speculative attack in the
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autumn of 1992 because the markets perceived it to be overvalued and ripe for a devaluation. Fixedexchangeratescanexertastrongdisciplineondomesticfirmsandemployeesto keeptheircostsundercontrolinordertoremaincompetitiveininternationalmarkets. This helps the government maintain low inflation which in the long run should bring interestratesdownandstimulateincreasedtradeandinvestment. Countrieswithdifferentexchangerateregimes Countrieswithfixedexchangeratesoftenimposetightcontrolsoncapitalflowstoand fromtheireconomy.Thishelpsthegovernmentorthecentralbanktolimitinflowsand outflowsofcurrencythatmightdestabilisethefixedexchangeratetarget, The Chinese Renminbi is essentially fixed at 8.28 renminbi to the US dollar. Currency transactions involving trade in goods and services are allowed full currency convertibility. But capital account transactions are tightly controlled by the State AdministrationofForeignExchange. TheHungarianshaveasemifixedexchangerateagainsttheEurowiththeforintallowed tomove2.5%aboveandbelowacentralrateagainsttheEuro.TheHungariancentral bankmustgivepermissionforoverseasportfolioinvestmentsonacasebycasebasis. TheRussianroubleisinamanagedfloatingsystembutthereisa1%taxonpurchasesof hardcurrency.Incontrast,theArgentinianpesoispeggedtotheUSdollaratparity($1= 1peso)butinternationaltradetransactions(involvingcurrentandcapitalflows)arenot subjecttostringentgovernmentorcentralbankcontrol.
NakedIntervention Acentralbanktypeofinterventionintheforeignexchangemarketwhichconsistsolelyofthe foreignexchangeactivity.Thistypeofinterventionhasamonetaryeffectonthemoneysupply andalongtermeffectonforeignexchange.
DEVALUATIONANDREVALUATION 1. Underafixedexchangeratesystem,devaluationandrevaluationareofficialchangesin thevalueofacountry'scurrencyrelativetoothercurrencies.Underafloatingexchange rate system, market forces generate changes in the value of the currency, known as currencydepreciationorappreciation. 2. Inafixedexchangeratesystem,bothdevaluationandrevaluationcanbeconductedby policymakers,usuallymotivatedbymarketpressures. CompiledbyMANAGEMENTPARADISETEAM. Page24
3. The charter of the International Monetary Fund (IMF) directs policymakers to avoid "manipulating exchange rates...to gain an unfair competitive advantage over other members." A. AttheBrettonWoodsConferenceinJuly1944,internationalleaderssoughttoinsureastable postwar international economic environment by creating a fixed exchange rate system. The UnitedStatesplayedaleadingroleinthenewarrangement,withthevalueofothercurrencies fixedinrelationtothedollarandthevalueofthedollarfixedintermsofgold$35anounce. Following the Bretton Woods agreement, the United States authorities took actions to hold downthegrowthofforeigncentralbankdollarreservestoreducethepressureforconversion ofofficialdollarholdingsintogold. B. Duringthemidtolate1960s,theUnitedStatesexperiencedaperiodofrisinginflation.Because currenciescouldnotfluctuatetoreflecttheshiftinrelativemacroeconomicconditionsbetween theUnitedStatesandothernations,thesystemoffixedexchangeratescameunderpressure. C. In 1973, the United States officially ended its adherence to the gold standard. Many other industrialized nations also switched from a system of fixed exchange rates to a system of floating rates. Since 1973, exchange rates for most industrialized countries have floated, or fluctuated, according to the supply of and demand for different currencies in international markets. An increase in the value of a currency is known as appreciation, and a decrease as depreciation. Some countries and some groups of countries, however, continue to use fixed exchangeratestohelptoachieveeconomicgoals,suchaspricestability. D. Under a fixed exchange rate system, only a decision by a country's government or monetary authority can alter the official value of the currency. Governments do, occasionally, take such measures, often in response to unusual market pressures. Devaluation, the deliberate downwardadjustmentintheofficialexchangerate,reducesthecurrency'svalue;incontrast,a revaluationisanupwardchangeinthecurrency'svalue. E. For example, suppose a government has set 10 units of its currency equal to one dollar. To devalue,itmightannouncethatfromnowon20ofitscurrencyunitswillbeequaltoonedollar. This would make its currency half as expensive to Americans, and the U.S. dollar twice as expensiveinthedevaluingcountry.Torevalue,thegovernmentmightchangetheratefrom10 unitstoonedollartofiveunitstoonedollar;thiswouldmakethecurrencytwiceasexpensive toAmericans,andthedollarhalfascostlyathome. UnderWhatCircumstancesMightaCountryDevalue?(motivebehindDevaluation) Whenagovernmentdevaluesitscurrency,itisoftenbecause the interaction of market forces and policy decisions has made the currency's fixed exchange Page25
rateuntenable.Inordertosustainafixedexchangerate,acountrymusthavesufficientforeign exchange reserves, often dollars, and be willing to spend them, to purchase all offers of its currencyattheestablishedexchangerate.Whenacountryisunableorunwillingtodoso,then it must devalue its currency to a level that it is able and willing to support with its foreign exchangereserves. A key effect of devaluation is that it makes the domestic currencycheaperrelativetoothercurrencies.Therearetwoimplicationsofadevaluation.First, devaluation makes the country's exports relatively less expensive for foreigners. Second, the devaluation makes foreign products relatively more expensive for domestic consumers, thus discouragingimports.Thismayhelptoincreasethecountry'sexportsanddecreaseimports,and maythereforehelptoreducethecurrentaccountdeficit. There are other policy issues that might lead a country to change its fixed exchange rate. For example, rather than implementing unpopular fiscal spendingpolicies,agovernmentmighttrytousedevaluationtoboostaggregatedemandinthe economy in an effort to fight unemployment. Revaluation, which makes a currency more expensive,mightbeundertakeninanefforttoreduceacurrentaccountsurplus,whereexports exceedimports,ortoattempttocontaininflationarypressures.
EffectsofDevaluation Asignificantdangeristhatbyincreasingthepriceofimports and stimulating greater demand for domestic products, devaluation can aggravate inflation. If this happens, the government may have to raise interest rates to control inflation, but at the costofslowereconomicgrowth. Anotherriskofdevaluationispsychological.Totheextentthat devaluationisviewedasasignofeconomicweakness,thecreditworthinessofthenationmay be jeopardized. Thus, devaluation may dampen investor confidence in the country's economy andhurtthecountry'sabilitytosecureforeigninvestment. Another possible consequence is a round of successive devaluations. For instance, trading partners may become concerned that a devaluation might negatively affect their own export industries. Neighboring countries might devalue their own currencies to offset the effects of their trading partner's devaluation. Such "beggar thy neighbor" policies tend to exacerbate economic difficulties by creating instability in broader financialmarkets. Since the 1930s, various international organizations such as theInternationalMonetaryFund(IMF)havebeenestablishedtohelpnationscoordinatetheir trade and foreign exchange policies and thereby avoid successive rounds of devaluation and retaliation.The1976revisionofArticleIVoftheIMFcharterencouragespolicymakerstoavoid Page26
"manipulatingexchangerates...togainanunfaircompetitiveadvantageoverothermembers." With this revision, the IMF also set forth each member nation's right to freely choose an exchangeratesystem.
WHATISCAPITALACCOUNTCONVERTIBILITY? Thereisnoformaldefinitionofcapitalaccountconvertibility(CAC).TheTaraporecommitteesetupby theReserveBankofIndia(RBI)in1997togointotheissueofCACdefineditasthefreedomtoconvert localfinancialassetsintoforeignfinancialassetsandviceversaatmarketdeterminedratesofexchange. InsimplelanguagewhatthismeansisthatCACallowsanyonetofreelymovefromlocalcurrencyinto foreigncurrencyandback. HowisCACdifferentfromcurrentaccountconvertibility? Current account convertibility allows free inflows and outflows for all purposes other than for capital purposessuchasinvestmentsandloans.Inotherwords,itallowsresidentstomakeandreceivetrade relatedpaymentsreceivedollars(oranyotherforeigncurrency)forexportofgoodsandservicesand pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts etc. In India, current account convertibility was establishedwiththeacceptanceoftheobligationsunderArticleVIIIoftheIMFsArticlesofAgreement inAugust1994. CanCACcoexistwithrestrictions? Contrary to general belief, CAC can coexist with restrictions other than on external payments. It does notprecludetheimpositionofanymonetary/fiscalmeasuresrelatingtoforextransactionsthatmaybe warrantedfromaprudentialpointofview. WhyisCACsuchanemotiveissue? CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen as a major comfortfactorforoverseasinvestorssincetheyknowthatanytimetheychangetheirmindtheywillbe abletoreconvertlocalcurrencybackintoforeigncurrencyandtakeouttheirmoney. Inabidtoattractforeigninvestment,manydevelopingcountrieswentinforCACinthe80snotrealising thatfreemobilityofcapitalleavescountriesopentobothsuddenandhugeinflowsaswellasoutflows, CompiledbyMANAGEMENTPARADISETEAM. Page27
both of which can be potentially destabilising. More important, that unless you have the institutions, particularlyfinancialinstitutions,capableofdealingwithsuchhugeflowscountriesmayjustnotbeable tocopeaswasdemonstratedbytheEastAsiancrisisofthelatenineties. Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank and the IMF realisedthatthedangersofgoinginforCACwithoutadequatepreparationcouldbecatastrophic.Since then the received wisdom has been to move slowly but cautiously towards CAC with priority being accordedtofiscalconsolidationandfinancialsectorreformaboveallelse. In India, the Tarapore committee had laid down a threeyear roadmap ending 19992000 for CAC. It alsocautionedthatthistimeframecouldbespeededupordelayeddependingonthesuccessachieved in establishing certain preconditions primarily fiscal consolidation, strengthening of the financial systemandalowrateofinflation.Withtheexceptionofthelast,theothertwopreconditionshavenot yetbeenachieved. WhatisthepositioninIndiatoday? ConvertibilityofcapitalfornonresidentshasbeenabasictenetofIndiasforeigninvestmentpolicyall along, subject of course to fairly cumbersome administrative procedures. It is only residents both individualsaswellascorporateswhocontinuetobesubjecttocapitalcontrols.However,aspartof theliberalisationprocessthegovernmenthasovertheyearsbeenrelaxingthesecontrols.Thus,afew yearsago,residentswereallowedtoinvestthroughthemutualfundrouteandcorporatestoinvestin companiesabroadbutwithinfairlyconservativelimits. Buoyedbytheverycomfortablebuildupofforexreserves,thestrongGDPgrowthfiguresforthelast twoquartersandthefactthatprogressiverelaxationsoncurrentaccounttransactionshavenotleadto anyflightofcapital,onFridaythegovernmentannouncedfurtherrelaxationsonthekindandquantum of investments that can be made by residents abroad. These relaxations are to be reviewed after six monthsandiftheexperienceisnotadverse,wemayseefurtherliberalisationandinthenottoodistant futurefullCAC. LERMS AnacronymforliberalizationExchangeManagementSystemthatwasintroducedfromMarch1,1992 underwhich therupeewasmadepartiallyconvertible.Theobjectivewasto encourageexportersand induceagreaterinflowofremittancesthroughproperchannelsaswellasbringaboutgreaterefficiency inimportsubstitution.Underthesystem,percentofeligibleforeignexchangereceiptssuchasexports earningsorremittanceswastobeconvertedatthemarketrateandthebalance40%attheofficialrate ofexchange.Importerscouldobtaintheirrequirementsofforeignexchangefromauthorizeddealersat CompiledbyMANAGEMENTPARADISETEAM. Page28
themarketrate.Becauseofcertainweaknesses,thissystemwasreplacedbyaunifiedexchangeratein March1993.Thisunificationwasrecommendedasanimportantsteptowardsfullconvertibilitybythe committee on balance of payments under the chairmanship of C Ragranajan. Under the unified rate system all foreign exchange transactions through authorized dealers out at market determined rate exchange.

INTERNATIONALMONETARYFUND
Introduction TheIMFisaninternationalorganisationconsistingof183membercountries.Itwascreated:
Topromoteinternationalmonetarycorporation; Tofacilitateexpansionandbalancedgrowthofinternationaltrade; Topromoteexchangestability; Toassistintheestablishmentofmultilateralsystemofpayments; To make its general resources temporarily available to its members experiencing balanceofpaymentdifficultiesunderadequatesafeguard. To shorten the duration and lessen the degree of disequilibrium in the intenational balanceofpaymentsofmembers.
Objectives AccordingtotheArticlesofAgreementofIMFArticleI,themainobjectivesofIMFare:
Topromoteinternationalmonetarycorporationthroughapermanentinstitutionwhich provides machinery for consultation and collaboration on International Monetary Problems. To facilitate the expansion and balanced growth of international trade and contribute thereby to the promotion and maintenance of high levels of employment and real income to the development of the productive resources of all members as primary objectivesofeconomicpolicy; To promote exchange stability to maintain orderly exchange agreement among the membersandtoavoidcompetitiveexchangedepreciation. Toassistintheestablishmentofmultilateralsystemofpaymentsinrespectofcurrent transactions between members in the elimination of foreign exchange restrictions, whichhamperthegrowthofworldtrade. To give confidence to the members by making the general resources of the fund temporarily available to them under adequate safeguard, thus providing them with
opportunitiestocorrectmaladjustmentsintheirbalanceofpaymentwithoutresorting tomeasuresdestructiveofnationalandinternationalprosperity. In accordance with the above, to shorten the duration and lessen the degree of disequilibriumintheinternationalbalanceofpaymentofmembers. IMFFinancialFacilities TheIMFmakesitsfinancialresourcesavailabletomembercountriesthroughavariety offinancialfacilities.ExceptfortheESAF(seebelow),membersavailthemselvesofthe IMF's financial resources by purchasing (drawing) other members' currencies or SDRs with an equivalent amount of their own currency. The IMF levies charges on these drawings and requires that members repurchase (repay) their own currency from the IMFoveraspecifiedtime.
IMFFinancialPolicies IMFfinancialpoliciesgovernthemodalitiesfortheuseofitsfinancialresourcesunder existingIMFfacilities.Theseinclude:
A. Reserve Tranche Policies. A member has a reserve tranche position in the IMF to the extent that its quota exceeds the IMF's holdings of its currency, excluding credits extended to it by the IMF. Subject only to balance of payments need, a member may drawuptothefullamountofitsreservetranchepositionatanytime.Thisdrawingdoes not constitute a use of IMF credit, as its reserve position is considered part of the member'sforeignreserves,andisnotsubjecttoanobligationtorepay. B. CreditTranchePolicies.Creditsunderregularfacilitiesaremadeavailabletomembers in tranches (segments) of 25 percent of quota. For first credit tranche drawings, membersmustdemonstratereasonableeffortstoovercometheirbalanceofpayments difficulties,andnophasingapplies.Uppercredittranchedrawings(over25percent)are normallyphasedinrelationtocertainconditionsor"performancecriteria." C. Policy on Emergency Assistance. The IMF provides emergency assistance by allowing members to make drawings to meet balance of payments needs arising from sudden and unforeseeable natural disasters and in postconflict situations. Normally this takes the form of an outright purchase of up to 25 percent of quota provided that the member is cooperating with the IMF. It does not entail performance criteria or a phasingofdrawings. D. DebtandDebtServiceReductionPolicies.Partofacreditextendedtoamemberbythe IMF under regular facilities can be set aside to finance operations involving debt
principaland debt servicereduction. The exact amount ofthe setaside is determined onacasebycasebasis;itsavailabilityisgenerallytiedtoprogramperformance. RegularIMFFacilities A. Standby arrangements (SBA): designed to provide shortterm balance of payments assistancefordeficitsofatemporaryorcyclicalnature,sucharrangementsaretypically for12to18months.Drawingsarephasedonaquarterlybasis,withtheirreleasemade conditional on meeting performance criteria and the completion of periodic program reviews.Repurchasesaremade3to5yearsaftereachpurchase. B. Extended Fund Facility (EFF): designed to support mediumterm programs that generally run for three years, the EFF aims at overcoming balance of payments difficulties stemming from macroeconomic and structural problems. Performance criteria are applied, similar to those in standby arrangements, and repurchases are madein4to10years. ConcessionalIMFFacility A. EnhancedStructuralAdjustmentFacility(ESAF):establishedin1987,andenlargedand extendedin1994.Designedforlowincomemembercountrieswithprotractedbalance ofpaymentsproblems,ESAFdrawingsareloansandnotpurchasesofothermembers' currencies. They are made in support of threeyear programs and carry an annual interest rate of 0.5 percent, with a 5year grace period and a 10year maturity. Quarterly benchmarks and semiannual performance criteria apply; 80 lowincome countriesarecurrentlyeligibletousetheESAF. SpecialIMFFacilities A. SystemicTransformationFacility(STF):ineffectfromApril1993toApril1995.TheSTF wasdesignedtoextendfinancialassistancetotransitioneconomiesexperiencingsevere disruptionintheirtradeandpaymentsarrangements.Repurchasesaremadeover4to 10years. B. Compensatory and Contingency Financing Facility (CCFF): provides compensatory financing for members experiencing temporary export shortfalls or excesses in cereal import costs, as well as financial assistance for external contingencies in Fund arrangements.Repurchasesaremadeover3to5years.
C. Supplemental Reserve Facility (SRF): provides financial assistance for exceptional balanceofpaymentsdifficultiesduetoalargeshorttermfinancingneedresultingfrom a sudden and disruptive loss of market confidence. Repurchases are expected to be madewithin1to1years,butcanbeextended,withIMFBoardapproval,to2to2 years. SpecialDrawingRights(SDRs) TheSDRisaninternationalreserveasset,createdbytheIMFin1969tosupplementtheexisting officialreservesofmembercountries.SDRsareallocatedtomembercountriesinproportionto their IMF quotas. The SDR also serves as the unit of account of the IMF and some other internationalorganizations.Itsvalueisbasedonabasketofkeyinternationalcurrencies. WhywastheSDRcreatedandwhatisitusedfortoday? TheSpecialDrawingRight(SDR)wascreatedbytheIMFin1969tosupporttheBretton Woodsfixedexchangeratesystem.Acountryparticipatinginthissystemneededofficial reservesgovernment or central bank holdings of gold and widely accepted foreign currenciesthat could be used to purchase the domestic currency in world foreign exchange markets, as required to maintain its exchange rate. But the international supply of two key reserve assets gold and the U.S. dollarproved inadequate for supporting the expansion of world trade and financial development that was taking place. Therefore, the international community decided to create a new international reserveassetundertheauspicesoftheIMF. However, only a few years later, the Bretton Woods system collapsed and the major currencies shifted to a floating exchange rate regime. In addition, the growth in international capital markets facilitated borrowing by creditworthy governments. Both ofthesedevelopmentslessenedtheneedforSDRs. Today,theSDRhasonlylimiteduseasareserveasset,anditsmainfunctionistoserve astheunitofaccountoftheIMFandsomeotherinternationalorganizations.TheSDRis neitheracurrency,noraclaimontheIMF.Rather,itisapotentialclaimonthefreely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchangesbetweenmembers;andsecond,bytheIMFdesignatingmemberswithstrong externalpositionstopurchaseSDRsfrommemberswithweakexternalpositions.
SDRvaluation
ThevalueoftheSDRwasinitiallydefinedasequivalentto0.888671gramsoffinegold which, at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton Woods system in 1973, however, the SDR was redefined as a basket of currencies,today consisting of the euro, Japanese yen, pound sterling, and U.S. dollar. TheU.S.dollarvalueoftheSDRisposteddailyontheIMF'swebsite.Itiscalculatedas thesumofspecificamountsofthefourcurrenciesvaluedinU.S.dollars,onthebasisof exchangeratesquotedatnooneachdayintheLondonmarket. The basket composition is reviewed every five years to ensure that it reflects the relative importance of currencies in the world's trading and financial systems. In the mostrecentreviewthattookplaceinNovember2005,theweightsofthecurrenciesin the SDR basket were revised based on the value of the exports of goods and services andtheamountofreservesdenominatedintherespectivecurrencieswhichwereheld byothermembersoftheIMF.ThesechangesbecameeffectiveonJanuary1,2006.The nextreviewbytheExecutiveBoardwilltakeplaceinlate2010.
TheSDRinterestrate TheSDRinterestrateprovidesthebasisforcalculatingtheinterestchargedtomembers onregular(nonconcessional)IMFloans,theinterestpaidandchargedtomemberson their SDR holdings, and the interest paid to members on a portion of their quota subscriptions. The SDR interest rate is determined weekly and is based on a weighted averageofrepresentativeinterestratesonshorttermdebtinthemoneymarketsofthe SDRbasketcurrencies.
SDRallocations UnderitsArticlesofAgreement,theIMFmayallocateSDRstomembersinproportionto their IMF quotas. Such an allocation provides each member with a costless asset on which interest is neither earned nor paid. However, if a member's SDR holdings rise above its allocation, it earns interest on the excess; conversely, if it holds fewer SDRs thanallocated,itpaysinterestontheshortfall.TheArticlesofAgreementalsoallowfor cancellationsofSDRs,butthisprovisionhasneverbeenused.TheIMFcannotallocate SDRstoitself.
Therearetwokindsofallocations: A. GeneralallocationsofSDRshavetobebasedonalongtermglobalneedtosupplement existing reserve assets. General allocations are considered every five years, although decisionstoallocateSDRshavebeenmadeonlytwice.Thefirstallocationwasforatotal
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amountofSDR9.3billion,distributedin197072.Thesecondallocationwasdistributed in197981andbroughtthecumulativetotalofSDRallocationstoSDR21.4billion. B. AproposalforaspecialonetimeallocationofSDRswasapprovedbytheIMF'sBoardof GovernorsinSeptember1997throughtheproposedFourthAmendmentoftheArticles of Agreement. This allocation would double cumulative SDR allocations to SDR 42.8 billion.ItsintentistoenableallmembersoftheIMFtoparticipateintheSDRsystemon an equitable basis and correct for the fact that countries that joined the Fund subsequentto1981morethanonefifthofthecurrentIMFmembershiphavenever received an SDR allocation. The Fourth Amendment will become effective when three fifthsoftheIMFmembership(111members)with85percentofthetotalvotingpower accept it. As of endAugust, 2006, 131 members with 77.3 percent of total voting power had accepted the proposed amendment. Approval by the United States, with 17.1percentoftotalvotes,wouldputtheamendmentintoeffect. HowfarSDRshavebeenabletosolvetheproblemofinternationalliquidity? AstheBrettonWoodssystemstartedfacingproblems,andthepressureonthedollar increased, a new reserve asset named SDRs was created by IMF in 1967. This internationalcurrencywasallocatedtotheIMFmembercountriesinproportionoftheir quotas. The biggest benefit of SDRs was that there was a provision for international moneytobecreatedwithoutanycountryneedingtorunaBoPdeficitortominegold. Its value lay not in any backing by a currency or a real asset (like gold), but in the readinessoftheIMFcountriestoacceptitasanewformofinternationalmoney. Any member country, when facing payment imbalances arising out of BoP deficits, coulddrawontheseSDRsaslongasitmaintainedanaveragebalanceof30%ofitstotal allocations.ItcouldselltheseSDRstoasurpluscountryinexchangeforthatcountrys currency and use it for settlement of international payments. Every member country wasobligedtoacceptupto3timesitstotalallocationsasasettlementofinternational payments.Itwasaninterestbearingsourceoffinance,i.e.countriesholdingtheirSDRs receiveinterestandtheonedrawingthempayinterest.Theseratesweredetermined onthebasisoftheaveragemoneymarketinterestratesprevailinginFrance,Germany, Japan,UKandUS.OnlythemembercountriesofIMFandspecificofficialinstitutionsare eligibletoholdSDRs.ItisalsoanaccountofallIMFtransactions.
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ThevalueofaSDRwasinitiallydeterminedasequaltothatofadollar,i.e.,oneounce of gold was equalized to 35 SDRs. Later, its value was revised and put equal to the weightedaveragevalueof16majorcurrenciesUSdollar,yen,poundsterling,DM,and French Franc. Both the times the weights were based on the importance of the respectivecountriesinworldtrade.AnimportantadvantageofSDRswasthatitsvalue wasmorestablethanthatofindividualcurrencies.Thishappenedbecauseitderivedits value from a number of currencies, whose values were unlikely to vary in the same directionandtothesameextentthusmakingitabetterunitthanasinglecurrency. However,despitetheintroductionofSDRs,theproblemofinternationalliquiditycrisis was not solved. US gold holdings had reduced considerably and by 1979, its reserve turnednegativeastheBoPdeficitincreaseddrastically.Therewasgreatpressureonthe US in the early 1971, because a number of countries had to buy a lot of dollars to defendtheirexchangerates.TheconditionofUSworsenedbecauseitsufferedfroma tradedeficitcausinggreatunemployment. This problem continued for some period of time thus reducing the validity of SDRs to resolvetheinternationalliquiditycrisis.
EURPOEANMONETARYSYSTEM
Examine the transformation of the European Union from a political and economic uniontoamonetaryunion. ThebasisoftheEuropeanMonetaryUnionwastobuildaunitedEuropeaftertheWorldWarII. This was initiated by when the European nations created the European Coal and Steel community, with a view to freeing trade in these two sectors. The pricing policies and commercial practices of the member nations of this community were regulated by a supranational agency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxemburg and the Netherlands to form the European Economic Community (EEC), wherebytheyagreedtomakeEuropeacommonmarket.Whiletheyagreedtoliftrestrictions onmovementsofallfactorsofproductionandtoharmonizedomesticpolicies,theultimateaim waseconomicintegration.TheEECachievedthestatusofacustomsunionby1968.Inthesame year,itadoptedaCommonAgriculturalPolicy(CAP),underwhichuniformpricesweresetfor farm products in the member countries, and levies were imposed on imports from non membercountriestoprotecttheregionalindustryfromlowerexternalprices.IntheEuropean unification,powerwasgiventoallmembercountriesthattheycouldvetoanydecisiontaken by other members. This hindrance was removed when the members approved of the Single European Act, in 1986, making it possible for a lot of proposals to be passed by weighted majorityvoting.Thispavedwayfortheunificationsofthemarketsforcapitalandlabour,which convertedEECpracticallyintoamarketonJanuary1,1993. The Headsof State and governments of the countries of the EU decided at Maastricht on 9th and10thDecember1991toputinplacetheEuropeanMonetaryUnion(EMU).Adheringtothe EMU meant irrevocable fixed exchange rates between different countries of the Union. The settingupoftheEMUhadbeenastepforwardtowardstheintroductionofacommoncurrency inthememberstatesofEU,aspertheMaastrichtTreaty.Ithadbeenratifiedbyall12countries which constituted the union at that point of time. The EMU completed the mechanism that started with the Customs Union of the Treaty of Rome and the big Common Market of the SingleAct. TheobjectivesoftheEMUare: Adoption of an economic policy, based on a close coordination between economic policiesofthememberstates. Fixingofirrevocableexchangeratesleadingtoasinglecurrency. Development of a single monetary policy having objective of price stability and the supporttotheeconomicpoliciesofthememberstatesingeneral. TheprimaryadvantageofEMUwasthatithelpedinstabilizingexchangeratesinthecurrencies of member states. It also helped in elimination of transaction costs, greater transparency in
pricesandgreatercredibilitywithrespecttotheworldoutside.Also,EMUsignifiedgivingupa independentnationalmonetarypolicy.Thereseemedtobeanagreementamongthemember states that the effect of the EMS would be beneficial for the economic growth of Europe. However it was anticipated there would be some problems in short and medium term. For instance,theprogrammesofstructuraladjustmentcarriedoutbythecountrieslikeItaly,Spain, Germanytoreducepublicdeficitsandinflationbyarestrictivepolicyhadnegativeeffectson internaldemandandgrowth.Thispolicyalsohadnegativeeffectsonneighboringcountriesin terms of reduction of their international business. The countries which had not attained a required level of economic convergence found it difficult for maintaining the currency within theEMS. Thus the transformation of the European Union from a political and economic union to a monetaryunionhasexplainedabovealongwiththefeaturesoftheEMU. EMUIntroduction The European Monetary SystemA system with the following objectives: to stabilize exchangerates,toreduceinflationandtoprepareforeuropeanmonetaryunification. The European Monetary System, was created on account of a Resolution of the EuropeanCouncilonthe5thDecember1978.Itenteredintoforceonthe13thMarch 1979,accordingtoanagreementcelebratedthesamedaybetweenthecentralbanksof thecountriesthatformedpartoftheCommunity.Ithad3fundamentalobjectives: tostabilizetheexchangeratesinordertorectifytheexistinginstability, toreduceinflationand toprepareEuropeanmonetaryunificationthroughcooperation.
ThebasicelementsofthisSystemarethree: TheECU:itreferredtoacomposedcurrency(orcurrencybasket),formedbygivenpercentages of each one of the participating currencies, established in function to the contribution of the respective countries to the GNP of the Community and to the communities interexchanges. Thevalueofthebasketwascalculatedbymultiplyingtheweightattributedtoeachcurrencyby itsexchangeratewithrespecttotheecu. It is a currency that was used to specify the community budget, however it was not legal tender.Itservedasameansofpaymentandreservationatthecentralbanks.
An exchange rate and intervention mechanism (ERM): it is the basis of the EMS. The ERM established, for each one of the communities currencies, a central type of change to the ecu (centralpivot),andsomecentralexchangeratesorfixedparitiesforeachcurrencywithrespect totheremainder(lateralpivots). Withthisgridironofparities,formedbyallthebilateralexchangerates,thedifferentexchange rates of the participating currencies had to stabilize. In this way, the central banks were committed to intervening in order to attempt to maintain to their currencies always within establihedfluctuationmargin. EuropeanMonetaryCooperationFund(EMCF):createdinOctober1972andwhoseprincipal functionswere: SNAKEINTHETUNNEL TheconceptofparitygridwasacceptedbyEuropeanEconomicCommunitysince1972,though wascalleddifferentlyasJointfloatSNAKE.Theplanofjointfloatwasputineffectimmediately after the Smithsonian Agreement. It provided for fluctuation up to +/ 2.25% against dollar. Which meant any other two currencies could fluctuate by +/4.50% against each other (one currency going 2.25+/ % per dollar). EEC countries undertook to narrow the fluctuations amongst member currencies to half the amount i.e. +/2.25%. The graph of currency movementsagainsteachotherwouldlooklikesnakeinthetunnel.Asithitsupperlimit,it hastocomedownandatlowerlimit,hastostartnorthwardsusuallyanycurrencywasplotted againstdollar.Thus,jointfloatwasnamedasSNAKE.BritainandItalydidnotparticipatein SNAKEandFranceparticipatedintermittently. tofacilitateinterventionsinthecurrencymarkets, toeffectliquidationsbetweenthecentralbanksand tomanagetheshorttermcreditfacilitiesassociatedwiththeEMS.

SECTION3:FOREGINEXCHANGEMARKET FOREGINEXCHANGEMARKET(STRUCTURE&TRANSACTIONS)
WHATISFOREIGNEXCHANGE? In a business setting, there is a fundamental difference between making payment in the domesticmarketandmakingpaymentabroad.Inadomestictransaction,onlyonecurrencyis usedwhileinaforeigntransaction,twoormorecurrenciesmaybeused. SupposeanU.SimporterhasagreedtopurchaseacertainquantityofIndianspicesandtopay theIndianexporterRs.1000000forit.Howwouldhegoaboutdoingthis?Hewouldhavetopay theamountindollars,whichwillbeequivalenttoitsexistingrateinrupeesatadecideddate. Thatiswhytheforeignexchangemarketcomesintoexistencesothatsuchtransactionsbecome possibleandeasier. The special checks and other instruments for making payment abroad are referred to collectivelyasforeignexchange.Inotherwords,Foreignexchangeincludescurrenciesandother instrumentsofpaymentdenominatedincurrencies. Elaborate the structure of the foreign exchange market and compare it with the foreign exchangeofIndia Themajorparticipantsintheforeignexchangemarketsarecommercialbanks;foreignexchange brokers and other authorized dealers, and the monetary authorities. It is necessary to understand that the commercial banks operate at retail level for individual exporters and corporations as well as at wholesale levels in the inter bank market. The foreign exchange brokersinvolveeitherindividualbrokersorcorporations.Bankdealersoftenusebrokerstostay anonymous since the identity of banks can influence short term quotes. The monetary authorities mainly involve the central banks of various countries, which intervene in order to maintain or influence the exchange rate of their currencies within a certain range and also to executetheordersofthegovernment. Page40
Itisimportanttorecognizethat,althoughtheparticipantsthemselvesmaybebasedwithinthe individual countries, and countries may have their own trading centers, the market itself is world wide. The trading centers are in close and continuous contact with one another, and participantswilldealinmorethanonemarket. Primarily,exchangemarketsfunctionthroughtelephoneandtelex.Also,itisimportanttonote thatcurrencieswithlimitedconvertibilityplayaminorroleintheexchangemarket.Besidesthis, onlyasmallnumberofcountrieshaveestablishedtheirfullconvertibilityoftheircurrenciesfor fulltransactions. The foreign exchange market in India consists of 3 segments or tires. The first consists of transactions between the RBI and the authorized dealers. The latter are mostly commercial banks.ThesecondsegmentistheinterbankmarketinwhichtheADsdealwitheachother.And thethirdsegmentconsistsoftransactionsbetweenADsandtheircorporatecustomers. The retail market in currency notes and travelers cheques caters to tourists. In the retail segmentinadditiontotheADstherearemoneychangers,whoareallowedtodealinforeign currencies. The Indian market started acquiring some depth and features of well functioning markete.g.activemarketmakerspreparedtoquotetwowayratesonlyaround1985.Eventhen 2wayforwardquotesweregenerallynotavailable.Intheinterbankmarket,forwardquotes wereevenintheformofneartermswapsmainlyforADstoadjusttheirpositionsinvarious currencies. ApartfromtheADscurrencybrokersengageinthebusinessofmatchingsellerswithbuyers.In the interbank market collecting a commission from both. FEDAI rules required that deals betweenADsinthesamemarketcentersmustbeeffectedthroughaccreditedbrokers. LearningObjectives o o o o o o Examinethefunctionsperformedbytheforeignexchange(FOREX)market,whoarethe participants,size,geographicandcurrencycomposition Distinguish among spot, forward, swaps and other types of foreign exchange financial instruments Identify the forms of currency quotations used by currency dealers, financial institutions,andagents Analyze the interaction among changing currency values, cross exchange rates and opportunitiesarisingfromintermarketarbitrage The FOREX market provides the physical and institutional structure through which the moneyofonecountryisexchangedforthatofanothercountry A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate.
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MarketParticipants
The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retailmarket Fivebroadcategoriesofparticipantsoperatewithinthesetwotiers o o o o o Bankandnonbankforeignexchangedealers Individualsandfirmsconductingcommercialorinvestmenttransactions Speculatorsandarbitragers Centralbanksandtreasuries Foreignexchangebrokers
BankandNonbankDealers These participants profit from buying currencies at a bid price and then reselling them at an offeroraskprice Competitionamongdealersnarrowsthespreadbetweenthebidandofferratecontributingto themarketsefficiency Dealersonbehalfoflargeinternationalbanksoftenactasmarketmakers,oftenwillingtostand in and buy or sell these currencies without having a counterpart with which to unload the inventory They trade amongst other banks and dealers in order to keep their inventory levels at manageablelevels Currencytradingisprofitableandoftencontributesbetween10%20%ofabanksaveragenet income Smalltomediumsizedbanksrarelyactasmarketmakersyetstillparticipateintheinterbank market IndividualsandFirmsConductingCommercial/InvestmentTransactions Importers, exporters, portfolio investors, MNEs, tourists and others use the FOREX market to facilitateexecutionofcommercialorinvestmenttransactions Someoftheseparticipantsusethemarkettohedgeforeignexchangeraterisk SpeculatorsandArbitragers Speculatorsandarbitragersseektoprofitfromtradinginthemarketitself They operate for their own interest, without need or obligation to serve clients or ensure a continuousmarket Speculatorsseekalltheirprofitfromexchangeratechanges Arbitragerstrytoprofitfromsimultaneousdifferencesinexchangeratesindifferentmarkets CompiledbyMANAGEMENTPARADISETEAM. Page42
Alargeproportionofspeculationandarbitrageisconductedonbehalfofmajorbanksbytraders employedbythosebanks CentralBanksandTreasuries Central banks and treasuries use the market to acquire or spend their countrys currency reservesaswellastoinfluencethepriceatwhichtheirowncurrencytrades Theymayacttosupportthevalueoftheircurrencybecauseoftheirgovernmentspoliciesor obligations or because of commitments entered through joint float agreements such as the EuropeanMonetarySystem(EMS) Consequently their motive is not to profit but rather influence the foreign exchange value of theircurrencyinamannerthatwillbenefittheirinterests ForeignExchangeBrokers Foreignexchangebrokersareagentswhofacilitatetradingbetweendealerswithoutthemselves becomingprincipalsinthetransaction Forthisservicetheychargeasmallcommission Theymaintaininstantaccesstohundredsofdealersworldwideviaopenlinesandattimesmay maintain such lines with several banks, with separate lines for differing currencies, spot and forwardrates TransactionsintheInterbankMarket Transactionswithinthismarketcanbeexecutedonaspot,forward,orswapbasis o o o Aspottransactionrequiresalmostimmediatedeliveryofforeignexchange Aforwardtransactionrequiresdeliveryofforeignexchangeatsomefuturedate Aswaptransactionisthesimultaneousexchangeofoneforeigncurrencyforanother 1. Value Date: The settlement of a transaction takes place by transfers of deposits between two parties.ThedayonwhichthesetransfersareeffectediscalledtheSettlementDateortheValue Date. 2. Spot Rate: When the exchange of currencies takes place on the second working day after the dateofthedeal,itiscalledspotrate. 3. ForwardTransactions:Iftheexchangeofcurrenciestakesplaceafteracertainperiodfromthe dateofthedeal(morethan2workingdays),itiscalledaforwardrate.Atradermayquotea forwardtransactionforanyfuturedate.Itisabindingcontractbetweenacustomeranddealer CompiledbyMANAGEMENTPARADISETEAM. Page43
for the purchase or sale of a specific quantity of a stated foreign currency at the rate of exchangefixedatthetimeofmakingthecontract. 4. SwapTransaction:Aswaptransactionintheforeignexchangemarketiscombinationofaspot and a forward in the opposite direction. Thus a bank will buy DEM spot against USD and simultaneouslyenterintoaforwardtransactionwiththesamecounterpartytosellDEMagainst USDagainstthemarkcoupledwitha60dayforwardsaleofUSDagainstthemark.Astheterm swap implies, it is a temporary exchange of one currency for another with an obligation to reverseitataspecificfuturedate. 5. SpotTransactions A spot transaction in the interbank market is the purchase of foreign exchange, with delivery andpaymentbetweenbankstotakeplace,normally,onthesecondfollowingbusinessday Thesettlementdateisoftenreferredtoasthevaluedate This is the date when most dollar transactions are settled through the computerized Clearing HouseInterbankPaymentSystems(CHIPS)inNewYork
OutrightForwardTransactions Thistransactionrequiresdeliveryatafuturevaluedateofaspecifiedamountofonecurrency foranother Theexchangerateisagreeduponatthetimeofthetransaction,butpaymentanddeliveryare delayed Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months Terminologytypicallyusedisbuyingorsellingforward A contract to deliver dollars for euros in six months is both buying euros forward for dollarsandsellingdollarsforwardforeuros SwapTransactions Aswaptransactionintheinterbankmarketisthesimultaneouspurchaseandsaleofagiven amountofforeignexchangefortwodifferentvaluedates Bothpurchaseandsaleareconductedwiththesamecounterpart Acommontypeofswapisaspotagainstforward The dealer buys a currency in the spot market and simultaneously sells the same amountbacktothesamebankintheforwardmarket Since this transaction occurs at the same time and with the same counterpart, the dealerincursnoexchangerateexposure
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ForwardforwardswapsAdealersells20,000forwardfordollarsfordeliveryintwomonths at $1.6870/ and simultaneously buys 20,000 forward for delivery in three months at $1.6820/ The difference between the buying and selling price is equivalent to the interest rate differential Thus a swap can be viewed as a technique for borrowing another currency on a fully collateralizedbasis Nondeliverableforwards(NDFs)NDFspossessthesamecharacteristicsastraditionalforward contractsexceptthattheyaresettledonlyinUSdollarsandtheforeigncurrencybeingsoldor boughtforwardisnotdelivered The dollarsettlement feature reflects the fact that NDFs are contracted offshore and arebeyondthereachandregulatoryframeworksofthehomecountrygovernments PricingofNDFsreflectsbasicinterestratedifferentials SizeoftheFOREXMarket The Bank for International Settlements (BIS) estimates that daily global net turnover in traditionalFOREXmarketactivitytobeUS$1,210billioninApril2001 GlobalForeignExchangeMarketTurnover (dailyaveragesinApril,billionsofUSdollars) 800 Spot
100 700 600 500 400 300 200
Forwards Swaps
Twoofthethreecategoriesfellbetween1998and2001withspotmarketdailyturnoverfalling 1989 1992 1995 1998 2001 themost,from$568billionin1998to$387billionin2001 Forwardtransactionsincreasedslightlyfrom$128billionin1998to$131billionin2001 Swapsfellto$656billionin2001from$734billionin1998 CompiledbyMANAGEMENTPARADISETEAM. Page45
0
BIS attributes the introduction of the Euro, the growing share of electronic broking in thespotmarketandconsolidationinbankingasexplanationsforthereduction GeographicDistributionofForeignExchangeMarketTurnover (dailyaveragesinApril,billionsofUSdollars)
700 600 500 400 300 200 100 0 1989
Unite d State s Unite d Kingdom Japan Singapore Ge rmany
1992
1995
1998
2001
Source:BankforInternationalSettlements,CentralBankSurveyofForeignExchangeandDerivatives MarketActivityinApril2001,October2001,www.bis.org.
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FOREIGNQUOTATIONS&ARBITRAGE
WhatisCHIPS? CHIPS, Clearing House Interbank Payments System, is the premier bankowned payments system for clearing large value payments. CHIPS is a realtime, final payments system for U.S. dollars that uses bilateral and multilateral netting for maximum liquidity efficiency. CHIPS is theonlylargevaluesystemintheworldthathasthecapabilityofcarryingextensiveremittance information for commercial payments. CHIPS processes over 320,000 payments a day with a gross value of $1.6 trillion. It is a premier payments platform serving the largest banks from aroundtheworld,representing19countriesworldwide. Over its 37 year history, CHIPS has developed and maintained a reputation of reliability, efficiency and innovation in the marketplace by processing over 95% of the USD crossborder payments. And now, with new valueadded features CHIPS is the leading system for all your largevaluepaymentneedsbothinternationalanddomestic.
WhyshouldabankuseCHIPStoprocesspayments? SWIFT Realtime,MultilateralNettingwithPaymentFinality GlobalProcessingHours 96%StraightthroughProcessingRate EliminatesDaylightOverdraftCharges MaximizesLiquidity$1turnsover500times OnlineManagementTools PaymentsonDemandCapability RemittanceInformationDelivery AlternativetoFedwireforContingencyPlanning UniversalIdentificationNumbers(UIDs)
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SWIFT is the industryowned cooperative supplying secure, standardised messaging services andinterfacesoftwaretonearly8,100financialinstitutionsin207countriesandterritories. SWIFTmembersincludebanks,brokerdealersandinvestmentmanagers. ThebroaderSWIFTcommunityalsoencompassescorporatesaswellasmarketinfrastructuresin payments,securities,treasuryandtrade. Over the past ten years, SWIFT message prices have been reduced over 80%, and system availabilityapproaches5x9reliability99.999%ofuptime.
BidRate:Thebidratedenotesthenumberofunitsofacurrencyabankiswillingtopaywhenitbuys anothercurrency. OfferRate:Theofferratedenotesthenumberofunitsofacurrencyabankwillwanttobepaidwhenit sellsacurrency. 1. Example:118.27118.37/$isthebid/askforJapaneseyen 2. Thebankwillbuyyenat118.27perdollarandsellyenat118.37perdollarmakingprofiton thespread BidOfferRate:ThebidofferRateistheratewhichstatesboth,thepricewhichisthebankiswillingto paytobuyothercurrenciesandthepricethebankexpectswhenitsellsthesamecurrency.BidandAsk willalwaysbefromabankspointofview.Thus(A/B)bidwilldenotethenumberofunitsofAthebank willpaywhenitbuysoneunitofBand(A/B)askwillmeanthenumberofunitsofAthebankwillwantto bepaidinordertoselloneunitofB. EuropeanQuote:ThequotesaregivenasnumberofunitsofacurrencyperUSD.ThusDEM1.5675/USD isaEuropeanquote. American Quotes: American quotes are given as number of dollars per unit of a currency. Thus USD0.4575/DEMisanAmericanquote. DirectQuotes:inacountry,directquotesarethosethatgiveunitofthecurrencyofthatcountryper unitofaforeigncurrency.ThusINR35.00/USDisadirectquoteinIndia Sfr1.6000/$isadirectquoteinSwitzerland . Indirect Quote: Indirect or Reciprocal Quotes are stated as number of units of a foreign currency per unitofthehomecurrency.ThusUSD3.9560/INR100isanindirectquoteinIndia. Sfr1.600/$isanindirectquoteintheUS, $0.625/SfrisadirectquoteintheUSandanindirectquoteinSwitzerland ExpressingForwardQuotationsonaPointsBasis Thepreviouslymentionedratesforyenwereconsideredoutrightquotes Forwardquotesaredifferentandtypicallyquotedintermsofpoints Apointisthelastdigitofaquotation,withconventiondictatingthenumberof digitstotherightofthedecimal CompiledbyMANAGEMENTPARADISETEAM. Page48
Example:
Henceapointisequalto0.0001ofmostcurrencies Theyenisquotedonlytotwodecimalpoints A forward quotation is not a foreign exchange rate, rather the difference betweenthespotandforwardrates
Outrightspot: 118.27 118.37 Pluspoints(3months) 1.43 1.40 _______________________ Outrightforward: 116.84 116.97 ForwardQuotationsinPercentageTerms Forward quotations may also be expressed as the percentperannum deviation from thespotrate Thisissimilartotheforwarddiscountorpremiumcalculatedearlier Theimportantthingtorememberiswhichcurrencyisbeingusedasthehomeorbase currency Forindirectquotes(i.e.quoteexpressedinforeigncurrencyterms),theformula is Spot - Foward 360 FC f = x x 100 Foward days ForwardQuotationsinPercentageTerms Fordirectquotes(i.e.quoteexpressedinhomecurrencyterms),theformulais Forward - Spot 360 fH = x x 100 Spot days CrossRates Many currencies pairs are inactively traded, so their exchange rate is determined throughtheirrelationshiptoawidelytradedthirdcurrency Example:AMexicanimporterneedsJapaneseyentopayforpurchasesinTokyo.Both theMexicanpeso(Ps)andJapaneseyen()arequotedinUSdollars Assumethefollowingquotes: Japaneseyen 121.13/$ Mexicanpeso Ps9.190/$
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6. Arbitrage: Arbitrage may be defined a san operation that consists in deriving a profit without riskfromadifferentialexistingbetweendifferentquotedrates.Itmayresultfrom2currencies,also knownas,geographicalarbitrageorfrom3currencies,alsoknownas,triangularcurrencies. Definearbitrageandexplainthedifferenttypesofarbitrage. Sometimes companies deal in foreign exchange to make a profit, even though the transaction is not connected to any other business purpose, such as trade flows or investment flows. Usually, however, thistypeofforeignexchangeactivitiesismorelikelytobepersuadedbyforeignexchangetraders andinvestors.Onetypeofprofitseekingactivityisarbitrage,whichisthepurchaseofforeigncurrency ononemarketforimmediateresaleonanothermarket(inadifferentcountry)inordertoprofitfroma price discrepancy. Hence, arbitrage may be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates. It may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage). Interestarbitrageinvolvesinvestinginforeignbearinginstrumentsinforeignexchangeinaneffortto earnaprofitduetointerestratesdifferentials.Forexample,atradermayinvest$1000intheUnited Statesforninetydaysorconvert$1000intoBritishpounds,investthemoneyintheUnitedKingdomfor ninetydaysandthenconvertthepoundsbackintodollars.Theinvestorwouldtrytopickthealternative thatwouldbethehighestyieldingattheendofninetydays. But Speculation is the buying or the selling of the commodity i.e. foreign currency, where the activity containsboththeelementofriskandthechancesofagreaterprofit.Speculatorsareimportantinthe foreignexchangemarketbecausetheyspottrendsandtrytotakeadvantageofthem.Thustheycan beavaluablesourceofbothsupplyanddemandforacurrency.Asaprotectionagainstrisk,foreign exchangetransactionscanbeusedtohedgeagainstapotentiallossduetoanexchangeratechange. SpotQuotations: Arbitraging between Banks: Though one hears the term market rate, it is not true that all bankswillhaveidenticalquotesforagivenpairofcurrenciesatagivenpointoftime.Therates willbeclosetoeachotherbutitmaybepossibleforacorporatecustomertosavesomemoney byshoppingaround. Inversequotesand2pointarbitrage:Thearbitragetransactionthatinvolvebuyingacurrency inonemarketandsellingitatahigherpriceinanothermarketiscalledTwopointArbitrage. Foreign exchange markets quickly eliminate two point arbitrage opportunities if and when theyarise. Cross rates and 3 point arbitrage: The term three point arbitrage refers to the kind of transactionwhereonestartswithcurrencyA,sellitforB,sellBforCandfinallysellCbackforA Page50
endingupwithmoreAthanonebeganwith.Efficientforeignexchangemarketsdonotpermit risklessarbitrageprofitofthiskind. Outrightforwardquotation: Some of the major currencies quoted in the forward marketareDeutschmarks,Poundsterling,Japaneseyen,Swissfranc,Canadiandollaretc.they aregenerallyquotedintermsofUSdollars.Currenciesmaybequotedintermsofone,three,six monthsandoneyearforward.Butenterprisesmayobtainformbanksquotationsfordifferent periods. Asmentionedearlier,thespotmarketisforforeignexchangetransactionswithintwobusiness days.However,sometransactionsmaybeenteredintoononedaybutnotcompleteduntilafter two business days. For example, a French exporter of perfume might sell perfume to an US importerwithimmediatedeliverybutpaymentnotrequiredforthirtydays.TheUSimporteris obligatedtopayinfrancsinthirtydaysandmayenterintoacontractwithatradertodeliver francsinthirtydaysataforwardrate,aratetodayforfuturedelivery. Thustheforwardrateistheratequotedbyforeignexchangetradersforthepurchaseorsale of foreign exchange in the future. The difference between the spot and the forward rates is knownaseithertheforwarddiscountortheforwardpremiumonthecontract.Ifthedomestic currency is quoted on a direct basis and the forward rate is greater than the spot rate, the foreigncurrencyissellingatapremium.Itiscalculatedasfollows:
Forwarddiscount/premium=ForwardmidSpotmid*12/n*100 Spotmid
Wherenindicatesthenumberofmonthsforward. WhenFwdrate>Spotrate,itimpliespremium. Fwdrate<Spotrate,itimpliesdiscount. In the case of forward market, the arbitrage operates in the differential of interest rates and the premiumordiscountonexchangerates. PURCHASINGPOWERPARITY WhatisPurchasingPowerParity? Purchasingpowerparity(PPP)isatheorywhichstatesthatexchangeratesbetweencurrencies areinequilibriumwhentheirpurchasingpoweristhesameineachofthetwocountries.This means that the exchange rate between two countries should equal the ratio of the two CompiledbyMANAGEMENTPARADISETEAM. Page51
countries'pricelevelofafixedbasketofgoodsandservices.Whenacountry'sdomesticprice level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciatedinordertoreturntoPPP. The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countrieswhenthepricesareexpressedinthesamecurrency.Forexample,aparticularTVset that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in SeattlewhentheexchangeratebetweenCanadaandtheUSis1.50CAD/USD.Ifthepriceofthe TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver.Ifthisprocess(called"arbitrage")iscarriedoutatalargescale,theUSconsumers buyingCanadiangoodswillbidupthevalueoftheCanadianDollar,thusmakingCanadiangoods morecostlytothem.Thisprocesscontinuesuntilthegoodshaveagainthesameprice.There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barrierstotrade,andothertransactioncosts,canbesignificant.(2)Theremustbecompetitive markets for the goods and services in both countries. (3) The law of one price only applies to tradeablegoods;immobilegoodssuchashouses,andmanyservicesthatarelocal,areofcourse nottradedbetweencountries. Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described in the previous paragraph; it refers to the equalization of price levelsacrosscountries.Putformally,theexchangeratebetweenCanadaandtheUnitedStates ECAD/USD is equal to the price level in Canada PCAN divided by the price level in the United StatesPUSA.Assume thatthepricelevelratioPCAD/PUSDimpliesaPPPexchangerateof 1.3 CADper1USD.Iftoday'sexchangerateECAD/USDis1.5CADper1USD,PPPtheoryimpliesthat theCADwillappreciate(getstronger)againsttheUSD,andtheUSDwillinturndepreciate(get weaker)againsttheCAD. Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates betweentheforeignandthehomecountry.Forexample,ifCanadahasaninflationrateof1% andtheUShasaninflationrateof3%,theUSDollarwilldepreciateagainsttheCanadianDollar by2%peryear.Thispropositionholdswellempiricallyespeciallywhentheinflationdifferences arelarge.
DoesPPPdetermineexchangeratesintheshortterm? No. Exchange rate movements in the short term are newsdriven. Announcements about interestratechanges,changesinperceptionofthegrowthpathofeconomiesandthelikeare allfactorsthatdriveexchangeratesintheshortrun.PPP,bycomparison,describesthelongrun behaviour of exchange rates. The economic forces behind PPP will eventually equalize the purchasing power of currencies. This can take many years, however. A time horizon of 410 yearswouldbetypical. CompiledbyMANAGEMENTPARADISETEAM. Page52
HowisPPPcalculated?
Thesimplestwaytocalculatepurchasingpowerparitybetweentwocountriesistocomparethe price of a "standard" good that is in fact identical across countries. Every year The Economist magazine publishes a lighthearted version of PPP: its "Hamburger Index" that compares the priceofaMcDonald'shamburgeraroundtheworld.MoresophisticatedversionsofPPPlookat a large number of goods and services. One of the key problems is that people in different countriesconsumerverydifferentsetsofgoodsandservices,makingitdifficulttocomparethe purchasingpowerbetweencountries.
AccordingtoPPP,byhowmucharecurrenciesovervaluedorundervalued? ThefollowingchartcomparesthePPPofacurrencywithitsactualexchangerate.Thechartis updatedperiodicallytoreflectthecurrentexchangerate.Itisalsoupdatedabouttwiceayear to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the Organization of Economic Cooperation and Development (OECD) and others; however, they shouldnotbetakenas"definitive".DifferentmethodsofcalculationwillarriveatdifferentPPP rates. ThecurrencieslistedbelowarecomparedtotheUSDollar.Agreenbarindicatedthatthelocal currency is overvalued by the percentage figure shown on the axis; the currency is thus expectedtodepreciateagainsttheUSDollarinthelongrun.Aredbarindicatesundervaluation of the local currency; the currency is thus expected to appreciate against the US Dollar in the longrun.
Theory of Interest Rate Parity (IRP)

The Interest Rate Parity Theorem examines the impact of nominal interest rate differentials between two countries on the forward rate of the foreign currency. The approximate IRP equation is: ih - if = p where, ih = Home Interest Rate if = Foreign Interest Rate p = Forward Premium or discount of the foreign currency Recall that p is computed as: (Fj - Sj)/Sj x 100 If the (Home Interest Rate - Foreign Interest Rate) interest differential exactly equals the forward premium or discount, then there is Interest Rate Parity. At that point, the interest advantage is offset by the forward discount. In scenario #4 above, US investors earn 2% return regardless of where they choose to invest. Note that IRP does not imply that all country investors earn the same return at the point of IRP. In scenarios 1 through 3, US investors have an advantage in investing in Germany by CIA. The concept of IRP is further explained in Figure # 3
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Note: This Figure is reproduced by permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright 2000 by West Publishing Company. All Rights Reserved.
On the horizontal axis, the Forward premium or discount is given. On the vertical axis, (Home Interest Rate - Foreign Interest Rate) interest rate difference is plotted. Point #1 corresponds to scenario # 1 from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table. As we already know, US investors make 4% on interest income and 5% by exchange gain as the forward rate shows a premium of 5%. Likewise, in point #2 corresponding to scenario #2, US investors make 2 % more than what is available in the US, solely on the interest rate front. Points #1 and #2 lie to the right of the IRP line and therefore we can generalize and conclude that at the points to the right of IRP line, it will be advantageous for US investors to invest overseas. Similarly, at the points to the left of the IRP line, it will be advantageous for the foreign investors to invest in the US. At all points on the IRP line, there is interest rate parity. This means that a given country investor will get the same rate of return regardless of which country he chooses to invest in. The exact version of IRP equation is given by: (1+ih)/(1+if) - 1 = p Where, ih = Home Interest Rate
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if = Foreign Interest Rate p = Forward Premium or discount of the foreign currency
The only difference here is that the interaction term (p*if) adds an extra component to the interest rate difference between home and foreign country. Recall that in our State 1 example from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table, we had a 0.20 % difference on return to CIA in the approximate method in scenario #4. Given the German interest rate of 0.04 and premium of 0.05, (p*if) works out to 0.20 %, the difference we observed earlier. IRP holds true in the real world especially in the Eurocurrency markets. Arbitrage transactions ensure that interest differentials in different segments of the Eurocurrency markets are off-set by corresponding forward premiums or discounts. IRP impacts on instruments of similar maturity and risk. However, if capital controls and such are imposed, IRP may not hold true in the real world.
International Fisher Effect (IFE)

IFE predicts the same magnitude and direction in the spot rate of a currency as PPP does, but IFE looks at the nominal interest rate rather than inflation rate. IFE argues that a currency's value will adjust to reflect the difference in nominal interest rates between countries. The rationale behind IFE is that if a currency exhibits a high nominal interest rate, it may anticipate high inflation. Thus the inflation will put pressure on the currency's value causing a depreciation. Note: Nominal Interest Rate = Real Interest rate + Inflation Premium (approximate version) The approximate version of IFE equation is given by if - ih = Ef Where, if = Nominal interest rate in the foreign country, ih = Nominal interest rate in the home country, Ef = % Change in the Spot Rate of the Foreign Currency. According to both theories, the foreign currency should appreciate by 2%. While IFE looks at the nominal interest rate (total picture), PPP looks at the inflation rate. Both provide the same result; it is the same wine in different bottles! This means that if an American investor invests in the US, he or she will get 8% in nominal return. And if the investor invests abroad, he or she will get 6% return from interest income and an additional 2% return from the appreciation of the foreign currency. Summary:
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In this Module, we studied the concept of arbitrage and the types of arbitrage: 1) Locational, 2) Triangular and, 3) Covered Interest. Arbitrage helps to bring about the re-alignment of the exchange rates. We also discussed the theories of Interest Rate Parity, Purchasing Power Parity, and International Fisher Effect.
SECTION4:INTERNATIONALFINANCIALMARKET INTERNATIONALFINANCIALMARKET
DistinguishbetweenEurocredit&Eurobondmarket.
Costof borrowing Maturity Eurobond Eurobondsareissuedinbothfixedrateand floatingrate. Longermaturityperiod Eurocredit Eurocurrencyloanarevariable
Comparativelyshortermaturity period Borrowerscanraisefundsintheeuro currencymarketveryquickly.
Speed
Aeurobondfinancinggenerallytakesmore time,althoughherethedifferenceis becominglesssignificant Nowhoweverthevolumeofeurobond offeringismore
Sizeofthe issue
Historically,moreamountofloan ablefundswereavailable
Eurocreditmarket
EurocreditmarketconsistsmainlyofEurocurrencydepositandEurocurrencyloan.Eurocurrency deposit is a deposit in relevant currency with a bank outside the home country. Thus, a U.S. dollar CompiledbyMANAGEMENTPARADISETEAM. Page57
depositwithabankinLondonisaeurodollardeposit;adeutschemarkdepositwithabankinParisisa euro mark deposit. Note that what matters is the location of the bank neither the ownership of the banknortheownershipofthedeposit.ThusadollardepositbelongingtoanAmericancompanyheldin ParissubsidiaryofanAmericanbankstillisaeurodollardeposit.Similarlyaeurodollarloanisadollar loan made by a bank outside the U.S. to a customer or another bank. If loan would have been in deutschemarkitwouldbetermedaseuromarkloan.
Eurobondmarket
Eurobondslargelyconsistoffixedrate,floatingrate,andequityrelateddebt.TheprefixEuroindicates that the bonds are sold outside the countries in whose currencies they are denominated e.g. bond denominatedinU.S.dollarstradedin London.The marketdealingwith theseeurobondsformtheso calledEurobondmarket.Eurobondmarketisalmostentirelyfreeofofficialregulation,butinsteadare selfregulatedbytheAssociationofInternationalbonddealers. DistinctionbetweenEuroCreditandEuroBondMarket BothEurobondsandEurocredit(Eurocurrency)financinghavetheiradvantagesanddisadvantages.For agivencompany,underspecificcircumstances,onemethodoffinancingmaybepreferredtotheother. Themajordifferencesare: Costofborrowing Eurobondsareissuedinbothfixedrateandfloatingrateforms.Fixedratebondsareanattractive exposuremanagementtoolsincetheknownlongtermcurrencyinflowscanbeoffsetbytheknown longtermoutflowsinthesamecurrency.Incontrast,Eurocurrencyloanscarryvariablerates. Maturity EurobondshavelongermaturitieswhiletheperiodofborrowingintheEurocurrencymarkethas tendedtolengthenovertime. Sizeoftheissue Earlier,thefundsavailableforlendingatanytimehavebeenmuchmoreintheinterbankmarketthan in the bond market. But of late, this situation does not hold true. Moreover, although in the past the flotationcostsofaEurocurrencyloanhavebeenmuchlowerthanaEurobond(about0.5%ofthetotal loanamountversusabout2.25%ofthefacevalueofaEurobondissue),compensationhasworkedto lowerEurobondflotationcosts. Flexibility
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InaEurobondissue,thefundsmustbedrawninonesumonafixeddateandrepaidaccordingtoa fixedschedule,unlesstheborrowerpaysasubstantialprepaymentpenalty.Bycontrast,thedrawdown inafloatingrateloancanbestaggeredtosuittheborrowersneedsandcanberepaidinwholeorin partatanytime,oftenwithoutpenalty.Moreover,aEurocurrencyloanwithamulticurrencyclause enablestheborrowertoswitchcurrenciesonanyrolloverdate,whereasswitchingthedenominationof aEurobondfromcurrencyAtocurrencyBwouldrequireacostly,combined,refundingandreissuing operation. Speed FundscanberaisedbyaknownborrowerveryquicklyintheEurocurrencymarket.Often,aperiodof twotothreeweeksshouldsuffice.AEurobondfinancinggenerallytakesmoretime,thoughthe differenceisbecominglesssignificant. EuroCreditMarket EurocreditorEuroLoansaretheloansextendedforoneyearorlonger.Themarketthatdeals insuchloansiscalledEuroCreditMarket. The common maturity for euro credit loans is 5 years. Since Euro banks accept shortterm depositsandprovidelongtermloans,itislikelythatassetliabilitymismatchmayarise.Toavoid thisEurobanksoftenextendfloatingrateeurocreditloansfixedtosomemarketinterestrate. TheLondonInterBankOfferRate(LIBOR)isthemostcommonlyusedinterestrate.Itistherate chargedforloansbetweenEuroBanks.
ParticipantsinEurocreditMarket ThemajorlendingbanksintheEurocreditmarketareEurobanks,American,Japanese,British, Swiss,French,GermanandAsian(speciallythatofSingapore)banks,ChemicalBank,JPMorgan, Citicorp,BankersTrust,ChaseManhattanBank,FirstNationalBankofChicago,Barclay'sBank, NationalWestminster,BNP,etc.Amongtheborrowers,therearebanks,multinationalgroups, publicutilities,governmentagencies,localauthorities,etc.
DealinginEurocredits
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WhenaborrowerapproachesabankforEurocredit,aformaldocumentispreparedonbehalf of potential borrowers. This document contains the principal terms and conditions of loan, objectivesofloananddetailsoftheborrower. Before launching syndication, the approached bank decides primarily, in consultation with the borrower,onastrategytobeadopted,i.e.whethertoapproachalargemarketorarestricted numberofbankstoformthesyndicate.Eachofthebanksinsyndicatelendsapartoftheloan. Thedurationofthisoperationisnormallyabout6to8weeks.
SeveralclausesmaybeintroducedinthecontractofEurodebt: Paripassuclausethatpreventstheborrowerfromcontractingnewdebtsthatsubordinatethe interestoflenders; Exchangeoptionclausethatallowsthewithdrawalofapartortotalityofloaninanothercurrency; Negativeguaranteeclausethatcommitstheborrowernottocontractotherdebtsthatsubordinate theinterestoflenders. CharacteristicsofEurocredit Most of the syndicated debts are of the order of $50 million. As far as the upper limits are concerned, amounts involved are of as high magnitude as $5 billion and more. In 1990, Euro tunnelborrowed$6.8billion. Onanaverage,maturityperiodsareofaboutfiveyears(insomecasesitisabout20years).The reimbursementoftheloanmaytakeplaceinonego(bullet)orinseveralinstallments. TheinterestrateonEurodebtiscalculatedwithrespecttoarateofreference,increasedbya margin(orspread).Theratesareavailableandgenerallyrenewable(rollovercredit)everysix months, fixed with reference to LIBOR. The LIBOR is the rate of money market applicable to shorttermcreditsamongthebanksofLondon.ThereferenceratecanequallybePIBORatParis andFIBORatFrankfurt,etc.Itisrevisedregularly. Themargindependsonthesupplyanddemandofthecapitalasalsoonthedegreeoftheriskof these credits and the rating of borrowers. Financial institutions are in vigorous competition. There is an active secondary market of Euro debts. Numerous techniques allow banks to sell theirtitlesinthismarket. Page60 A major part (more than 80 %) of the Euro debts is made in US dollars. The second (but far behind)isPoundSterlingfollowedbyDeutschmark,Japaneseyen,Swissfrancandothers.
EuroBondMarket
Euro Bond issue is one denominated in a particular currency but sold to investors in national capitalmarketsotherthanthecountrythatissuedthedenominatingcurrency.Anexampleis aDutchborrowerissuingDMdenominatedbondstoinvestorsintheUK,Switzerlandandthe Netherlands. TheEurobondmarketisthelargestinternationalbondmarket,whichissaidtohaveoriginated in1963withanissueofEurodollarbondsbyAutostrade,anItalianborrower.Themarkethas sincegrownenormouslyinsizeandwasworthabout$428billionin1994. EurobondmarketsinallcurrenciesexcepttheJapaneseYenarequitefreefromanyregulation by the respective governments. Straight bonds are priced with reference to a benchmark, typically treasury issues. Thus a Eurodollar bond will be priced to a yield a YTM (Yieldto Maturity)somewhatabovetheUStreasurybondsofsimilarmaturity,thespreaddepending upontheborrowersratingsandmarketconditions. FloatationcostsoftheEurobondarecomparativelyhigherthancostsindicatedwithsyndicated Eurocredits. 4.EuroCPs Commercialpaperisacorporateshortterm,unsecuredpromissorynoteissuedonadiscount to yield basis. Commercial paper maturities generally do not exceed 270 days. Commercial paper represents a cheap and flexible source of funds While CPs are negotiable, secondary marketstendtobenotveryactivesincemostinvestorsholdthepapertomaturity. TheemergenceoftheEuroCommercialPaper(ECP)ismuchmorerecent.Itevolvedasanatural culmination of the Note Issuance Facility and developed rapidly in an environment of securitisation and disintermediation of traditional banking. CP has also developed in the domestic segments of some European countries offering attractive funding opportunities to residententities.
5.EuroCDs ACertificateofDeposit(CD)isanegotiableinstrumentevidencingadepositwithabank.ACDis a marketable instrument so that the investor can dispose it off in the secondary market whenever cash is needed. The final holder is paid the face value on maturity along with the interest.Itisusedbythecommercialbanksasshorttermfundinginstruments. EuroCDsaremainlyissuedinLondonbybanks.InterestonCDswithmaturitymorethanayear ispaidannuallythansemiannually.
InternationalCapitalMarkets CompiledbyMANAGEMENTPARADISETEAM. Page61
International Capital Markets have come into existence to cater to the need of international financingbyeconomiesintheformofshort,mediumorlongtermsecuritiesorcredits.These marketsalsocalledEuromarkets,arethemarketsonwhichEurocurrencies,Eurobonds,Euro shares and Euro bills are traded/exchanged. Over the years, there has been a phenomenal growth both in volume and types of financial instruments transacted in these markets. Euro currencydepositsarethedepositsmadeinabank,situatedoutsidetheterritoryoftheoriginof currency.Forexample,EurodollarisadepositmadeinUSdollarsinabanklocatedoutsidethe USA;likewise,EurobanksarethebanksinwhichEurocurrenciesaredeposited.Theyhaveterm deposits in Euro currencies and offer credits in a currency other than that of the country in whichtheyarelocated. A distinctive feature of the financial strategy of multinational companies is the wide range of externalservicesoffundsthattheyuseonanongoingbasis.BritishTelecommunicationoffers stockinLondon,NewYorkandTokyo,whileSwissBankCorporation,aidedbyItalian,Belgian, CanadianandGermanbankshelpscorporationssellSwissfrancbondsinEuropeandthenswap theproceedsbackintoUSdollars. Firmshavethreegeneralsourcesoffundsavailable:(i)internallygeneratedcash,(ii)shortterm externalfunds,and(iii)longtermexternalfunds.Externalinvestmentcomesintheformofdebt orequity,whicharegenerallynegotiable(tradable)instruments.Thepatternoffinancingvaries from country to country. Companies in the UK get an average of 6070% of their funds from internalsources.Germancompaniesgetabout4050%oftheirfundsfromexternalsuppliers.In 1975, Japanese companies got more than 70% of their money from outside sources, but this patternhassincereversed;majorchunksoffinancescomefrominternalsources. Another significant aspect of financing behaviour is that debt accounts for the overwhelming shareofexternalfinance.Industrysourcesofexternalfinancealsodifferwidelyfromcountryto country.GermanandJapanesecompanieshavereliedheavilyonbankborrowing,whiletheUS and British industry raised much more money directly from financial markets by the sale of securities.However,inallcountries,bankborrowingisonadecline.Thereisagrowingtendency for corporate borrowing to take the form of negotiable securities issued in the public capital marketsratherthanintheformofcommercialbankloans.Thisprocessknownassecuritisation ismostpronouncedamongtheJapanesecompanies.
7.PetroDollar Duringtheoilcrisesof1973,theCapitalmarketshaveplayedaveryimportantrole.Theyacceptedthe dollardepositsfromoilexportersandchanneledthefundstotheborrowersinothercountries.Thisis calledrecyclingthepetrodollars. 8.JunkBonds CompiledbyMANAGEMENTPARADISETEAM. Page62
Ajunkbondisissuedbyacorporationormunicipalitywithabadcreditrating.Inexchangefor theriskoflendingmoneytoabondissuerwithbadcredit,theissuerpaystheinvestorahigher interestrate."Highyield bond"isanicernameforjunk bond Thecreditratingofahigh yield bond is considered "speculative" grade or below "investment grade". This means that the chanceofdefaultwithhighyieldbondsishigherthanforotherbonds.Theirhighercreditrisk means that "junk" bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios,suggestingthatthehigheryieldsmorethancompensatefortheiradditionaldefault risk. Junkbondsbecameacommonmeansforraisingbusinesscapitalinthe1980s,whentheywere usedtohelpfinancethepurchaseofcompanies,especiallybyleveragedbuyouts,thesaleof junkbondscontinuedtobeusedinthe1990stogeneratecapital
9.SamuraiBonds Theyarepubliclyissuedyendenominatedbonds.TheyareissuedbynonJapaneseentities. The Japanese Ministry of Finance lays down the eligibility guidelines for potential foreign borrowers. These specify the minimum rating, size of issue, maturity and so forth. Floatation coststendtobehigh.PricingisdonewithrespecttoLongtermPrimeRate.
ShibosaiBonds They are private placement bonds with distribution limited to banks and institutions. The eligibilitycriteriaarelessstringentbuttheMOFstillmaintainscontrol.
Shogun/GeishaBonds TheyarepubliclyfloatedbondsinaforeigncurrencywhileGeishaaretheirprivatecounterparts.
10.YankeeBonds These are dollar denominated bonds issued by foreign borrowers. It is the largest and most active market in the world but potential borrowers must meet very stringent disclosure, dual rating and other listing requirements, options like call and put can be incorporated and there arenorestrictionsonsizeoftheissue,maturityandsoforth.
Yankeebondscanbeofferedunderrule144aofSec.Theseissuesareexemptfromelaborate registrationanddisclosurerequirementsbutrating,whilenotmandatoryishelpful.Finallylow Page63
ratedorunratedborrowerscanmakeprivateplacements.Higheryieldshavetobeofferedand thesecondarymarketisverylimited. TracethedevelopmentoftheInternationalCapitalMarkets The financial revolution has been characterized by both a tremendous quantitative expansion andanextraordinaryqualitativetransformationintheinstitutions,instrumentsandregulatory structures. Global financial markets are a relatively recent phenomenon. Prior to 1980, national markets werelargely independent ofeachotherandfinancialintermediariesineach countryoperated principally in that country. The foreign exchange market and the Eurocurrency and Eurobond marketsbasedinLondonweretheonlymarketsthatweretrulyglobalintheiroperations. Financialmarketseverywhereservetofacilitatetransferofresourcesfromsurplusunits(savers) todeficitunits(borrowers),theformerattemptingtomaximizethereturnontheirsavingswhile thelatterlookingtominimizetheirborrowingcosts.Anefficientfinancialmarketthusachieves anoptimalallocationofsurplusfundsbetweenalternativeuses.Healthyfinancialmarketsalso offerthesaversarangeofinstrumentsenablingthemtodiversifytheirportfolios. Globalizationoffinancialmarketsduringtheeightieshasbeendrivenbytwounderlyingforces. Growing(andcontinuallyshifting)imbalancebetweensavingsandinvestmentwithinindividual countries, reflected in their current account balances, has necessitated massive crossborder financial flows. For instance, during the late seventies, the massive surpluses of the OPEC countrieshadtoberecycled,i.e.fedbackintotheeconomiesofoilimportingnations.During theeighties,thelargecurrentaccountdeficitsoftheUShadtobefinancedprimarilyfromthe mountingsurplusesinJapanandGermany.Duringthenineties,developingcountriesasagroup have experienced huge current account deficits and have also had to resort to international financial markets to bridge the gap between incomes and expenditures, as the volume of concessional aid from official bilateral and multilateral sources has fallen far short of their perceivedneeds. The other motive force is the increasing preference on the part of investors for international diversification of their asset portfolios. This would result in gross crossborder financial flows. Investigatorshaveestablishedthatsignificantriskreductionispossibleviaglobaldiversification ofportfolios. These demandside forces accompanied by liberalization and geographical integration of financialmarketshasledtoenormousgrowthincrossborderfinancialtransactions.Invirtually allmajorindustrialeconomies,significantderegulationofthefinancialmarketshasalreadybeen effected or is under way. Functional and geographic restrictions on financial institutions, restrictions on the kind of securities they can issue and hold in their portfolios, interest rate ceilings,barrierstoforeignentitiesaccessingnationalmarketsasborrowersandlendersandto Page64
foreign financial intermediaries offering various types of financial services have been already dismantledorarebeinggraduallyeasedaway.Finally,themarketsthemselveshaveprovedto be highly innovative, responding rapidly to changing investor preferences and increasingly complex needs of the borrowers by designing new instruments and highly flexible risk managementproducts. The result of these processes has been the emergence of a vast, seamless global financial market transcending national boundaries. But control and government intervention have not entirely disappeared. E.g. South East Asia Korea, Taiwan, etc permit only limited access to foreign investors. However, despite these reservations, the dominant trend is towards globalizationoffinancialmarkets. International financial markets can develop anywhere, provided that local regulations permit the market and potential users are attracted to it. The most important international financial centers are London, Tokyo and New York. All the major industrial countries have important domestic financial markets as well but only some such as Germany and France are also importantinternationalfinancialcenters.Ontheotherhand,eventhoughsomecountrieshave relatively unimportant domestic financial markets, they are important world financial centers suchasSwitzerland,Luxembourg,SingaporeandHongKong. International Capital Markets, also called Euro markets, are the markets on which Euro currencies;Eurobonds,EuroequityandEurobillsareexchanged.Internationalfinancinginthe form of short, medium or longterm securities or credits has become necessary for the internationaleconomy.Financingtechniqueshavediversified,volumesdealthaveincreasedand theprocessiscontinuingtogrow. Notabledevelopmentsininternationalcapitalmarketscanbetracedtotheendof1950s.There areseveralreasonsfortheirgrowth.Thesignificantonesare:
TransferofassetsoferstwhileSovietUniontoEurope.Inthe1950sandearly1960s,theformerSoviet Union and Sovietbloc countries sold gold and commodities to raise hard currency. Because of anti Sovietsentiment,theseCommunistcountrieswereafraidofdepositingtheirUSdollarsinUSbanksfor fear that the deposits could be frozen or taken. Instead they deposited their dollars in a French Bank whose telex address was EuroBank. Since that time, dollar deposits outside the US have been called Eurodollars and banks accepting Eurocurrency deposits have been called Euro banks. International capitalmarketssubsequentlycametobeknownasEuromarkets. Restrictivemeasurestakenbytheadministration.Severalregulatorymeasures(initiatedparticularlyin theUSA)alsocontributed(inanindirectmanner)tothedevelopmentofInternationalcapitalmarkets. Theimportantonesareasfollows: Regulation'Q'.In1960,Regulation'Q'intheUSAfixedaceilingoninterestratesofferedbyAmerican banksontermdepositsandprohibitedthemtoremuneratethedepositswhosetermwaslessthan30 CompiledbyMANAGEMENTPARADISETEAM. Page65
days.Besides,attheendofthe1960s,theFederalReservereducedthegrowthoftotalmonetarymass. Themoneymarketratewentup.AmericanbanksborrowedontheEurodollarmarket,whichresulted in: TheincreaseofindebtednessofthesebanksontheEurodollarmarket; TheflightofAmericanCapital,attractedbytheinterestrateonEuromarket. Tax of interest equalization. In 1963, tax was imposed on the purchase of foreign securities (portfolio investments)byAmericanresidents.TheobjectivewastoreducethedeficitofBOPoftheUSAandto establishequilibriumininternationalstructureofinterestrates.Infact,inordertoavoidtaxpayment, somecompanieslaunchedtheissueofdollarbondsoutsidetheUSA.Thiscontributedtothegrowthof Eurodollarmarket.Realizingitsadverseeffects,subsequently,thetaxwaswithdrawnin1974. Programofvoluntaryrestrictionsoninvestments.TheUSAinitiated/imposedvariousrestrictionsonits financial system to tackle BOP problems. For instance, banks were directed not to lend or invest in foreignoperationsbeyondthelimitsofthepreviousyear(s).Asaresult,thebusinesscommunityfelta scarcityoffunds.ThisinturnledthemtotakerecoursetotheEurodollarmarket. Differential of American lending and borrowing rates. The interest rate paid by American banks was low, visvis, the expected rate from borrowers. European banks availed of this opportunity; they offered higher rates of interest at the cost of contenting themselves with smaller margins than those offeredbyAmericanbanks,toattractinvestors.TheycoulddosobyoperatingonEurodollarmarkets, which were not subject to interestrate and other regulations. For instance, banks were neither constrained to respect a certain compulsory reserve ratio on their deposits in Euro dollars nor constrainedtomaintaintheirinterestratesbelowacertainceiling. TheremaybeotherreasonsaswellfordevelopmentofEurodollars.Globalizationofbigmultinationals has further boosted this development. The financing system practiced hitherto also was not able to respondtocapitalneedsoftheinternationaleconomy. Indianentitiesbeganaccessingexternalcapitalmarketstowardstheendoftheseventiesasgradually the amount of concessional assistance became inadequate to meet the increasing needs of the economy. The initial forays were lowkey. The pace accelerated around mideighties, but even the authorities adopted a selective approach and permitted only a few select banks, all India financial institutions and large public and private sector companies to access the market. After liberalization, during199394therewasasharpincreaseintheamountoffundsraisedbycorporateentitiesformthe globaldebtandequitymarkets. Indias borrowings have mainly been by way of syndicated bank loans, buyers credits and lines of credits.OtherinstrumentssuchasforeignandEurobondshavebeenemployedlessfrequentlythougha numberofcompaniesmadeissuesofEuroconvertiblebondsafter1993.Priortothatonlyapexfinancial CompiledbyMANAGEMENTPARADISETEAM. Page66
institutionsandthepublicsectorgiantONGChadtappedtheGerman,Swiss,Japanese,andEurodollar bondmarkets.Throughouttheeighties,therewasasteadyimprovementinthemarketsperceptionof thecreditworthinessofIndianborrowers(manifestedinthesteadydeclineinthespreadstheyhadto pay over LIBOR in the case of Euro loans). The 199091 crisis sent Indias sovereign rating below investmentgradeandtheforeigndebtmarketsvirtuallydrieduptobeopenedupagainafter1993. DescribethemechanismoftheEuroBondMarket. Euro Bond: issue is one denominated in a particular currency but sold to investors in national capitalmarketsotherthanthecountrythatissuedthedenominatingcurrency.Anexampleisa Dutch borrower issuing DMdenominated bonds to investors in the UK, Switzerland and the Netherlands. TheEurobondmarketisthelargestinternationalbondmarket,whichissaidtohaveoriginated in 1963 with an issue of Eurodollar bonds by Autostrade, an Italian borrower. The market has sincegrownenormouslyinsizeandwasworthabout$428billionin1994. EurobondmarketsinallcurrenciesexcepttheJapaneseYenarequitefreefromanyregulation bytherespectivegovernments. Straight bonds are priced with reference to a benchmark, typically treasury issues. Thus a Eurodollar bond will be priced to a yield a YTM (YieldtoMaturity) somewhat above the US treasury bonds of similar maturity, the spread depending upon the borrowers ratings and marketconditions. FloatationcostsoftheEurobondarecomparativelyhigherthancostsindicatedwithsyndicated Eurocredits. Primarymarket:AborrowerdesiringtoraisefundsbyissuingEurobondstotheinvestingpublic will contact an investment banker and ask it to serve as lead manager of an underwriting syndicate that will bring the bonds to market. The underwriting syndicate is a group of investmentbanks,merchantbanks,andthemerchantbankingarmsofcommercialbanksthat specializeinsomephaseofpublicissuance.Theleadmanagerwillusuallyinvitecomanagersto formamanaginggrouptohelpnegotiatetermswiththeborrower,ascertainmarketconditions andmanagetheissuance. The managing group along with other banks, will serve as underwriters for the issue, that is, theywillcommittheirowncapitaltobuy theissuefromtheborroweratadiscountfromthe issue price, if they are unable to place the bonds with investors. The discount or the Page67
underwriting spread is typically in the 2 or 2.5% range. Most of the underwriters along with otherbankswillbeapartoftheplacementorsellinggroupthatsellsthebondstotheinvesting public. The total elapsed time from the decision date of the borrower to issue Eurobonds until net proceedsfromthesalearereceivedistypically5to6weeks. The lead manager prepares a preliminary prospectus focusing on economic and financial characteristicsoftheprojectandfinancialstandingoftheborrower. After having consulted a certain number of banks, the lead manager decides on the interest rate. Subsequently, the issue price is fixed. Clauses of reimbursement before maturity are providedfor.After,theissueadvertisingisdoneinInternationalPressintheformoftombstone. Thistombstoneindicates thelead manager,coleadmanagersandmembers ofthe guarantee syndicate. Secondary Market: Eurobonds purchased in the primary market can be resold before their maturitiesinthesecondarymarket.Thesecondarymarketisanoverthecountermarketwith principal trading in London. However, important trading is also done in other major European cities. The bonds are quoted in percentage of their value, without taking into account the couponalreadyrunning. Thesecondarymarketcomprisesofmarketmakersandbrokers.Marketmakersstandreadyto buyorsellfortheirownaccountbyquotingatwowaybidandaskprices.Markettraderstrade directlywithoneanother,throughabroker,orwithretailcustomers.Thebidaskistheironly profit. Brokers accept buy or sell orders from market makers and then attempt to find a matching party for the other side of the trade; they may also trade for their own account. Brokerschargeasmallcommissiontothemarketmakersthatengagedthem.Theydonotdeal directlywithretailclients.
Whatisabond? Abondisaloanandyouarethelender.Theborrowerisusuallythegovernment,astate,alocal municipalityorabigcompanylikeGeneralMotors.Alloftheseentitiesneedmoneytooperate to fund the federal deficit, for instance, or to build roads and finance factories so they borrowcapitalfromthepublicbyissuingbonds. Whenabondisissued,thepriceyoupayisknownasits"facevalue."Onceyoubuyit,theissuer promisestopayyoubackonaparticulardaythe"maturitydate"atapredeterminedrateof interest the "coupon." Say, for instance, you buy a bond with a $1,000 face value, a 5% coupon and a 10year maturity. You would collect interest payments totaling $50 in each of those10years.Whenthedecadewasup,you'dgetbackyour$1,000andwalkaway.
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Akeydifferencebetweenstocksandbondsisthatstocksmakenopromisesaboutdividendsor returns.GeneralElectric'sdividendmaybeasregularasaheartbeat,butthecompanyisunder noobligationtopayit.AndwhileGEstockspendsmostofitstimemovingupward,ithasbeen knowntospendmonthsevenyearsgoingtheotherway. WhenGEissuesabond,however,thecompanyguaranteestopaybackyourprincipal(theface value) plus interest. If you buy the bond and hold it to maturity, you know exactly how much you're going to get back (in most cases, anyway). That's why bonds are also known as "fixed income" investments they assure you a steady payout or yearly income. And although they can carry plenty of risk, this regular income is what makes them inherently less volatile than stocks. Global Bond: They have a minimum value of $1 billion and are effected simultaneously in Europe,AmericaandAsia.Thesalientfeaturesofthesebondsarethattheypermittoraisevery highamounts.Theyofferveryhighliquiditysincetheyarequotedonseveralexchangeswhile secondary market functions round the clock, with uniform price all over the world. They are especially used by governments, public enterprises, international organisations and private financialinstitutions. External Bond Market: The external bond market refers to bond trading activity wherein the bonds are underwritten by an international syndicate, are offered in several countries simultaneously, are issued outside any country's jurisdiction, and are not registered. The Eurobondmarketisamajorexternalbondmarket.Theexternalbondmarketcombinedwiththe internalbondmarketcomprisestheglobalbondmarket.Examplesofanexternalbondarethe "globalbond,"issuedbytheWorldBank,andEurodollarbonds. Internal Bond Market: The internal bond market refers to all bond trading activity in a given country and is comprised of both a domestic bond market and a foreign bond market. Also referredtoasthe"nationalbondmarket."Theinternalandexternalbondmarketscomprisethe globalbondmarket BulldogBonds:Asterlingdenominatedforeignbond,pricedwithreferencetotheUKgilts. RembrandtBond:DenominatedintheDutchguilder.
3.Whatarethedifferentinternationalfinancialmarkets? The international financial markets consist of the credit market, money market, bond market andequitymarket. The international credit market, also called Euro credit market, is the market that deals in mediumtermEurocreditorEuroloans.
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InternationalbanksandtheirclientscomprisetheEurocurrencymarketandformthecoreofthe international money market. There are several other money market instruments such as the EuroCommercialPaper(ECP)andtheEuroCertificateofDeposit(ECD). ForeignbondsandEurobondscomprisetheinternationalbondmarket.Thereareseveraltypes ofbondssuchasfloatingratebonds,zerocouponbonds,deepdiscountbonds,etc. Theinternationalequitymarkettellsushowownershipinpubliclyownedcorporationsistraded throughout the world. This comprises both, the primary sale of new common stock by corporations to initial investors and how previously issued common stock is traded between investorsinthesecondarymarkets.
InternationalFinancialMarket(generalcanbeusedinany) Thelasttwodecadeshavewitnessedtheemergenceofavastfinancialmarketacrossnational boundariesenablingmassivecrossbordercapitalflowsfromthosewhohavesurplusfundsand asearchofhighreturnstothoseseekinglowcostfunding.Thedegreeofmobilityofcapital,the globaldispersalofthefinanceindustryandtheenormousdiversityofmarketsandinstruments, whichafirmseekingfundscantap,issomethingnew. Major OECD (Organization for Economic Cooperation and Development) countries had began deregulating and liberalizing their financial markets towards the end of seventies. While the process was far from smooth, the overall trend was in the direction of relaxation of controls, which till then had compartmentalized the global financial markets. Exchange and capital controls were gradually removed, nonresidents were allowed freer access to national capital marketsandforeignbanksandfinancialinstitutionswerepermittedtoestablishtheirpresence inthevariousnationalmarkets.
While opening up of the domestic markets began only around the end of seventies, a truly international financial market had already been born in the midfifties and gradually grown in size and scope during sixties and seventies. This refers to the Euro currencies Market where borrower (investor) from country A could raise (place) funds from (with) financial institutions locatedincountryB,denominatedinthecurrencyofcountryC.Duringtheeightiesandnineties, thismarketgrewfurtherinsize,geographicalscopeanddiversityoffundinginstruments.Itisno morea"euro"marketbutapartofthegeneralcategorycalledoffshoremarkets. Alongsideliberalization,otherqualitativechangeshavebeentakingplaceintheglobalfinancial markets. Removal of restrictions has resulted into geographical integration of the major financial markets in the OECD countries. Gradually this trend is spreading to developing countries many of which have opened up their marketsat least partiallyto nonresident investors,borrowersandfinancialinstitutions. Page70
Anothernoticeabletrendisfunctionalintegration.Thetraditionaldistinctionsbetweendifferent financial institutionscommercial banks, investment banks, finance companies, etc. are giving waytodiversifiedentitiesthatofferthefullrangeoffinancialservices.Theearlypartofeighties saw the process of disintermediation get underway. Highly rated issuers began approaching investorsdirectlyratherthangoingthroughthebankloanroute. Ontheotherside,debtcrisisinthedevelopingcountries,adoptionofcapitaladequacynorms and intense competition, forced commercial banks to realize that their traditional business of acceptingdepositsandmakingloanswasnotenoughtoguaranteetheirlongtermsurvivaland growth. They began looking for new products and markets. Concurrently, the international financial environment was becoming more volatile there were fluctuations in interest and exchange rates. These forces gave rise to innovative forms of funding instruments and tremendous advances in risk management. The decade saw increasing activity in and sophisticationofthederivativesmarket,whichhadbegunemergingintheseventies. Taken together, these developments have given rise to a globally integrated financial marketplaceinwhichentitiesinneedofshortorlongtermfundinghaveamuchwiderchoice than before in terms of market segment, maturity, currency of denomination, interest rate basis,incorporatingspecialfeaturesandsoforth.Thesameflexibilityisavailabletoinvestorsto structure their portfolios in line with their riskreturn tradeoffs and expectations regarding interestrates,exchangerates,stockmarketsandcommodityprices.
EmergenceofEuromarkets: During the 1950s, the erstwhile USSR was earning dollars from the sale of gold and other commoditiesandwantedtousethemtobuygrainandotherproductsfromtheWest,mainly fromtheUS.However,theydidnotwanttokeepthesedollarsondepositwithbanksin New York,astheywereapprehensivethattheUSgovernmentmightfreezethedepositsifthecold war intensified. They approached banks in Britain and France who accepted these dollar depositsandinvestedthempartlyinUS. Domestic banks in US (as in many other countries) were subjected to reserve requirements, whichmeantthatapartoftheirdepositswerelockedupinrelativelylowyieldingassets. Theimportanceofthedollarasavehiclecurrencyininternationaltradeandfinanceincreased, somanyEuropeancorporationshadcashflowsindollarsandhencetemporarydollarsurpluses. DuetodistanceandtimezoneproblemsaswellastheirgreaterfamiliaritywithEuropeanbanks, thesecompaniespreferredtokeeptheirsurplusdollarsinEuropeanbanks,achoicemademore attractivebythehigherratesofferedbyEurobanks. ThemainfactorsbehindtheemergenceandstronggrowthoftheEurodollarmarketswerethe regulations on borrowers and lenders imposed by the US authorities which motivated both banks and borrowers to evolve Eurodollar deposits and loans. Added to this are the Page71
considerationsmentionedabove,viz.theabilityofEurobankstoofferbetterratesbothtothe depositors and the borrowers and convenience of dealing with a bank that is closer to home, whoisfamiliarwithbusinesscultureandpracticesinEurope. 1.ParticipantsinInternationalProjectFinancinga)Sponsorsb)Lenders Sponsors Thesearepartnersintheprojectwhobringintheequitycapitalorriskcapital.Beingso,they arekeenlyinterestedinthesuccessfulcompletionoftheprojectandshouldermajor responsibilitiesasregardsitsexecution.Thefactthattheybringintheequitycapitalisan indicationoftheirinterest.Alsotheamountofequitythattheybringhasamarkedbearingon theextentofdebtthatcanberaisedfortheproject. Sometimespeoplewhobringintheequitycapitalarejusttheinitiatorsoftheproject.Included inthiscategoryaremultinationalfirms,futurebuyersofproductsorservicesoftheproject,the publicorprivateinvestors,internationalorganisations,developmentbanksetc. Lenders Theybringinthedebtcapital.Financingofabigprojectnecessitatesinterventionofabanking poolconsortiumcomposedofbanks,nationalorinternationalfinancialinstitutions,export financinginstitutionsetc. Guarantors Guaranteesmaybeprovidedbybanks,publicfinancingorganisations,internationalfinancial institutions,privateinsurancecompaniesetc. ProjectOperators Risksassociatedwithinternationalprojectsfinancial,political,others Financialrisk Ingeneral,internationalprojectsarepronetogreaterfinancialriskasabulkoffinanceisinthe form of debt. The major factors affecting financial risk are degree of indebtedness, the terms andconditionsofrepaymentofdebtandcurrencyused. Anoperatingcompanyintervenesintheerectionoftheproject.Itbringsitsorganisational knowhowtomanagetheproject.
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Someprojectswillhaveexpensesandrevenuesthatinvolveseveralcurrencies.Asaresultthe exchangerateriskisveryhigh. Projectsmaybefinancedwithfloatingrates.Inviewofthevolatilityobservedontherateslike LIBOR,theinterestrateriskisalsosignificant.Thereforeitisnecessarytoplanthecoverageof alltheserisks.
ForeignExchangeRisk As corporations expand their international activities, they begin to acquire foreign assets and foreign liabilities. As exchange rates change, the values of these foreign assets and liabilities change accordingly. For a corporation, exchange rate risk is the sensitivity of the value of the corporationwhentheexchangerateschange.Obviously,thechangeinthecorporationvalueis relatedtothenetchangeinthevaluesoftheforeignassetsandforeignliabilities.(E.g.foreign directinvestment,foreignexchangeloss,salesandincomefromforeignsources.)
EconomicRisk Economicriskisriskcreatedbychangesintheeconomy.Typically,itisrelatedtotechnological changes, the actions of competitors, shifts in consumer preferences, etc. Ideally, a pure domestic firm is affected only by domestic economic conditions the domestic economic risk. However, in today's integrated world economy, the concept of a pure domestic firm has less practical relevance. Many firms that appear strictly pure domestic confront foreign economic riskindirectly.(E.g.:localrestaurant/deptstore,realestateagent)
PoliticalRisk Politicalriskisriskcreatedbypoliticalchangesorinstabilityinacountry.Thesefactorsinclude, butarenotlimitedto,nationalization,confiscation,pricecontrols,foreignexchangeandcapital controls, administrative hurdles, uncertain property rights, discriminative or arbitrary regulations on business practices (hiring, contract negotiation), civil wars, riots, terrorism, etc. Eachcountryintheworldpresentsadifferentpoliticalprofileandrepresentsauniquesourceof politicalriskthatfirmsmustassessandmanagewhentheymakeforeigninvestments. Inordertominimizethisrisk,localinvestorsorthelocalgovernmentmaybeassociatedwiththe project. Insurance against political risk is another useful technique recommended for the purpose.
SECTION5:INTERNATIONALEQUITYMARKET
INTERNATIONALEQUITYMARKET
DepositoryReceipts Depositaryreceipt(DR)isatypeofnegotiable(transferable)financialsecuritythatistradedonalocal stock exchange but represents a security, usually in the form of equity, that is issued by a foreign publiclylistedcompany.TheDR,whichisaphysicalcertificate,allowsinvestorstoholdsharesinequity of other countries. One of the most common types of DRs is the American depositary receipt (ADR), which has been offering companies, investors and traders global investment opportunities since the 1920s.Sincethen,DRshavespreadtootherpartsoftheglobeintheformofglobaldepositaryreceipts (GDRs) (the other most common type of DR), European DRs and International DRs. ADRs are typically tradedonaU.S.nationalstockexchange,suchastheNewYorkStockExchange(NYSE)ortheAmerican Stock Exchange, while GDRs are commonly listed on European stock exchanges such as the London Stock Exchange. Both ADRs and GDRs are usually denominated in U.S. dollars, but can also be denominatedineuros. HowDoestheDRWork? The DR is created when a foreign company wishes to list its already publiclytraded shares or debt securities on a foreign stock exchange. Before it can be listed to a particular stock exchange, the company in question will first have to meet certain requirements put forth by the exchange. Initial public offerings, however, can also issue a DR. DRs can be traded publicly or overthecounter. Let us lookatanexampleofhowanADRiscreatedandtraded: Example Say a gas company in Russia has fulfilled the requirements for DR listing and now wants to list its publiclytradedsharesontheNYSEintheformofanADR.Beforethegascompany'ssharesaretraded freely on the exchange, a U.S. broker, through an international office or a local brokerage house in Russia,wouldpurchasethedomesticsharesfromtheRussianmarketandthenhavethemdeliveredto the local (Russian) custodian bank of the depository bank. The depository bank is the American institution that issues the ADRs in America. In this example, the depository bank is the Bank of New York. Once the Bank of New York's local custodian bank in Russia receives the shares, this custodian bankverifiesthedeliveryofthesharesbyinformingtheBankofNewYorkthatthesharescannowbe issued in the United States. The Bank of New York then delivers the ADRs to the broker who initially purchased them. Based on a determined ADR ratio, each ADR may be issued as representing one or moreoftheRussianlocalshares,andthepriceofeachADRwouldbeissuedinU.S.dollarsconverted from the equivalent Russian price of the shares being held by the depository bank. The ADRs now representthelocalRussiansharesheldbythedepository,andcannowbefreelytradedequityonthe NYSE. After the process whereby the new ADR of the Russian gas company is issued, the ADR can be traded freely among investors and transferred from the buyer to the seller on the NYSE, through a procedure known as intramarket trading. All ADR transactions of the Russian gas company will now CompiledbyMANAGEMENTPARADISETEAM. Page74
takeplaceinU.S.dollarsandaresettledlikeanyotherU.S.transactionontheNYSE.TheADRinvestor holds privileges like those granted to shareholders of ordinary shares, such as voting rights and cash dividends.TherightsoftheADRholderarestatedontheADRcertificate. PricingandCrossTrading WhenanyDRistraded,thebrokerwillaimtofindthebestpriceoftheshareinquestion.Heorshewill therefore compare the U.S. dollar price of the ADR with the U.S. dollar equivalent price of the local shareonthedomesticmarket.IftheADRoftheRussiangascompanyistradingatUS$12pershareand thesharetradingontheRussianmarketistradingat$11pershare(convertedfromroublestodollars), abrokerwouldaimtobuymorelocalsharesfromRussiaandissueADRsontheU.S.market.Thisaction thencausesthelocalRussianpriceandthepriceoftheADRtoreachparity.Thecontinualbuyingand selling in both markets, however, usually keeps the prices of the ADR and the security on the home marketincloserangeofoneanother.Becauseofthisminimalpricedifferential,mostADRsaretraded bymeansofintramarkettrading.AU.S.brokermayalsosellADRsbackintothelocalRussianmarket. This is known as crossborder trading. When this happens, an amount of ADRs is canceled by the depositoryandthelocalsharesarereleasedfromthecustodianbankanddeliveredbacktotheRussian brokerwhoboughtthem.TheRussianbrokerpaysfortheminroubles,whichareconvertedintodollars bytheU.S.broker. TheBenefitsofDepositaryReceipts TheDRfunctionsasameanstoincreaseglobaltrade,whichinturncanhelpincreasenotonlyvolumes onlocalandforeignmarketsbutalsotheexchangeofinformation,technology,regulatoryproceduresas wellasmarkettransparency.Thus,insteadofbeingfacedwithimpedimentstoforeigninvestment,asis often the case in many emerging markets, the DR investor and company can both benefit from investmentabroad.Let'stakeacloseralookatthebenefits: FortheCompany A company may opt to issue a DR to obtain greater exposure and raise capital in the world market. Issuing DRs has the added benefit of increasing the share's liquidity while boosting the company's prestigeonitslocalmarket("thecompanyistradedinternationally").Depositaryreceiptsencouragean international shareholder base, and provide expatriates living abroad with an easier opportunity to invest in their home countries. Moreover, in manycountries, especially those with emerging markets, obstaclesoftenpreventforeigninvestorsfromenteringthelocalmarket.ByissuingaDR,acompanycan stillencourageinvestmentfromabroadwithouthavingtoworryaboutbarrierstoentrythataforeign investormightface. FortheInvestor BuyingintoaDRimmediatelyturnsaninvestors'portfoliointoaglobalone.Investorsgainthebenefits ofdiversification,whiletradingintheirownmarketunderfamiliarsettlementandclearanceconditions. More importantly, DR investors will be able to reap the benefits of these usually higherrisk, higher returnequities,withouthavingtoenduretheaddedrisksofgoingdirectlyintoforeignmarkets,which CompiledbyMANAGEMENTPARADISETEAM. Page75
may pose lack of transparency or instability resulting from changing regulatory procedures. It is important to remember that an investor will still bear some foreignexchange risk, stemming from uncertainties in emerging economies and societies. On the other hand, the investor can also benefit fromcompetitiveratestheU.S.dollarandeurohavetomostforeigncurrencies. Conclusion Givingyoutheopportunitytoaddthebenefitsofforeigninvestmentwhilebypassingtheunnecessary risksofinvestingoutsideyourownborders,youmaywanttoconsideraddingthesesecuritiestoyour portfolio.Aswithanysecurity,however,investinginADRsrequiresanunderstandingofwhytheyare used,andhowtheyareissuedandtraded. GLOBALDEPOSITORYRECIEPTS FeaturesofGDR Noforeignexchangerisksfortheissuer Novotingrightsfortheholder Proceeds for the issuer are in foreign currency which enables him to meet the foreign exchange component of the project cost, repayment of foreign currency loans, meeting overseas commitments andforsuchotherpurposes ParticipantsinaGDRissue 1. Lead & colead managers : Their responsibilities include undertaking due meticulousness and preparing the offer document, marketing the issues, arrangement and conducting road shows (presentingthecorrectpictureofthecompanysstrengthsandfutureprospectstotheinvestors),actas underwritertotheissuewhoundertaketosubscribetotheunsubscribedportionoftheissue. 2.Depository usuallyaninternationalbank. DepositoriesinvolvedinADRsinUSA _BankofNewYork _MorganGuaranty _Citibank _DeutscheBank Receivescompensationforitsservicesbyissuingcompanyaswellastheinvestors. Responsible for issuing actual DRs, passing information from the issuer to the DR holders, paying dividends or other distributions and facilitating the exchange of DRs into underlying shares when presentedforredemption 3.Custodian CompiledbyMANAGEMENTPARADISETEAM. Page76
Abankappointedbythedepository Responsible for keeping custody of shares, certificates, right and bonus shares, collecting rupee dividendsonunderlyingshares. Receivescompensationfromthedepositoryforitsservices. 4.Clearingsystem KeepsrecordofallparticularsofGDRsandinvestors.InUSA,DepositoryTrustCompany(DTC)does thisfunction.InEuropethereisEUROCLEAR(Brussels)andCEDEL(London) AmericanDepositaryReceipt(ADR) ishowthestockofmostforeigncompaniestradesinUnitedStatesstockmarkets.EachADRisissuedby aU.S.depositarybankandrepresentsoneormoresharesofaforeignstockorafractionofashare.If investors own an ADR they have the right to obtain the foreign stock it represents, but U.S. investors usuallyfinditmoreconvenienttoowntheADR.ThepriceofanADRisoftenclosetothepriceofthe foreignstockinitshomemarket,adjustedfortheratioofADRstoforeigncompanyshares. DepositarybankshavenumerousresponsibilitiestotheholdersofADRsandtothenonU.S.company theADRsrepresent.ThelargestdepositarybankisTheBankofNewYork. IndividualsharesofaforeigncorporationrepresentedbyanADRarecalledAmericanDepositaryShares (ADS). TypesofADRprograms WhenacompanyestablishesanAmericanDepositaryReceiptprogram,it mustdecidewhatexactly it wantsoutoftheprogramandhowmuchtheyarewillingtocommit.Forthisreason,therearedifferent typesofprogramsthatacompanycanchoose. Unsponsoredshares UnsponsoredsharesareADRsthattradeontheoverthecounter(OTC)market.Theseshareshaveno regulatory reporting requirements and are issued in accordance with market demand. The foreign companyhasnoformalagreementwithacustodianbankandsharesareoftenissuedbymorethanone depositary.Eachdepositaryhandlesonlythesharesithasissued. Duetothehassleofunsponsoredsharesandhiddenfees,theyarerarelyissuedtoday.However,there arestillsomecompanieswithoutstandingunsponsoredprograms.Inaddition,therearecompaniesthat setupasponsoredprogramandrequireunsponsoredshareholderstoturnintheirsharesforthenew sponsored.Often,unsponsoredwillbeexchangedforLevelIdepositaryreceipts. LevelI Level1depositaryreceiptsarethelowestsponsoredsharesthatcanbeissued.Whenacompanyissues sponsoredshares,ithasonedesignateddepositaryactingasitstransferagent. CompiledbyMANAGEMENTPARADISETEAM. Page77
A majority of American depositary receipt programs currently trading are issued through a Level 1 program.ThisisthemostconvenientwayforaforeigncompanytohaveitssharestradeintheUnited States. Level 1 shares can only be traded on the OTC market and the company has minimal reporting requirementswiththeU.S.SecuritiesandExchangeCommission(SEC).Thecompanyisnotrequiredto issuequarterlyorannualreports.Itmaystilldoso,butatitsowndiscretion.Ifacompanychoosesto issuereports,itisnotrequiredtofollowUSgenerallyacceptedaccountingprinciples(GAAP)standards andthereportmayshowmoneydenominationsinforeigncurrency. CompanieswithsharestradingunderaLevel1programmaydecidetoupgradetheirsharetoaLevel2 orLevel3programforbetterexposureintheU.S.markets. LevelII(listed) Level 2 depositary receipt programs are more complicated for a foreign company. When a foreign company wants to set up a Level 2 program, it must file a registration statement with the SEC and is underSECregulation.Inaddition,thecompanyisrequiredtofileaForm20Fannually.Form20Fisthe basic equivalent of an annual report (Form 10K) for a U.S. company. In their filings, the company is requiredtofollowGAAPstandards. The advantage that the company has by upgrading their program to Level 2 is that the shares can be listedonaU.S.stockexchange.TheseexchangesincludetheNewYorkStockExchange(NYSE),NASDAQ, andtheAmericanStockExchange(AMEX). Whilelistedontheseexchanges,thecompanymustmeettheexchangeslistingrequirements.Ifitfails todoso,itwillbedelistedandforcedtodowngradeitsADRprogram. LevelIII(offering) ALevel3depositaryreceiptprogramisthehighestlevelaforeigncompanycanhave.Becauseofthis distinction,thecompanyisrequiredtoadheretostricterrulesthataresimilartothosefollowedbyU.S. companies. SettingupaLevel3programmeansthattheforeigncompanyisnotonlytakingsomeofitssharesfrom itshomemarketanddepositingthemtobetradedintheU.S.;itisactuallyissuingsharestoraisecapital. Inaccordancewiththisoffering,thecompanyisrequiredtofileaFormF1,whichistheformatforan OfferingProspectusfortheshares.TheyalsomustfileaForm20FannuallyandmustadheretoGAAP standards.Inaddition,anymaterialinformationgiventoshareholdersinthehomemarket,mustbefiled withtheSECthroughForm8K. ForeigncompanieswithLevel3programswilloftenissuematerialsthataremoreinformativeandare moreaccommodatingtotheirU.S.shareholdersbecausetheyrelyonthemforcapital.Overall,foreign companieswithaLevel3programsetuparetheeasiestonwhichtofindinformation. Restrictedprograms Foreigncompaniesthatwanttheirstocktobelimitedtobeingtradedbyonlycertainindividualsmayset uparestrictedprogram.TherearetwoSECrulesthatallowthistypeofissuanceofsharesintheU.S.: Rule 144A and Regulation S. ADR programs operating under one of these 2 rules make up approximately30%ofallissuedADRs. CompiledbyMANAGEMENTPARADISETEAM. Page78
ForeignCurrencyConvertibleBondFCCB
Atypeofconvertiblebondissuedinacurrencydifferentthantheissuer'sdomesticcurrency.Inother words,themoneybeingraisedbytheissuingcompanyisintheformofaforeigncurrency.Aconvertible bondisamixbetweenadebtandequityinstrument.Itactslikeabondbymakingregularcouponand principalpayments,butthesebondsalsogivethebondholdertheoptiontoconvertthebondintostock. FDIFOREGINDIRECTINVESTMENT Foreign direct Investment is direct investments in productive assets by a company incorporated in a foreign country, as opposed to investments in shares of local companies by foreign entities. It is an importantfeatureofanincreasinglyglobalizedeconomicsystem. A Foreign company is one that has been incorporated outside India and conducts business in India. ThesecompaniesarerequiredtocomplywiththeprovisionsoftheIndianCompaniesAct,1956asfaras theIndianOperationsareconcerned. Therearetwotypesofforeigncollaborations: a)Financialcollaboration(foreignequityparticipation)whereforeignequityaloneisinvolved b) Technical collaboration (Technology transfer) involving licensing of technology by the foreign collaboratoronduecompensation. INDIAADESTINATIONTOINVEST AsrightlysaidbySukomalCBasu,Chairman&ManagingDirector,BankofMaharashtra;India isthefourthlargesteconomyintheworldandhasthesecondlargestGDPamongdeveloping countries, in purchasing power terms. It is experiencing growth with macro economic stability and is in the process of integrating with the global economy. Farreaching economic reforms initiatedinJuly1991generatednumerousbusinessopportunities,leadingtodegenerationwith removalofmostlicensingprocedures.Todaymostsectorsareopentoforeigninvestment,and agovernmentcommitmenttofurtheropeningoftheforeigngoods,servicesandinvestments. Thisstepaimsatrapidandsubstantialeconomicgrowth. A decade after launching free market reforms, the Indian economy is still a dot on the map whenitcomestoattractingforeigninvestment. Indian policymakers will put their best foot forward to try to showcase the attractiveness of Asia'sthirdlargesteconomy. Page79
When it comes to luring foreign investment, India trails far behind China, which attracts $30 $40billionannually.NewDelhi,bycontrast,drawsascant$3.04.0billion. "India can be a roaring tiger if all these problems are taken care of," Amit Mitra, secretary generaloftheFederationofIndianChambersofCommerceandIndustry(FICCI),toldReuters. "There are many positives. We have a stable external sector, a stable monetary and financial regimeandarejuvenatedcorporatesectorreadytofacetheglobalizationchallenge,"saidICRA creditratingagencyeconomicadviserSaumitraChaudhuri. WhileIndiacanboastofmanypositivesrisingexports,growingindustrialoutput,buoyanttax revenuesandlargeforeignexchangesrevenuesitalsohasastringofnegatives. "Wedon'thavetherequiredinfrastructureyettoabsorbthekindofmoneyflowingintoChina as foreign direct investment," said Nikhil Khattau, CEO of Sun F&C Asset Management, which hasover10billionrupeesinvestedinIndianmarkets. Analystssaythegovernmentmustpressaheadwithaggressiveprivatizationofstaterunfirms, deregulation,reformofarchaiclaborlaws,andreductionofitshugefiscaldeficitandlowering oftariffbarriersthatarestillamongthehighestintheworld. Therearealsootherhurdleskeepingtheeconomyfromrealisingitspotentialandleavinglittle roomforcreditratingagenciestoupgradeIndia'sratingsthatareatjunklevels. "Chinesepolicymakersareseriouswithwhatevertheysetouttodo,butsomehowwetendto benonseriouswhenitcomestoimplementingpolicydecisions,"saidICRA'sChaudhuri. However,Indiamustimproveitscreakinginfrastructureandrevivereformsinthepowersector ifitwantstocatchupwiththeeconomicchallengeposedbyChina,whichbeganitslongmarch tothemarketin1979,analystssay. "Atpresent,wehaveanedgeoverChinainsoftwareservices,butifwefailtoevolveandmove upthevaluechain,eventhatpositioncouldbethreatened,"saidNikhilKhattau. Indiawelcomesforeigninvestorswithopenarmswithrelativelyfewandspecifiedexceptions. The key sectors where such prospects are available are: Information Technology, Telecommunications,Transportation,InsuranceandFinancialservices,Chemical,Petrochemical, Agriculture and food products, Oil and Gas Housing and constructions, Mining, Metals and minerals,Environment,PowerandenergyandFilmsetc. TheprocessofeconomicreformshasmadetheIndianpoliciesconcentrateonattractingcapital from abroad and making India a global industrial base. The resultant inflows of foreign direct investment and technology transfers have created an atmosphere for dynamic growth and increased competitiveness of Indian industry. Several multinationals have established their presenceintheIndianmarket.Whilesomeofforeigncompanieshaveestablishedoperationsin the country on their own, others have successfully teamed up with local companies and leveragedtheirpresenceinthecountry.Earlier,amoredistinctmultinationalpresenceinnon core sectors such as consumer goods, intermediates and services was observed, primarily becausethecoresectorswerereservedforthepublicsector.Atpresent,foreigninvestmentis beingencouragedinthecoresectorssuchasbasicinfrastructure.Thishasledtotheentryofa largenumberofforeigninvestorsinvarioussectorsofIndianmarket,whichincludeFortune500 companies,aswellassmallandmediumenterprises(SMEs)fromallovertheworld. Page80
FOREIGNDIRECTINVESTMENTININDIA
With the liberalization of the India economy, the large Indian market is being opened up to foreign investors. Several companies are setting up or have already set up operations in India to cater to the Indianmarket. Eversinceliberalisationandindustrialreformprocessstartedinthe1990's,thelicensingandinvestment restrictions in various sectors have gradually been done away with. The Industrial policy resolution of 1956 and the statement on Industrial Policy of 1991 provides the basic framework for the overall industrialpolicyofthegovernmentofIndia. ThereareseveralstrategiesbywhichaforeignenterprisecansetupIndianoperations. Broadly,entrystrategiesmaybeclassifiedintotwomajortypes: A foreign investor may directly set up its operations in India through a branch office or a representativeofficeorliaisonofficeorprojectofficeoftheforeignCompany;or It may do so through an Indian arm i.e. through a subsidiary company set up in India under Indianlaws.
ForeigncompaniescansetuptheiroperationsinIndiathroughopeningofliaison,projectandbranch offices.SuchcompanieshavetoregisterthemselveswiththeRegistrarofCompanies(ROC),NewDelhi within30daysofsettingupaplaceofbusinessinIndia. ForeignDirectInvestment(FDI)ispermittedasunderthefollowingformsofinvestments. 1. Throughfinancialcollaborations. 2. Throughjointventuresandtechnicalcollaborations. 3. ThroughcapitalmarketsviaEuroissues. 4. Throughprivateplacementsorpreferentialallotments. ListofindustriesforwhichIndustrialLicensingiscompulsory:

Distillationandbrewingofalcoholicdrinks Cigarsandcigarettesoftobaccoandmanufacturedtobaccosubstitutes Electronicaerospaceanddefenceequipment;alltypes Page81
Industrial explosives including detonating fuses, safety fuses, gun powder, nitrocellulose and matches Hazardouschemicals Drugsandpharmaceuticals
ForbiddenTerritories: FDIisnotpermittedinthefollowingindustrialsectors: 1. Armsandammunition. 2. AtomicEnergy. 3. RailwayTransport. 4. Coalandlignite. 5. Miningofiron,manganese,chrome,gypsum,sulphur,gold,diamonds,copper,zinc. ForeigndirectinvestmentsinIndiaareapprovedthroughtworoutes: AutomaticapprovalbyRBI: TheReserveBankofIndiaaccordsautomaticapprovalwithinaperiodoftwoweeks(providedcertain parametersaremet)toallproposalsinvolving: Thelistsarecomprehensiveandcovermostindustriesofinteresttoforeigncompanies.Investmentsin highpriority industries or for trading companies primarily engaged in exporting are given almost automaticapprovalbytheRBI. OpeninganofficeinIndia OpeninganofficeinIndiafortheaforesaidincorporatesassessingthecommercialopportunityforself, planningbusiness,obtaininglegal,financial,official,environmental,andtaxadviceasneeded,choosing CompiledbyMANAGEMENTPARADISETEAM. Page82 Foreignequityupto50%in3categoriesrelatingtominingactivities(List2). Foreignequityupto51%in48specifiedindustries(List3). Foreignequityupto74%in9categories(List4). WhereList4includesitemsalsolistedinList3,74%participationshallapply.
legal and capital structure, selecting a location, obtaining personnel, developing a product marketing strategyandmore. TheForeignInvestmentPromotionBoard(FIPB)Route: Processingofnonautomaticapprovalcases FIPB approves all other cases where the parameters of automatic approval are not met. Normal processing time is 4 to 6 weeks. Its approach is liberal for all sectors and all types of proposals, and rejections are few. It is not necessary for foreign investors to have a local partner, even when the foreigninvestorwishestoholdlessthantheentireequityofthecompany.Theportionoftheequitynot proposedtobeheldbytheforeigninvestorcanbeofferedtothepublic. Portfolioinvestment Portfolioinvestmentrepresentspassiveholdingsofsecuritiessuchasforeignstocks,bonds,or other financial assets, none of which entails active management or control of the securities' issuerbytheinvestor;wheresuchcontrolexists,itisknownasforeigndirectinvestment. Portfolioinvestmentisstrictlyconnectedwithaportfoliodiversificationprocess. SomeexamplesofPortfolioinvestmentare:
1. purchaseofsharesinaforeigncompany. 2. purchaseofbondsissuedbyaforeigngovernment. 3. acquisitionofassetsinaforeigncountry. Portfolioinvestmentispartofthecapitalaccountofbalanceofpaymentsstatistics.
SECTION6:MULTILATERALFINANCIALINSTITUTIONS
INTERNATIONALFINANCE
1.ODA(OfficialDevelopmentAssistance) Many developing countries continue to struggle under the grips of extreme poverty. The trends in globalizationandeconomictransitionhavehadbothabrightanddarkside.Certaincountrieshavebeen left behind by or out of the entire process, and in others, the gulf between the rich and poor has widened. As a result of this they are in a constant need of funds and other forms of assistance to developthem.TheassistanceprovidedforthispurposefromonecountrytoanotheristermedasODA. Previouslyitwasgrantedtoacountrythatneededtorebuilditselfafterthewar.ODAcameintheform ofinfusionsofaidfromtheinternationalcommunity,ODAisavehiclethroughwhichcountriesstriveto cultivateasoundinternationalenvironmentandpromotetiesofgoodwillwithothercountriesODAwas instrumental in helping lay essential infrastructure and in other ways set the stage for the economic takeoffofdevelopingcountries.ODAcanserveasavitaldiplomatictoolfortohelpcreateadesirable internationalclimateandpromoteclosertieswithotherstates.ThemaingoalsofODAcanbeincluded infollowingpoints:

Providing humanitarian assistance for the purpose of attaining global prosperity and development. TacklingGlobalIssuessuchasglobalenvironmentaldegradation,thepopulationexplosion,the food and energy crises, AIDS and other infectious diseases, to drug abuse, terrorism, crimes againstinternationalsociety,andnowfinancialturmoil. Creatingaharmoniousenvironmentofsecurityintermsofensuringpeaceandsecurityforthe humanraceandtheworldatlarge,
2.ForeignAid Oneoftheimportantmethodsoffinancingtradeisthroughaid.Largertradeispossiblethroughlarger aid and it is in this context that a study of the mechanics of aid is relevant in international finance. Movementofmoneyfromonecountrytoanotherintheformofaidisreferredtoastheforeignaid. The donor countries not only look into their own capacity to grant aid but at the recipient countrys capacitytoabsorbaid.Thelatterisjudgedbytheefficiencyandproductivityintheresourceallocation in the pattern of planning and investment and in priorities of allocation, the methods of raising resourcesandtheoverallperformanceoftheeconomy. Availability of foreign aid for the purpose of investment would accelerate growth by helping the cooperatingfactorsathometobefullydeployedandbyacceleratingtherateofinvestment.Thiswould enable the necessary technical innovation and accelerate the entrepreneurial function. Foreign aid augments domestic economic growth. The pattern of flows under foreign aid does not depend upon pureeconomicfactorsnoronpurecommercialconsiderationsbutmoreonpoliticoeconomicfactors. Theeffectofforeignaidontheforeignexchangemarketisto: CompiledbyMANAGEMENTPARADISETEAM. Page84
increasethesupplyandeasethepressuresofdemand, tofacilitatethetransfermechanisminthecurrencymarketsand toobviatetheneedforfrequentchangesintheexchangerates,pendingtheprocessofstructural adjustmentinthedomesticeconomy. Theinflowofforeignaidwouldhoweverincreasethemoneysupply,whichmaynotleadtoinflationary pressuressolongasfundsareefficientlyandproductivelyusedinthedevelopmentprocess.Thebasic postulateisthatforeignaidsfillsinthegapsmakeavailablenonavailableandcomplimentaryresources andaugmentstheinvestmentprocess. 3.MultilateralInvestmentGuarantee MultilateralInvestmentGuaranteeisanoncommercialguarantee(insurance)forinvestmentsmadein developing countries. Such a guarantee protects investors against the risks of transfer restriction (includingconvertibility),expropriation,warandcivildisturbanceandbreachofcontract.MIGhasajoint sponsorshipbydevelopedanddevelopingcountriesandmultilateralcharacter. MIGsupplementsnationalandprivateagenciessupportingforeigndirectinvestmentthroughtheirown investment insurance programmes. The MIG encourages foreign investments by providing viable alternatives in investment insurance against noncommercial risks in developing countries thereby creating investment opportunities in those countries. E.g. Investors who would like to invest in a developingcountrylikeAfricawouldsurelyliketogetacoverfortheirinvestmentsandcanattainthis insurancethroughaMultilateralGuaranteeandthuscaninvestjointlyinsuchaninvestmentproject. 4.MultilateralAid Multilateralmeans"manysides".Hereorganisationsthatinvolvemanycountries,givehelp.Thisaidis runbygroupssuchastheWorldHealthOrganisation(WHO)andUnitedNationsEducational,Scientific andCulturalOrganisation(UNESCO)bothofwhicharepartoftheUnitedNations(UN).Economicaid for development by the developed countries is based on political affinities with the recipient country. Suchanaidmaybebilateralormultilateral.Multilateralaidisthroughinternationalfinancialinstitutions foruseintheimportofgoodsandservicesfromanycountry.Multilateralaidisusableanywhereand henceitsrateofutilizationwillbehigh. 5.BilateralAid Bilateral means "two sides". This type of aid is from one country to another. An example would be BritaingivingmoneyandsendingexpertstohelpbuildadaminTurkey.Quiteoftenbilateralaidisalso tied Aid. This is the most common type of aid. In this type of aid the giving (or donor) country also benefitseconomicallyfromtheaid.Thishappens,asthereceivingcountryhastobuygoodsandservices fromthedonorcountrytogettheaidinthefirstplace.Inbuildingadam,forexample,theBritainmay insistthattheircompanies,expertsandequipmentareused.Whethertheaidisgivenmaydependon the receiving country agreeing to buy e.g. military jets from the donor. Bilateral aid is from one CompiledbyMANAGEMENTPARADISETEAM. Page85
government to the other. Generally bilateral aid constitutes the bulk of the total aid granted to any country.Itmaybetiedoruntied. Foreign Capital ForeignAid
1.Foreigncapitalimpliesfundsthatareraised Movementofmoneyfromonecountrytoanotherin from foreign investors for investment theformofaidfordevelopmentisreferredtoasthe purposes in development projects in a host foreignaid. country. 2.Foreigncapitalcanenterthecountryinthe Foreignaidflowstodevelopingcountriesintheform formof: ofloans,assistanceandoutrightgrantsfromvarious governmentalandinternationalorganizations. DirectInvestment:meanstheconcerns of the investing country exercise de factocontrolovertheassetscreatedin the capital importing country by meansofthatinvestment.E.g.MNCs Indirect Investment: better known as portfolioinvestmentconsistsmainlyof the holding of transferable securities or guaranteed by the govt. of the capital importing country. Such holdings do not amount to right to control the company. E.g. shares, debenture,bondsetc.
Foreign aid is more important than foreign capital 3.Foreigncapitalhasnothingtodowithsocial because the financial needs of the developing expendituressuchaseducation,publichealth, countries cannot be alone met by raising foreign technicaltrainingandresearch. capital. 4. Foreign capital helps reduce shortage of domesticsavingsthroughtheinflowofcapital equipment and raw materials thereby raising themarginalrateofcapitalformation. Foreignaidfacilitatesinvestmentinlowyieldingand slow projects. Such an aid can be used by the recipientcountryinaccordancewithitsdevelopment programmes. Foreign aid is important for easing of foreignexchangeconstraintinacountrywithsluggish It overcomes not only capital exportgrowthandotherforeignexchangeproblems. deficiency but also technological Page86
backwardness. It also helps in industrializing the economy. Itcreatesmoreemployment. Itminimizesinflationarypressures It also overcomes the balance of payments difficulties.
Foreignaidisallocatedonlongrepaymentschedules, 5.Therearenospecialrepaymentschedulesor at lower interest rates and softer terms. Debt softterms. servicingbecomesaburdenifaidistiedortheterms ofaidareonerous. Generallyrepaymentofprincipalandinterestexceed 6. It generates money in the economy and thegrossexternalaidwiththeresultthatthereisnet helpsinminimizingtheinflationarypressures. outflowonthisaccount.
Foreign aid leads to dependency amongst the developing countries & is often used for extremely 6.Foreign capital helps in movement of wastefulprojects. technical knowhow and advancements and provestobeofgreatdynamism. 7. Foreign capital is advanced to the developing countries mainly after observing the opportunities and evaluating the credibilityoftherecipientcountry. BilateralAid MultilateralAid Tradefollowsaid:i.e.aidsmakewayforinvestments intherecipientcountriesresources.
This type of aid flows from one country to Multilateralaidisthroughinternationalfinancial institutionsforuseintheimportofgoodsand another. servicesfromanycountry. Itgenerallyresultsinhigherprojectcosts. Multilateralaidisusableanywhereandhenceitsrate Itconstitutesthebulkoftheaidtaken bythe ofutilizationwillbehigh. developingcountries. Multilateralaidisgenerallymorepreferablethanthe bilateralaidbecauseofthebenefitsthatitoffers. CompiledbyMANAGEMENTPARADISETEAM. Page87
PreferenceforMultilateralAid: Multilateralaidsarepreferredoverbilateralaidsmainlybecauseofthefollowingreasons:
Sincethistypeofaidisthroughinternationalfinancialinstitutionsthehostcountrydoesnot owetoaparticularcountrybuttothepoolofresources. Bilateral aid essentially flows from one country to another and change in policies of the donatingcountrywoulddefinitelyaffecttherecipientcountry. Foreignexchangefluctuationswouldalsonotbeaffectingtherecipientcountry. Thetermsofmultilateralaidstendtobemilderascomparedtothatofthebilateralaid. Itsafeguardstheinterestofthedonorcountriessinceitisthroughacommonsource. Theprojectcostsbecomehigherwhenaidisonbilateralbasiswhenthealternativeavenues ofsuppliesofgoodsorservicesarecheaperandtherecipientcountryhastopayahigher priceforthegoodsimportedandfortheservicesrenderedfromabroadwiththeresultthat thedebtburdenbecomesheavier.
THEWORLDBANK
TheWorldBankisavitalsourceoffinancialandtechnicalassistancetodevelopingcountriesaroundthe world. We are not a bank in the common sense. We are made up of two unique development institutions owned by 185 member countriesthe International Bank for Reconstruction and Development(IBRD)andtheInternationalDevelopmentAssociation(IDA). Eachinstitutionplaysadifferentbutsupportiveroleinourmissionofglobalpovertyreductionandthe improvementoflivingstandards.TheIBRDfocusesonmiddleincomeandcreditworthypoorcountries, while IDA focuses on the poorest countries in the world. Together we provide lowinterest loans, interestfree credit and grants to developing countries for education, health, infrastructure, communicationsandmanyotherpurposes. President:PaulWolfowitz Membership:185countriesrepresentedbyBoardsofDirectors
WorldBank: InternationalBankforReconstructionandDevelopment(IBRD) InternationalDevelopmentAssociation(IDA)
Affiliates InternationalFinanceCorporation(IFC) MultilateralInvestmentGuaranteeAgency(MIGA) Page88
InternationalCentreforSettlementofInvestmentDisputes(ICSID)
Organisation The World Bank is like a cooperative, where its 185 member countries are shareholders. The shareholdersarerepresentedbyaBoardofGovernors,whoaretheultimatepolicymakersat the World Bank. Generally, the governors are member countries' ministers of finance or ministers of development. They meet once a year at the Annual Meetings of the Boards of GovernorsoftheWorldBankGroupandtheInternationalMonetaryFund. Because the governors only meet annually, they delegate specific duties to 24 Executive Directors,whoworkonsiteattheBank.Thefivelargestshareholders,France,Germany,Japan, theUnitedKingdomandtheUnitedStatesappointanexecutivedirector,whileothermember countriesarerepresentedby19executivedirectors. "The President of the World Bank, Paul Wolfowitz, chairs meetings of the Boards of Directors andisresponsibleforoverallmanagementoftheBank.Bytradition,theBankpresidentisaU.S. nationalandisnominatedbytheUnitedStates,theBank'slargestshareholder.ThePresidentis electedbytheBoardofGovernorsforafiveyear,renewableterm. The Executive Directors make up the Boards of Directors of the World Bank. They normallymeetatleasttwiceaweektooverseetheBank'sbusiness,includingapprovalofloans and guarantees, new policies, the administrative budget, country assistance strategies and borrowingandfinancialdecisions. The World Bank operates daytoday under the leadership and direction of the president, management and senior staff, and the vice presidents in charge of regions, sectors, networks andfunctions. VicePresidentsaretheprincipalmanagersattheWorldBank.Formoreinformationaboutbank vicepresidents,keybankmanagersandtheorganizationoftheBank,visit: InadditiontotheInternationalBankforReconstructionandDevelopmentandtheInternational DevelopmentAssociation,threeotherinstitutionsarecloselyassociatedwith theWorldBank: the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA),and the InternationalCentreforSettlementofInvestmentDisputes (ICSID).Allfiveof theseinstitutionstogethermakeuptheWorldBankGroup. History Since inception in 1944, the World Bank has expanded from a single institution to a closely associated group of five development institutions. Our mission evolved from the International Bank for Reconstruction and Development (IBRD) as facilitator of postwar reconstruction and developmenttothepresentdaymandateofworldwidepovertyalleviationinconjunctionwith ouraffiliate,theInternationalDevelopmentAssociation. Once we had a homogeneous staff of engineers and financial analysts, based solely in Washington,DC.Today,wehaveamultidisciplinaryanddiversestaffthatincludeseconomists, publicpolicyexperts,sectorexpertsandsocialscientists,and30%ofourstaffisnowbasedin countryoffices. CompiledbyMANAGEMENTPARADISETEAM. Page89
Reconstruction remains an important focus of our work, given the natural disasters and post conflict rehabilitation needs that affect developing and transition economies. We have, however, broadened our portfolio's focus to include social sector lending projects, poverty alleviation, debt relief and good governance. At today's World Bank, we have sharpened our focusonpovertyreductionastheoverarchinggoalofallourwork. Organizationalstructure Togetherwithfouraffiliatedagenciescreatedbetween1956and1988,theIBRDispartofthe World Bank Group. The Group's headquarters are in Washington, D.C. It is an international organizationownedbymembergovernments;althoughitmakesprofits,theseprofitsareused tosupportcontinuedeffortsinpovertyreduction. TechnicallytheWorldBankispartoftheUnitedNationssystem,butitsgovernancestructureis different:eachinstitutionintheWorldBankGroupisownedbyitsmembergovernments,which subscribetoitsbasicsharecapital,withvotesproportionaltoshareholding.Membershipgives certainvotingrightsthatarethesameforallcountriesbuttherearealsoadditionalvoteswhich depend on financial contributions to the organization. The President of the World Bank is nominatedbythePresidentoftheUnitedStatesandelectedbytheBank'sBoardofGovernors. AsofNovember1,2006theUnitedStatesheld16.4%oftotalvotes,Japan7.9%,Germany4.5%, andFranceandtheUnitedKingdomeachheld4.3%.Asmajordecisionsrequirean85%super majority,theUScanblockanysuchmajorchange SourcesofFundoftheWorldBank The World Bank's two closely affiliated entitiesthe International Bank for Reconstruction and Development(IBRD)and theInternationalDevelopment Association(IDA)providelowornointerest loansandgrantstocountriesthathaveunfavorableornoaccesstointernationalcreditmarkets.Unlike otherfinancialinstitutions,wedonotoperateforprofit.TheIBRDismarketbased,andweuseourhigh creditratingtopassthelowinterestwepayformoneyontoourborrowersdevelopingcountries.We payforourownoperatingcosts,sincewedontlooktooutsidesourcestofurnishfundsforoverhead. So,wheredoesthemoneycomefromtooperatetheWorldBank,andhowdoweusethefundstocarry outourmission? 1. FundGeneration IBRD lending to developing countries is primarily financed by selling AAArated bonds in the world's financial markets. While IBRD earns a small margin on this lending, the greater proportionofitsincomecomesfromlendingoutitsowncapital.Thiscapitalconsistsofreserves builtupovertheyearsandmoneypaidinfromtheBank's185membercountryshareholders. IBRDs income also pays for World Bank operating expenses and has contributed to IDA and debtrelief. IDA, the world's largest source of interestfree loans and grant assistance to the poorest countries, is replenished every three years by 40 donor countries. Additional funds are CompiledbyMANAGEMENTPARADISETEAM. Page90
regenerated through repayments of loan principal on 35to40year, nointerest loans, which arethenavailableforrelending.IDAaccountsfornearly40%ofourlending. 2. Loans ThroughtheIBRDandIDA,weoffertwobasictypesofloansandcredits:investmentloansand developmentpolicyloans.Investmentloansaremadetocountriesforgoods,worksandservices insupportofeconomicandsocialdevelopmentprojectsinabroadrangeofeconomicandsocial sectors. Development policy loans (formerly known as adjustment loans) provide quick disbursingfinancingtosupportcountriespolicyandinstitutionalreforms.IDAloansareinterest free. For information about the IBRDs financial products, services, lending rates and charges, pleasevisittheWorldBankTreasury. Each borrowers project proposal is assessed to ensure that the project is economically, financially,sociallyandenvironmentallysound.Duringloannegotiations,theBankandborrower agree on the development objectives, outputs, performance indicators and implementation plan,aswellasaloandisbursementschedule.Whilewesupervisetheimplementationofeach loanandevaluateitsresults,theborrowerimplementstheprojectorprogramaccordingtothe agreedterms.Asnearly30%ofourstaffisbasedinsome100countryofficesworldwide,three fourths of outstanding loans are managed by country directors located away from the World BankofficesinWashington. IDAlongtermloans(credits)areinterestfreebutdocarryasmallservicechargeof0.75percent onfundspaidout.IDAcommitmentfeesrangefromzeroto0.5percentonundisbursedcredit balances;forFY06commitmentfeeshavebeensetat0.30percent.Forcompleteinformation aboutIBRDfinancialproducts,services,lendingratesandcharges,pleasevisittheWorldBank Treasury.TreasuryisattheheartofIBRD'sborrowingandlendingoperationsandalsoperforms treasuryfunctionsforothermembersoftheWorldBankGroup. 3. Grants Grantsaredesignedtofacilitatedevelopmentprojectsbyencouraginginnovation,cooperation between organizations and local stakeholders participation in projects. In recent years, IDA grantswhichareeitherfundeddirectlyormanagedthroughpartnershipshavebeenusedto: Relievethedebtburdenofheavilyindebtedpoorcountries Improvesanitationandwatersupplies Support vaccination and immunization programs to reduce the incidence of communicable diseaseslikemalaria CombattheHIV/AIDSpandemic Supportcivilsocietyorganizations Createinitiativestocuttheemissionofgreenhousegasses 4. AnalyticandAdvisoryServices Whilewearebestknownasafinancier,anotherofourrolesistoprovideanalysis,adviceand information to our member countries so they can deliver the lasting economic and social improvements their people need. We do this in several ways: through economic research on broad issues such as the environment, poverty, trade and globalization and through country CompiledbyMANAGEMENTPARADISETEAM. Page91
specific economic and sector work , where we evaluate a country's economic prospects by examining its banking systems and financial markets, as well as trade, infrastructure, poverty andsocialsafetynetissues,forexample. Wealsodrawupontheresourcesofourknowledgebanktoeducateclientssotheycanequip themselvestosolvetheirdevelopmentproblemsandpromoteeconomicgrowth.Byknowledge bankwemeanthewealthofcontacts,knowledge,informationandexperiencewe'veacquired over the years, country by country and project by project, in our development work. Our ultimateaimistoencouragetheknowledgerevolutionindevelopingcountries.
Theseareonlysomeofthewaysouranalyses,adviceandknowledgearemadeavailabletoourclient countries,theirgovernmentanddevelopmentprofessionals,andthepublic: PovertyAssessments PublicExpenditureReviews CountryEconomicMemoranda SocialandStructuralReviews SectorReports TopicsinDevelopment CapacityBuilding Anothercorebankfunctionistoincreasethecapabilitiesofourownstaff,ourpartnersandthe people in developing countriesto help them acquire the knowledge and skills they need to provide technical assistance, improve government performance and delivery of services, promote economic growth and sustain poverty reduction programs. Linkages to knowledge sharing networks such as these have been set up by the Bank to address the vast needs for informationanddialogueaboutdevelopment: AdvisoryServicesandAskUshelpdesksmakeinformationavailablebytopicviatelephone,fax, emailandtheweb.Therearemorethan25advisoryservicesattheBank.Staffmemberswho respondtoinquiriesaddvaluetotheworkofourownstaff,clientsandpartnersbyresponding quickly to their knowledge needs. Often, they are the first and possibly the only contact the publicatlargeandthepeopleindevelopingcountrieshavewiththeWorldBank. GlobalDevelopmentLearningNetworkisanextensivenetworkofdistancelearningcentersthat uses advanced information and communications technologies to connect people working in developmentaroundtheworld. World Bank Institute Global and Regional Programs bring together leading development practitionersonlineandfacetofacetoexchangeexperiencesandtodevelopskills. BSPANwebcastingserviceisanInternetbasedbroadcastingstationthatpresentsWorldBank seminars,workshopsandconferencesonsustainabledevelopmentandpovertyreduction.
INTERNATIONALFINANCECORPORATION
The world was a different place 50 years ago. No one spoke of emerging markets. There was no worldwide trend toward privatization, no communications revolution, no globalized economy. World population was less than half of what it is today. It was into this environment that the International FinanceCorporationwasbornin1956. Introduction The world was a different place when the International Finance Corporation (IFC) was establishedin1956.Noonespokeofemergingmarkets.Therewasnoworldwidetrendtoward privatization,nocommunicationsrevolution,noglobalizedeconomy.Worldpopulationwasless thanhalfofwhatitistoday. The economies of poor countries were still in very early stages of development, lacking the human resources, physical infrastructure and sound institutions needed to raise incomes and improvelivingstandards.Theresponsibilityfordevelopmentwasalmostuniversallyassignedto the public sector. Private sector investment in developing countries was small, and not much thoughtwasgiventoincreasingit.ItwasintothisenvironmentthatIFCwasborn. For several years officials of the World Bank had been supporting the creation of a new and different entity to complement their own. The Bank had been founded to finance postWorld War II reconstruction and development projects by lending money to member governments, andhadbeendoingsoeffectively.Yetinitsinitialyears,someseniorstaffhadseentheneedfor creatingarelatedinstitutiontospurgreaterprivatesectorinvestmentinpoorcountries. Major international corporations and commercial financial institutions at the time showed relatively little interest in working in Africa, Asia, Latin America or the Middle East. Entrepreneursintheseregionshadfewdomesticsourcesofcapitaltodrawuponandevenless fromabroad.Theyneededacatalyst. At the 1944 Bretton Woods Conference that led to the creation of the Bank and the International Monetary Fund, initial proposals for this kind of support had been madeand rejected.TheseproposalswouldhavegiventheBanktheabilitytomeetsomeofthesegoalsby lending to private companies without government guarantees. Then, in the late 1940s, the concept was greatly refined by Bank President Eugene R. Black and his Vice President, former U.S.bankerandGeneralFoodsCorporationexecutiveRobertL.Garner. Garner was an ardent believer in the role of private enterprise. Addressing the Inaugural MeetingofIFCsBoardofGovernorsonNovember15,1956,hesaid,"Ibelievedeeplythatthe mostdynamicforceinproducingabetterlifeforpeople,andamoreworthylife,comesfrom theinitiativeoftheindividualtheopportunitytocreate,toproduce,toachieveforhimselfand his familyeach to the best of his individual talents. And this is the essence of the system of competitive private enterprise20th century modelas it has been developed by the most enlightened and successful business concerns. It holds the promise of rewards according to whattheindividualaccomplishes.Itisbasedontheconceptthatitwillbenefitmostitsowners and managers if it best satisfies its customers; if it promotes the legitimate interests of its employees;ifinallregardsitactsasagoodcitizenofthecommunity.Itismovedbythedesire to earn a profita most respectable and important motive, so long as profit comes from
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providingusefulanddesirablegoodsandservices.Itismybeliefthatthebestservicesandthe bestprofitsresultfromacompetitivesystemwhereinskillandefficiencygettheirjustreward." Garner worked with his assistant Richard Demuth and others to create a new private sector investment arm affiliated with the Bank, rather than having it lend directly from its own resources to the private sector. This new multilateral entity, at first internally termed the International Development Corporation, would be owned by governments but act like a corporationandbeequallycomfortableinteractingwiththepublicandprivatesectors.Itwould lend money, take equity positions and provide the technical expertise in appraising private investmentproposalsindevelopingcountries,astheBankwasdoingforpublicsectorprojects. Italsowouldworkalongsideprivateinvestors,assumingequalcommercialrisks.Intheprocess of removing some of the major barriers to new private investment in developing countries, it would encourage the domestic capital formation needed to create jobs, increase foreign exchange earnings and tax revenues, and transfer knowledge and technology from north to south. TheideareceiveditsfirstofficialbackingintheMarch1951reportofaU.S.developmentpolicy advisory board headed by Nelson Rockefeller. This panel conceived of a package to add considerablevaluetotheBanksownproductbyencouragingthegrowthofproductiveprivate enterprisesthatwouldcontributemanykeycomponentstodevelopment.
IFCsArticlesofAgreement TheIFCArticlesofAgreementcameintoforceonJuly20,1956,whentherequisitenumberofatleast30 member countries subscribing at least $75 million to IFCs capital was attained. The initial total authorized capital was $100 million. The first thirtyone member countries as of July 20, 1956 were: Iceland,Canada,Ecuador,UnitedStates,Egypt,Australia,Mexico,CostaRica,Ethiopia,Peru,Dominican Republic, United Kingdom, Panama, Ceylon, Haiti, Guatemala, Nicaragua, Bolivia, Honduras, India, El Salvador,Pakistan,Jordan,Sweden,Norway,Japan,Denmark,Finland,Colombia,GermanyandFrance. Onthatdatethecapitalsubscriptionsamountedto$78,366,000. IFCs Articles of Agreement enshrined three critical principles. The founders insisted that IFC adopt a business principle, taking on the full commercial risks of its investments, accepting no government guaranteesandearningaprofitfromitsoperations;beanhonestbroker,usingitsuniqueabilitiesasa corporationownedbygovernmentsto"bringtogetherinvestmentopportunities,domesticandprivate capital, and experienced management," and; play a catalytic role, investing only in projects for which "sufficientprivatecapitalisnotavailableonreasonableterms." VISIONisthatpoorpeoplehavetheopportunitytoescapepovertyandtoimprovetheirlives. VALUESareexcellence,commitment,integrity,andteamwork. Ourpurposeisto: Promoteopenandcompetitivemarketsindevelopingcountries Supportcompaniesandotherprivatesectorpartners Page94
Generateproductivejobsanddeliverbasicservices CreateopportunityforpeopletoescapepovertyandimprovetheirlivesOurSharedMission
IFC,astheprivatesectorarmoftheWorldBankGroup,sharesitsmission:
Tofightpovertywithpassionandprofessionalismforlastingresults.Tohelppeoplehelpthemselves and their environment by providing resources, sharing knowledge, building capacity, and forging partnershipsinthepublicandprivatesectors. IFCSTRADITIONALFINANCIALPRODUCTS, Technical assistance, and reputation have established the Corporation as a leader in promoting economicgrowthinthedevelopingworld.Buildingonitslineofproductsandservicesastheneedsof clients have evolved, IFC continues to develop new financial tools. These tools enable companies to manageriskandtobroadentheiraccesstoforeignanddomesticcapitalmarkets.IFCsmorecommon typesoffinancinginclude: Projectfinance,inwhichtherepaymentoftheprincipalandinterestoftheinvestmentcomes fromtherevenuesgeneratedbytheprojectitself,withlimitedornorecoursetothesponsors balance sheet. Project finance is primarily suitable where a project can be structured as a separateentityfromthesponsors. Corporate finance, which provides companies with the funds or guarantees needed for developing,expanding,orrestructuringtheirbusiness.Theassetsandliabilitiesaregenerallyon thesponsorsbalancesheet. Trade finance, which provides companies with guarantees and credits through local banks to developandincreasetheirexportsandimports. LoansandIntermediaryServices IFC offers its clients a variety of lending instruments, including senior, subordinated, and convertible loans,aswellasachoiceofinterestrates:fixedrateloans,variablerateloans,and,onoccasion,loans indexedtothepriceofacommodity.Loansareissuedatmarketrates,andmostloansaredenominated inmajorcurrencies.AsignificantamountofIFClendingismadethroughcreditlinesforonlending to intermediary banks, leasing companies, and other financial institutions. These credit lines are often targeted to small businesses and can sometimes be extended in some local currencies. IFC finances projectsandcompaniesthroughitsAloans,alsoknownasstraightseniorloans;theseloansareforIFCs ownaccount.IFCssyndicatedBloansarefortheaccountsofparticipants.ThematuritiesofIFCloans generallyrangebetweensevenand12yearsatorigination,butsomeAloanshavebeenextendedtoas longas20years.IFCundertakescomprehensiveduediligencebeforemakinganinvestment.Becauseof the Corporations extensive lending experience in developing countries, it is uniquely qualified to evaluate the risks associated with these projects. IFCs Articles of Agreement stipulate that loans providedbyIFCcannotbesecuredbyasovereignguarantee. LocalCurrencyFinancing CompiledbyMANAGEMENTPARADISETEAM. Page95
Toavoidrisksfromexchangeratevolatility,companieswithrevenuesinlocalcurrencyshouldgenerally borrowinthesamecurrency.IFCloansareprovidedinmajorcurrenciesandinanincreasingnumberof emerging market currencies. IFC can provide direct local currency financing through direct loans or swapsin23countries.Bymatchingthecurrencydenominationofassetsandliabilities,companiescan concentrate on their core business rather than worry about how unstable exchange rates will affect profitability. IFC provides local currency debt financing in three ways: loans from IFC denominated in local currency; risk management swaps that allow clients to hedge existing or new foreign currency denominatedliabilitiesbackintolocalcurrency;andcreditenhancementstructuresthatallowclientsto borrowinlocalcurrencyfromothersources.IFChasalsomadelocalcurrencyfinancingaprioritytohelp developlocalcapitalmarkets. EquityandQuasiEquity IFC risks its own capital by buying and holding shares in companies, other project entities, financial institutions,andportfolioorprivateequityfunds.IFCisalwaysaminorityshareholderinthecompanies inwhichitinvests,generallylimitingitsshareholdingto20percentorlessofacompanysequity,and will not normally be the largest shareholder in a project. When it comes time to sell its shares, IFC preferstoexitbysellingeitherthroughatradesaleorinthecapitalmarketsthroughapublicoffering. IFC also exits a project by selling its shares back to the sponsor. With quasiequity instruments, IFC invests through products that have both debt and equity characteristics. Some instruments, like subordinatedloansandconvertibledebt,imposefixedrepaymentschedules.Others,suchaspreferred stockandincomenotes,donotrequiresuchrigidrepaymentarrangements. PrivateEquityandInvestmentFunds IFCpromotesforeigninvestmentindevelopingcountriesbyestablishingandinvestinginawiderangeof funds, including private equity funds, distressed assets funds, listed equity funds, and debt funds that investinemergingmarketsecurities.Bypioneeringandpromotingsuchfundsfordevelopingcountries, IFC has introduced many international institutional investors to emerging markets. Through IFCs mobilizationefforts,bothlargeandsmallcompaniesinthedevelopingworldgainaccesstolongerterm finance, many for the first time. Accessing financing from international markets helps them enhance theircompetitivenessinmoreopeneconomiesaroundtheworld. SyndicatedLoans Through its syndicated loan (or Bloan) program, IFC offers commercial banks and other financial institutions the chance to lend to projects and companies they might not otherwise consider. These loans are a key part of IFCs efforts to mobilize additional private sector financing in developing countries,therebybroadeningtheCorporationsdevelopmentimpact.ThroughtheBloanprogram,IFC sells participations in its loans while remaining the lender of record. Participants in IFC Bloans share fullyinthecommercialcreditrisksofprojectsbutalsosharefullyintheadvantagesthatIFCderivesasa multilateral development institution, including preferred creditor access to foreign exchange in the eventofaforeigncurrencycrisisinaparticularcountry.Whereapplicable,theseparticipantbanksare alsoexemptedfromthemandatorycountryriskprovisioningrequirementsthatregulatoryauthorities mightimposeifthesebanksweretolenddirectlytoprojectsindevelopingcountries. CompiledbyMANAGEMENTPARADISETEAM. Page96
StructuredFinance IFCsstructuredfinanceproductsenableclientswithstrong,sustainableprojectstoaccesscapitalthat otherwise might not be available to them. Products include credit enhancement structures for bonds andloansthroughpartialcreditguarantees,participationinsecuritizations,andrisksharingfacilities. PartialcreditguaranteesallowIFCto useitsinternationaltripleAcreditratingtohelpclientsdiversifytheirfundingsources,extend maturities,andobtainfinancingintheircurrencyofchoice,includinglocalcurrency.Partialloan andbondguaranteesalsohelpbroadenclientsaccesstointernationalandlocalcapitalmarkets. Creditenhancementstructureshelpclientsattractnewsourcesoffinancingintheircurrencyof choice, reduce borrowing costs, and extend maturities beyond what private investors would otherwiseprovide. Securitizations help IFCs clients obtain financing that would otherwise be unavailable or unsuitabletothembecauseofperceivedcreditrisk.Thisformoffinancinginvolvesthepooling andactualsaleoffinancialassetsandissuanceofsecuritiesthatarerepaidfromthecashflows generatedbysuchassets.Theriskassociatedwiththisformoffinancingcomesfromtheasset poolratherthanfromtheinstitutionthatoriginatedthoseassets.Securitizationsarecommonly used for mortgages, credit cards, auto and consumer loans, corporate debt, and other assets withrelativelypredictablecashflows. RisksharingfacilitiesallowclientstotransfercreditrisktoIFCfromtheirownportfolioorfrom anewportfoliotheyoriginate.Theassetstypicallyremainontheclientsbalancesheet,andthe risktransfercomesfromapartialguaranteeprovidedbyIFC.Ingeneral,clientswillenterinto such a facility with IFC because it helps them increase their capacity to originate new assets withinanassetclassinwhichIFCseekstoincreaseitsownexposure. RiskManagementProducts IFCsriskmanagementproductsprovideclientswithaccesstolongtermderivativesmarkets.hedging instruments allow clients to hedge their foreign exchange exposures, which are typically related to foreign currency borrowings. IFC offers these longterm hedges in the local currency where markets exist. IFC also provides derivative products to enable clients to manage their interest rate and commodity price risks. The main instruments used to manage currency, interest rate, and commodity pricerisksareswapsandoptionsavailableinthemarket. MunicipalFinance The Municipal Fund, a joint initiative of the World Bank and IFC, provides capital investment to municipalities and other local public entities in developing countries without requiring sovereign guarantees. The Municipal Funds offerings make new financial products and services and access to capitalmarketsavailabletostates,municipalities,andmunicipallycontrolledinstitutionstohelpthem deliverkeyinfrastructureservicesandimprovetheirefficiencyandaccountability.Suchservicesinclude water,wastewatermanagement,transportation,andpower. TECHNICALASSISTANCEANDADVISORYSERVICES CompiledbyMANAGEMENTPARADISETEAM. Page97
INADDITIONTOSUPPORTINGPRIVATESECTORDEVELOPMENTbyinvestingincompaniesindeveloping countries, IFC provides technical assistance and advisory services to strengthen the business environment, develop local financial markets, encourage environmental and social development, implement publicprivate partnerships, and help tailor business services to firms. This work includes technicalassistancetiedtoIFCloanandequityinvestments,servicesprovidedtosmalllocalbusinesses intheregionswhereIFCworks,andadvisoryservicestogovernmentsonregulatoryreforms,investment climate,andprivatization.MuchofIFCstechnicalassistanceisfundedthroughpartnershipswithdonor governments, other multilateral institutions, and foundations, as well as IFCs own resources. IFC administers these funds and oversees a wide variety of activities, including feasibility studies, sector studies, capacity building, and assessments of environmental and social impacts of investment projects. IFCs advisory servicesareprovidedbyitsspecializedstaffonastandalonefeebasis AttractingForeignInvestment JointlymanagedbyIFCandtheWorldBank,theForeignInvestmentAdvisoryServiceadvisesdeveloping countrygovernmentsonhowtoattractandretainforeigndirectinvestmentanditsimpactonpoverty reduction.FIASdevelopslongtermstrategiestailoredtoeachclientcountrysneedsandobjectives.FIAS identifiespracticesthatimpedeproductiveforeigndirectinvestment,designspracticalplansofaction, andsupportsitsclientsthroughallphasesoftransitionandimplementation.Sinceitsestablishmentin 1985,FIAShasadvisedmorethan130countriesonalmost600projects. AdvisoryServicesforPublicPrivatePartnerships IFC provides advisory assistance, primarily to governments, on private sector participation in infrastructureandotherpublicservices,aswellastherestructuringofstateownedenterprises.These services help establish publicprivate partnerships through which governments can obtain increased performanceunderbudgetconstraintswhilebenefitingfromprivatesectorexpertise,management,and finance.IFCsservicesgobeyondtransactionsupporttoincludeadviceonpolicyandregulatoryissues, optimizingcommercialvalueforinvestorswhilebeingsensitivetothecountryseconomicandpolitical context. Its efforts focus primarily on expanding access to public services such as power, water and sanitation,transport,and,morerecently,healthservices,whereitcanhelpstrikethebalancebetween thecommitmenttosustainabledevelopmentandanunderstandingofwhatinvestorsneed. BuildingFinancialInfrastructureandInstitutions IFC works to improve access to finance for underserved and smaller businesses by building critical financialinfrastructure,strengtheningcoreoperationsofbanksandnonbankfinancialinstitutions,and developingnewlinesofbusinessforbankstotargetthemarketforenvironmentalfinanceinemerging andtransitioneconomies.Thedevelopmentofcreditbureausisakeypriority,andIFCishelpingcreate and improve consumer and small business credit reporting in over 30 countries. Most of IFCs institutionbuilding projects in financial markets entail working with banks and specialized financial institutions to deepen their capacity for providing financial services to micro, small, and medium enterprises. RevenueManagement CompiledbyMANAGEMENTPARADISETEAM. Page98
In many developing and transition countries, revenues from oil, gas, and mining production generate taxes,royalties,andotherreceiptsthatcanbeusedtofostereconomicgrowthandsocialdevelopment. In some nations, however, lack of accountability and transparency exacerbates poor governance and leads to corruption, conflict, and greater economic inequality. IFC believes that, if used wisely, abundant resources can provide a foundation for sustainable economic growth. The Corporation is committed to increasing transparency and accountability related to revenues from the extractive industries. Along with the World Bank, it is supporting an industrywide approach to greatertransparency about countrylevel revenues from oil, gas, and mining through the Extractive IndustriesTransparencyInitiative,anditispromotinggreatertransparencyabouttherevenuepayments oftheindividualprojectsitsupports. ServicesforSmallandMediumEnterprises Strengthening smaller firms in the developing and transition countries is a strategic priority for IFC. Efforts center on providing specialized services to promote thedevelopment of local businesses, including improving the business climate, increasing access to capital and business development services, building capacity, demonstrating the value of environmental improvements and biodiversity, and linking smaller businesses to largescale investment projects. Based on its experience in every regionofthedevelopingworld,IFChaslearnedmanyvaluablelessonsinpromotingthedevelopmentof these enterprises. Drawing from these lessons makes new projects more effective and less costly, therebyincreasingtheiroverallimpact. Thefacilitiesalsoprovidesectorspecificservices,suchasinagribusiness,inareasthatofferthegreatest growth potential for smaller businesses. Some of the specificservices that IFC provides to small businessesinclude: Expanding access to financing: Accessing finance is critical to the survival and growth of smaller businesses.IFCsexperienceincreatingandstrengtheningfinancialinstitutionsthroughacombination of investments and technical assistance has led to an indepth understanding of how financial intermediaries function in their markets and has enabled the Corporation to develop programs that increase the availability of financing to small and medium enterprises. These programs include investments in private equity funds that specialize in small businesses and support to microfinance institutions,banksthatlendtosmallbusinesses,andleasingcompanies. Improving the business environment: Small firms often face more obstacles related to business registration,taxation,licensing,exportregulations,laborpolicy,inspections,judicialsystems,property rights,andfinancialmarketregulationthanlargerfirmsdo.Addressingthesehurdlesisakeyobjective ofIFC.Someofthetoolsusedinthiseffortincludeinvestmentclimateassessments,policysurveysof smallbusinesses,andadvocacytopromotereform. LinkinglocalbusinessestoIFCinvestments:DesignedaroundIFCinvestmentprojectstoincreasethe flow of benefits to local firms and communities, linkage programs improve the technical and business skills of small businesses; facilitate access to finance for local suppliers; support creation of more efficient distribution channels with wider regional reach; expand the ability of consumers to pay for services and utilities provided by IFC clients; mitigate risk by strengthening relations with host CompiledbyMANAGEMENTPARADISETEAM. Page99
governmentsandlocalcommunitiesthroughhealth,education,andinfrastructureprograms;andfocus onfrontierregionswherefeweralternativesexistforlocalenterprises.
INTERNATIONALDEVELOPMENTASSOCIATION
TheInternationalDevelopmentAssociation(IDA)isthepartoftheWorldBankthathelpsthe worldspoorestcountries.Establishedin1960,IDAaimstoreducepovertybyprovidinginterest free loans and grants for programs that boost economic growth, reduce inequalities and improvepeopleslivingconditions. Page100
IDA complements the World Banks other lending armthe International Bank for Reconstruction and Development (IBRD)which serves middleincome countries with capital investment and advisory services. IBRD and IDA share the same staff and headquarters and evaluateprojectswiththesamerigorousstandards. IDAisoneofthelargestsourcesofassistancefortheworlds82poorestcountries,39ofwhich areinAfrica.Itisthesinglelargestsourceofdonorfundsforbasicsocialservicesinthepoorest countries. IDAlendsmoney(knownascredits)onconcessionalterms.ThismeansthatIDAcreditshaveno interest charge and repayments are stretched over 35 to 40 years, including a 10year grace period. Sinceitsinception,IDAcreditsandgrantshavetotaledUS$161billion,averagingUS$79billion ayearinrecentyearsanddirectingthelargestshare,about50percent,toAfrica.
History When the International Bank for Reconstruction and Development (IBRD), better known as the World Bank,wasestablishedin1944,itsfirsttaskwastohelpEuroperecoverfromthedevastationofWorld WarII.OnceEuropewasrebuilt,theBankturneditsattentiontothedevelopingcountries.Asthe1950s progressed,itbecame clearthatthepoorestdevelopingcountriescouldnot affordtoborrowneeded capitalfordevelopmentonthetermsofferedbytheBank.Theyrequiredeasierterms.WiththeUnited Statestakingtheinitiative,agroupofBankmembercountriesdecidedtosetupaninstitutionthatcould lend to very poor developing nations on highly concessional terms. They called it the International DevelopmentAssociation(IDA).ItsfounderssawIDAasawayforthe"haves"oftheworldtohelpthe "havenots."ButtheyalsowantedIDAtobeimbuedwiththedisciplineofabank.Forthisreason,US PresidentDwightD.Eisenhowerproposed,andothercountriesagreed,thatIDAshouldbepartofthe WorldBank. IDA's Articles of Agreement became effective in 1960. The first IDA loans (known as credits) were approvedin1961,toHonduras,India,SudanandChile.IBRDandIDAarerunonthesamelines.They sharethesamestaff,thesameheadquarters,reporttothesamepresidentandusethesamerigorous standardswhenevaluatingprojects.IDAsimplytakesitsmoneyoutofadifferent"drawer."Acountry mustbeamemberofIBRDbeforeitcanjoinIDA;162countriesareIDAmembers. IDA'sBorrowers IDA lends to countries that have a per capita income in 2000 of less than $885 and lack the financial ability to borrow from IBRD. At present, 79 countries are eligible to borrow from IDA. Together these countries are home to 2.5 billion people, comprising half of the total population of the developing countries. An estimated 1.1 billion people in IDA countries survive on incomes of less than $1 a day. Somecountries,suchasIndiaandIndonesia,areeligibleforIDAduetotheirlowpercapitaincomes,but CompiledbyMANAGEMENTPARADISETEAM. Page101
arealsocreditworthyforsomeIBRDborrowing.Thesecountriesareknownas"Blend"borrowers.IDA eligibility is a transitional arrangement, allowing the poorest countries access to substantial resources beforetheycanobtainfromthemarketsthefinancingtheyneedinordertoinvest.Astheireconomies grow,countriesgraduatefromeligibility.Therepayments(orreflows)theymakeontheirloansthey hadobtainedthenhelpfinancenewIDAloanstotheremainingpoorcountries.Overtheyears,twenty twocountrieshaveseentheireconomiesdevelopandgrowbeyondtheIDAeligibility IDALending IDA credits have maturities of 35 or 40 years with a 10year grace period on repayment of principal. There is no interest charge, but credits do carry a small service charge of 0.75 percent on disbursed balances. In fiscal year 2001 (which ended June 30, 2001), IDA commitments totaled $6.8 billion and disbursements were $5.5 billion. Since 1960, IDA has lent $107 billion to 106 countries. It lends, on average, about $67 billion a year for different types of development projects especially those that address peoples' basic needs, such as primary education, basic health services, and clean water and sanitation. IDA also funds projects that protect the environment, improve conditions for private business,buildneededinfrastructure,andsupportreformsaimedatliberalizingcountries'economies. All these projects pave the way toward economic growth, job creation, higher incomes and a better qualityoflife.IDAfundsareallocatedtotheborrowingcountriesinrelationtotheirincomeleveland track record of success in managing their economies and their ongoing IDA projects. In the past fiscal year(FY01),atotalof$6.8billionwascommittedtoIDAborrowers.Thesenewcreditscomprised134 newoperationsin53countries.OnehalfofnewcreditswenttoSubSaharanAfrica,18percenttoSouth Asia,15percenttoEastAsiaandthePacific,8percenttoEasternEuropeandCentralAsia(ECA),andthe remainder to poor countries in North Africa and in Latin America and the Caribbean. The countries receivingthelargestnewcommitmentsinFY01arelistedinthetablebelow: IDAFunding Whereas IBRD raises most of its funds on the world's financial markets, IDA is funded largely by contributions from the governments of the richer member countries. Their cumulative contributions since IDA's beginning total US$109 billion. Additional funds come from IBRD's income and from IDA graduates'andborrowers'repaymentsofearlierIDAcredits.Donorsgettogethereverythreeyearsto replenishIDAfunds.The12threplenishmentfinancesprojectsoverthethreeyearsstartingJuly1,1999. Fundingforthe12threplenishmentallowsIDAtolendabout$20billion,ofwhichdonors'contributions willprovidealittleoverhalf.TheremainingfundscomelargelyfromrefoldsofpreviousIDAcredits,as wellasothernondonorresources.ThelargestpledgestoIDA12weremadebytheUnitedStates,Japan, Germany,France,United Kingdom,ItalyandCanada.Forexample,theUSis thelargestdonor,having pledged to contribute $803.4 million for each of the three years of the replenishment. Some less wealthynationsalsocontribute toIDA.Koreaand Turkey,forexample,onceborrowersfromIDA,are now donors. Countries currently eligible to borrow from IBRD Argentina, Brazil, Czech Republic, Hungary,Mexico,Poland,Russia,theSlovakRepublic,andSouthAfricaarealsoIDA12donors.Other CompiledbyMANAGEMENTPARADISETEAM. Page102
contributorstothe12thReplenishmentincludeAustralia,Austria,Barbados,Belgium,Denmark,Finland, Greece,Iceland,Ireland,Israel,Luxembourg,Netherlands,NewZealand,Norway,Portugal,SaudiArabia, Spain,Sweden,andSwitzerland. TheThirteenthReplenishmentofIDA(IDA13) Discussions on the 13th replenishment of IDA are underway in 2001, to provide the World Bank with resources to assist the worlds poorest countries in fiscal years 200305 the threeyear period beginningonJuly1,2002. ThefirstmeetingwasinParis,France,onFebruary28March1.Participantsdiscussedkeypolicyissues, includingIDAeligibilityanddifferentiationoftermsanddeterminingofIDAallocations.IDAdonorsalso decidedtoinvitesixIDAborrowerrepresentativestotakepartindiscussionsofIDA13policies:twofrom AfricaandoneeachfromtheEastAsia,SouthAsia,EasternEuropeandCentralAsia,andLatinAmerica andtheCaribbeanregions. ThesecondmeetingwasinAddisAbaba,Ethiopia,onJune67.Participants,whoincludednotonlyIDA donorsbutalsoIDAborrowerrepresentativesforthefirsttime,consideredhowIDAshouldrespondto poverty reduction strategy papers PRSP in IDA13, how IDA could improve postconflict allocations, andthemainconclusionsofamajorindependentevaluationofIDA.Thismeetingwasprecededbyan alldayAfricanDialoguewithIDADeputies,organizedandchairedbytheUNEconomicCommissionfor Africa and involving representatives of African governments, NGOs, and business, as well as African academics.Thiswasoneoftheinitiativesthatareunderwaytoincreasinglybringborrowerviewsinto discussions of IDA policies. This document summarizes the outcomes of thesecond meeting.The third andfourthIDA13replenishmentmeetingsofbothIDAdonorandborrowerrepresentativesareplanned forOctoberandDecember2001. IDA'sImpactonPoverty IDA addresses poverty through its broad range of projects, including investment projects targeted at human resource development such as education, health, safety nets, and water supply and sanitation (43percentinFY01),theprovisionofinfrastructure(19percent),andagricultureandruraldevelopment (16percent).WhilethebulkofIDAfinancingover72percentinFY01isforinvestmentprojects,IDA also provides adjustment credits. These credits help governments finance their overall development expenditures including teacher salaries, operations and maintenance of health centers, road rehabilitation, and agricultural extension in the context of macroeconomic and sectoral reform programs.ThedevelopmentexpendituresthatmadepossiblebyIDAfinancingarenecessaryforgrowth and poverty reduction. To help governments put in place reform programs, IDA advises on the best policies for attaining broadbased economic growth and reducing the vulnerability of the poor to economic shocks. IDA is now the single largest source of donor funds for basic social services in the poorest countries. Childrenone billion of whom live in IDA recipient countries are the main CompiledbyMANAGEMENTPARADISETEAM. Page103
beneficiaries of the resulting investments in basic health, primary and literacy education and clean water. ThankstoIDA:

Some45,000primaryschoolclassroomswereconstructedorrehabilitatedinAfricancountries, whichenabledapproximately1.8millionchildrentobenefitfromaccesstoprimaryeducation. In Asia, over 6,700 health care facilities were constructed or upgraded, then equipped and staffedtoprovidebasichealthcaretoruralpopulations. The social investment fund projects in Latin America reached some 9.5 million beneficiaries. Activities supported by these projects generated almost a million personmonths of employment. InAfrica,morethan5milliontextbooks(mostlylocallydevelopedandproduced)weresupplied toprimaryschools. In India, the National AIDS Control project supported training of 52,500 physicians and 60 percentofnursingstaffinHIV/AIDSmanagementtopics. In Yemen, the Taiz Flood Disaster Prevention and Municipal Development project prevented serious damage from the 1996 floods, benefiting 21,000 households directly and over half a millionpeopleindirectly. Improvements in Haiti's devastated power sector have given users access to about 20hours perday electricity service, contrasting with the previous situation of nearly 18 hours of blackoutsdaily.
IDA'smissionpovertyreduction. The mission of IDA is to support efficient and effective programs to reduce poverty and improve the qualityoflifeinitspoorestmembercountries.IDAhelpsbuildthehumancapital,policies,institutions, and physical infrastructure needed to bring about equitable and sustainable growth. IDA's goal is to reducethedisparitiesacrossandwithincountries,tobringmorepeopleintotheeconomicmainstream, and to promote equitable access to the benefits of development. Sustainable poverty reduction depends on forming effective partnerships, and on systematic inclusion of the poor, affected groups, and women in the development process. To achieve this, the focus must be on: results to get the biggest development return from scarce aid resources; sustainability to achieve enduring development impact within an environmentally sustainable framework; and equity to remove barriersandopenupopportunitiesforthedisadvantaged. IDA'sassistanceisprovidedunderabroadpolicyframeworkthatreflectsprioritiesagreedbyitsdonors, representedbytheirIDADeputies,andendorsedbytheExecutiveDirectors.Theseprioritiesaresetout inthisreportoftheIDA12Deputies.ThecurrentpolicyframeworkfortheTwelfthReplenishmentofIDA (IDA12)whichwillspanthetransitiontothenextcenturyisalsoguidedbythepovertyreduction andsocialdevelopmentgoalsforthe21stcentury(InternationalDevelopmentTargets)endorsedbythe international community. These goals include reducing the proportion of the population living in extremepovertybyhalfandachievinguniversalprimaryeducationinallcountriesby2015. CompiledbyMANAGEMENTPARADISETEAM. Page104
HowIDAResourcesareAllocated
IDA's79eligibleborrowerstogetherhaveverysignificantneedsforconcessionalfunds.Butsincemost ofIDA'sresourcesaredonated bymembergovernments,theamountoffundsavailableforlendingis virtually fixed once donations are pledged. IDA therefore must allocate resources among eligible borrowing countries. This note describes how IDA resources are allocated on the basis of borrowers' policyperformanceandinstitutionalcapacityinordertoconcentrateresourceswheretheyarelikelyto havethemostimpact. 1.Eligibility ThreecriteriaareusedtodeterminewhichcountriesareeligibletoborrowIDAresources:

Relativepoverty,definedasGNPpercapitabelowanestablishedthreshold,currentlyUS$885. Lack of creditworthiness to borrow on market terms and therefore a need for concessional resourcestofinancethecountry'sdevelopmentprogram. Good policy performance, defined as the implementation of economic and social policies that promotegrowthandpovertyreduction.
2.AllocationCriteria The main factor that determines the allocation of IDA resources among eligible countries is each country'sperformanceinimplementingpoliciesthatpromoteeconomicgrowthandpovertyreduction. Per capita income is also a determinant, with the poorest of the eligible countries receiving higher allocationsforagivenperformancelevel. 3.PerformanceRatings EveryyearWorldBankstaffassessesthequalityofeachborrower'spolicyperformance.Thecriteriaand methodology of these assessments have evolved over time to incorporate lessons fromexperience as well as research findings. Beginning in 1998, the country performance assessment was broadened to include an evaluation not only of the government's policies but also of the institutions in place to implementthem. Inaddition,adiscountisappliedtotheratingsofcountrieswithseveregovernance problems, as weak governance has been shown to be a major obstacle to development. Finally, the performance assessment also takes into account the performance of the country's active project portfolio.The20performancecriteriaaregroupedintofourclusters EconomicManagement StructuralPolicies PoliciesforSocialInclusion/Equity PublicSectormanagementandInstitutions
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4.AllocationProcess
TheallocationofIDA'sresourcesisdeterminedprimarilybyeachborrower'sratingintheannualcountry performanceandinstitutionalassessment.Inaddition,theIDA12Agreementrecommendsthatbecause the acceleration of economic and social development in SubSaharan Africa remains foremost among IDA's priorities, these countries should receive priority in the allocation process, provided that policy performance warrants it. Finally, for borrowers that are eligible for both IDA and IBRD funds ("Blend countries"),allocationsmusttakeintoaccountthosecountries'creditworthinessforandaccesstoother sourcesoffundsaswellastheirabilitytouseIDAresourceseffectivelytotacklepoverty. Lendingallocationsaredeterminedonathreeyearrollingbasisandareusedforplanningpurposesby the World Bank's operational departments. Individual country allocations serve as an anchor for the formulation of Country Assistance Strategy (CAS) lending programs, which, if appropriate, can deviate from the performancebased allocations to reflect changes in performance in between annual assessmentsand/orexceptionalcountrycircumstances. 5.LendingandPerformance IDA management monitors actual lending to each country in relation to the planning allocations. The allocations are administered flexibly, to ensure that they respond promptly to important changes in performance. As a result, actual lending on per capita terms is robustly correlated with performance levels.Thestronglinkbetweenlendingandperformancehasresultedinanincreasingconcentrationof lendingtocountrieswherepolicyperformanceismostconducivetoeffectiveresourceuse.
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THEMULTILATERALINVESTMENTGUARANTEEAGENCY
AboutMIGA As a member of the World Bank Group, MIGA's mission is to promote foreign direct investment (FDI) intodevelopingcountriestohelpsupporteconomicgrowth,reducepoverty,andimprovepeople'slives. WhyFDI? The development needs today are stark. Nearly 28 percent of the world's population1.7 billion peoplelivesonlessthanadollaraday.Billionsofpeoplelivewithoutaccesstosafedrinkingwateror sewage treatment. Children can't attend school because there's no electricity to light classrooms in some countries, and no roads to get to school in others. The list goes on. Developing country governmentscannotshouldertheburdenfinanciallyortechnicallyofaddressingtheseneedsalone. Foreign direct investors can play a critical role in reducing poverty, by building roads, for example, providingcleanwaterandelectricity,andaboveall,providingjobs.Bytakingonthesetasks,theprivate sectorcanhelpeconomiesgrowandaverttheneedforgovernmentstousefundsbetterspentonacute socialneeds,whiletakingadvantageoftheopportunitytomakeprofitableinvestments. MIGAandFDI CompiledbyMANAGEMENTPARADISETEAM. Page107
Concernsaboutinvestmentenvironmentsandperceptionsofpoliticalriskofteninhibitforeign directinvestment,withthemajorityofflowsgoingtojustahandfulofcountriesandleavingthe world'spooresteconomieslargelyignored.MIGAaddressestheseconcernsbyprovidingthree key services: political risk insurance for foreign investments in developing countries, technical assistancetoimproveinvestmentclimatesandpromoteinvestmentopportunitiesindeveloping countries,anddisputemediationservices,toremovepossibleobstaclestofutureinvestment. MIGA's operational strategy plays to our foremost strength in the marketplaceattracting investors and private insurers into difficult operating environments. The agency's strategy focusesonspecificareaswherewecanmakethegreatestdifference: Infrastructure development is an important priority for MIGA, given the estimated need for $230billionayearsolelyfornewinvestmenttodealwiththerapidlygrowingurbancentersand underservedruralpopulationsindevelopingcountries. Frontier marketshighrisk and/or lowincome countries and marketsrepresent both a challengeandanopportunityfortheagency.Thesemarketstypicallyhavethemostneedand stand to benefit the most from foreign investment, but are not well served by the private market. Investmentintoconflictaffectedcountriesisanotheroperationalpriorityfortheagency.While these countries tend to attract considerable donor goodwill once conflict ends, aid flows eventually start to decline, making private investment critical for reconstruction and growth. Withmanyinvestorswaryofpotentialrisks,politicalriskinsurancebecomesessentialtomoving investmentsforward. SouthSouth investments (investments between developing countries) are contributing a greater proportion of FDI flows. But the private insurance market in these countries is not always sufficiently developed and national export credit agencies often lack the ability and capacitytoofferpoliticalriskinsurance. MIGAofferscomparativeadvantagesinalloftheseareasfromouruniquepackageofproducts and ability to restore the business community's confidence, to our ongoing collaboration with the public and private insurance market to increase the amount of insurance available to investors.
MIGA'sGuarantees Investors and lenders in today's dynamic investment climate understand the potential benefits of openingupshopinemergingmarkets.Theevensmarteronesalsounderstandthecriticalimportanceof addressingthepoliticalrisksthatmayaccompanyaninvestmentinanuntestedenvironment.MIGAcan helpinvestorsandlendersdealwiththeserisksbyinsuringeligibleprojectsagainstlossesrelatingto: Currencytransferrestrictions Expropriation Warandcivildisturbance Breachofcontract
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Transfer restriction coverage protects against losses arising from an investor's inability to convertlocalcurrency(capital,interest,principal,profits,royalties,orothermonetarybenefits) into foreign exchange for transfer outside the host country. The coverage also insures against excessive delays in acquiring foreign exchange caused by the host government's actions or failuretoact.Currencydevaluationisnotcovered. Expropriation coverage offers protection against loss of the insured investment as a result of actsbythehostgovernmentthatmayreduceoreliminateownershipof,controlover,orrights to the insured investment. This policy also covers partial losses, as well as "creeping expropriation," a series of acts that over time have an expropriatory effect. Bona fide, non discriminatory measures taken by the host government in the exercise of its legitimate regulatoryauthorityarenotconsideredexpropriatory. Warandcivildisturbancecoverageprotectsagainstlossduetothedestruction,disappearance, or physical damage to tangible assets caused by politically motivated acts of war or civil disturbance,includingrevolution,insurrection,andcoupsd'tat. Terrorism and sabotage are also covered. War and civil disturbance coverage also extends to eventsthatresultinthetotalinabilityoftheprojectenterprisetoconductoperationsessential toitsoverallfinancialviability. Breachofcontractcoverageprotectsagainstlossesarisingfromthehostgovernment'sbreach or repudiation of a contractual agreement with the investor. In the event of such an alleged breachorrepudiation,theinvestormustbeabletoinvokeadisputeresolutionmechanism(e.g., arbitration) set out in the underlying contract and obtain an award for damages. The investor mayfileforaclaimif,afteraspecifiedperiodoftime,paymentisnotreceived. IfMIGAisunabletopreventaclaim,ourstrongbalancesheetallowsustomakepromptpayments.But the MIGA guarantee offers much more than just the assurance that losses will be recovered. Our insurancealsobenefitsinvestorsandlendersby: Deterring harmful actions MIGAs relationship with shareholder governments provides additionalleverageinprotectinginvestments. MediatingdisputesAsanhonestbroker,MIGAintervenesatthefirstsignoftroubletoresolve potentialinvestmentdisputesbeforetheyreachclaimstatus,helpingtomaintaininvestments andkeeprevenuesflowing. AccessingfundingOurguaranteeshelpinvestorsobtainprojectfinancefrombanks. Lowering borrowing costs MIGAguaranteed loans may help reduce riskcapital ratings of projects. IncreasingtenorsTheagencycanprovideinsurancecoverageforupto15years(insomecases 20),therebyincreasingthetenorofloansavailabletoinvestors. ProvidingextensivecountryknowledgeMIGAappliesdecadesofexperience,globalreach,and knowledgeofdevelopingcountriestoeachtransaction. Providing environmental and social expertise MIGA helps investors and lenders ensure that projects comply with what are considered to be the worlds best social and environmental safeguards. Page109
ProvidingTechnicalAssistancetoInvestmentPromotionIntermediaries
Foreign direct investment (FDI) is having a dramatic impact on the way companies do business and developingeconomiesintegratewiththeglobaleconomy.Whetherconsideringinvestmentsasameans to gain access to resources, reduce costs, or enjoy growth in new markets, international corporate investorsincreasinglyareimplementingtheirstrategiesonaglobalscale. Developing countries now compete with developed countries as well as each other to attract foreign direct investment. MIGA provides technical assistance (TA) to investment promotion intermediaries (IPIs)indevelopingmembercountriestoenhancetheircapacitytoprovideinvestorswithinformation and advice, with the goal of reducing the transaction costs associated with site selection, as well as helping new ventures get established. This assistance transfers best practice knowledge and skills so that the developing country IPIs are better equipped in their efforts to compete in promoting their locationsasdestinationsforFDI. MIGAisoneofthefeworganizationswithglobalexperienceandtheabilitytoprovidethebroadbased packageofassistanceneededtobuildanorganization'sinstitutionalcapacityinareassuchasstrategic planning, investor marketing, sector targeting, and in improving responsiveness to investor needs throughinformationservices.MIGAtypicallyengageswithnationallevelorganizations,butalsoworks on a provincial or regional basis. TA takes two basic forms: (1) capacity building and investment facilitationservicestohelpdevelopandimplementinvestmentpromotionstrategiesand(2)information servicesthatdisseminateinformationoninvestmentopportunitiesandbusinessoperatingconditionsin developing membercountries. Many ofMIGA'sTAprojectsare basedonpartnerships,notjustwithin theWorldBankGroup,butwiththebroaderdevelopmentcommunity. MIGAprovidesabroadrangeoftechnicalassistancetoclientsincludinginvestmentpromotionagencies, business associations, promotional departments within sectoral ministries and other government and private sector organizations that are involved in promoting or facilitating foreign direct investment. Special emphasis is placed on MIGA's strategy to support infrastructure development, highlight the attractivenessofinvestinginfrontiermarkets,stimulateinvestmentintoconflictaffectedcountries,and encourageinvestmentbetweendevelopingcountries. Coreservicesincapacitybuildingandinvestmentfacilitationaretailoredspecificallytoclients' needs.Componentsoftheassistancemayincludeallorsomeofthefollowingactivities: Investigative missions to conduct institutional needs assessments as the basis for designing a capacitybuildingprogram. Investment promotion skills training, which typically focuses on longterm investment promotion strategy development and skills building for staff in managing daily operations of investment intermediaries, including client relationship management, investor servicing and imagebuildingactivities.
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Workshops on basic principles of investment promotion designed for officials not directly involved with the national investment promotion intermediary (IPI) but with peripheral responsibilityforpromotingtheircountry. Sectorspecific strategy workshops designed to help public sector officials and industry associations in MIGA member countries understand the competition for investment, monitor industrytrendsaffectingpotentialinvestment,understandinvestordecisionmakingcriteria,as wellasconductmarketresearchonline. Assistance in online investment promotion, such as help in setting up a website through customizable templates (IPAWorks) and help in developing content necessary to service investors online; workshops on how to effectively utilize information technology tools for investmentpromotion;andassistanceinsettingupandusingaclientrelationshipmanagement system. To complement the expertise of its investment promotion advisers and to enhance service delivery, MIGA has developed the FDI Promotion Center, an online resource that forms the foundation for delivery of MIGA's technical assistance services and provides a valuable reference tool for sustaining investmentpromotioninitiativesaftercompletionofMIGA'sformalcapacitybuildingassistance.
SECTION7EXPOSURE&RISKINI.F RISK&EXPOSURE
1&2.ExposureandRisk
Exposureisameasureofthesensitivityofthevalueofafinancialitem(asset,liabilityorcashflow)to changes in the relevant risk factor while risk is a measure of variability of the value of the item attributabletotheriskfactor.Letusunderstandthisdistinction clearly.April 1993toaboutJuly1995 theexchangeratebetweenrupeeandUSdollarwasalmostrocksteady.Considerafirmwhosebusiness involvedbothexportstoandimportsfromtheUS.Duringthisperiodthefirmwouldhavereadilyagreed thatitsoperatingcashflowswereverysensitivetotherupeedollarexchangerate,i.e.;ithadsignificant exposuretothisexchangerate;atthesametimeitwouldhavesaidthatitdidntperceivesignificantrisk onthisaccountbecausegiventhestabilityoftherupeedollarfluctuationswouldhavebeenperceived tobeminimal.Thus,themagnitudeoftheriskisdeterminedbythemagnitudeoftheexposureandthe degreeofvariabilityintherelevantriskfactor. 3.Hedging: Hedgingmeansatransactionundertakenspecificallytooffsetsomeexposurearisingoutofthe firmsusualoperations.Inotherwords,atransactionthatreducesthepriceriskofanunderlying securityorcommoditypositionbymakingtheappropriateoffsettingderivativetransaction. Inhedgingafirmtriestoreducetheuncertaintyofcashflowsarisingoutoftheexchangerate fluctuations. With the help of this a firm makes its cash flows certain by using the derivative markets.
4.Speculation Speculation means a deliberate creation of a position for the express purpose of generating a profit from fluctuation in that particular market, accepting the added risk. A decision not to hedgeanexposurearisingoutofoperationsisalsoequivalenttospeculation. Oppositetohedging,inspeculationafirmdoesnottaketwooppositepositionsintheanyof themarkets.Theykeeptheirpositionsopen.
5.TransactionExposure Thisisameasureofthesensitivityofthehomecurrencyvalueoftheassetsandliabilities,which aredenominated,intheforeigncurrency,tounanticipatedchangesintheexchangerates,when the assets or liabilities are liquidated. The foreign currency values of these items are contractuallyfixed,i.e.;donotvarywithexchangerate.Itisalsoknownascontractualexposure.
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Sometypicalsituations,whichgiverisetotransactionsexposure,are: (a) Acurrencyhastobeconvertedinordertomakeorreceivepaymentforgoodsandservices; (b) Acurrencyhastobeconvertedtorepayaloanormakeaninterestpayment;or (c) Acurrencyhastobeconvertedtomakeadividendpayment,royaltypayment,etc.
Note that in each case, the foreign value of the item is fixed; the uncertainty pertains to the home currency value. The important points to be noted are (1) transaction exposures usually haveshorttimehorizonsand(2)operatingcashflowsareaffected.
6.TranslationExposure AlsocalledBalanceSheetExposure,itistheexposureonassetsandliabilitiesappearinginthe balancesheetbutwhichisnotgoingtobeliquidatedintheforeseeablefuture.Translationrisk istherelatedmeasureofvariability. Thekeydifferenceisthetransactionandthetranslationexposureisthattheformerhasimpact oncashflowswhilethelaterhasnodirecteffectoncashflows.(Thisistrueonlyifthereareno taxeffectsarisingoutoftranslationgainsandlosses.) Translation exposure typically arises when a parent multinational company is required to consolidate a foreign subsidiarys statements from its functional currency into the parents homecurrency.ThussupposeanIndiancompanyhasaUKsubsidiary.Atthebeginningofthe parentsfinancialyearthesubsidiaryhasrealestate,inventoriesandcashvaluedat,1000000, 200000and150000poundrespectively.ThespotrateisRs.52perpoundsterlingbythecloseof the financial year these have changed to 950000 pounds, 205000 pounds and 160000 pounds respectively.HoweverduringtheyeartherehasbeenadrasticdepreciationofpoundtoRs.47. If the parent is required to translate the subsidiarys balance sheet from pound sterling to Rupeesatthecurrentexchangerate,ithassufferedatranslationloss.Thetranslationvalueof its assets has declined from Rs. 70200000 to Rs. 61805000. Note that no cash movement is involved since the subsidiary is not to be liquidated. Also note that there must have been a translationgainonsubsidiarysliabilities,ex.Debtdenominatedpoundsterling.
7.ContingentExposure Theprinciplefocusisontheitemswhichwillhavetheimpactonthecashflowsofthefirmand whosevaluesarenotcontractuallyfixedinforeigncurrencyterms.Contingentexposurehasa muchshortertimehorizon.Typicalsituationgivingrisestosuchexposuresare a. Anexportandimportdealisbeingnegotiatedand quantitiesandpricesareyetnottobe finalized.Fluctuationsintheexchangeratewillprobablyinfluencebothandthenitwillbe convertedintotransactionsexposure. CompiledbyMANAGEMENTPARADISETEAM. Page113
b. The firm has submitted a tender bid on an equipment supply contract. If the contract is awarded,transactionsexposurewillarise. c. A firm imports a product from abroad and sells it in the domestic market. Supplies from abroad are received continuously but for marketing reasons the firm publishes a home currencypricelistwhichholdsgoodforsixmonthswhilehomecurrencyrevenuesmaybe moreorlesscertain,costsmeasuredinhomecurrencyareexposedtocurrencyfluctuations. Inallthecasescurrencymovementswillaffectfuturecashflows.
8.Competitiveexposure Competitiveexposureisthemostcrucialdimensionsofthecurrencyexposure.Itstimehorizon islongerthanoftransactionalexposuresayaroundthreeyearsandthefocusisonthefuture cash flows and hence on long run survival and value of the firm. Consider a firm, which is involvedinproducinggoodsforexportsand/orimportssubstitutes.Itmayalsoimportapartof itsrawmaterials,componentsetc.achangeinexchangerategivesrisetono.ofconcernsfor suchafirm,example,
1. Whatwillbetheeffectonsalesvolumesifpricesaremaintained?Ifpricesarechanged?Should prices be changed? For instance a firm exporting to a foreign market might benefit from reducingitsforeigncurrencypricedtoforeigncustomers.Followinganappreciationofforeign currency,afirm,whichproducesimportsubstitutes,maycontemplateinitsdomesticcurrency pricetoitsdomesticcustomerswithouthurtingitssales.Afirmsupplyinginputstoitscustomers whointurnareexporterswillfindthatthedemandforitsproductissensitivetoexchangerates. 2. Since a part of inputs are imported material cost will increase following a depreciation of the home currency. Even if all inputs are locally purchased, if their production requires imported inputsthefirmsmaterialcostwillbeaffectedfollowingachangeinexchangerate. 3. Labourcostmayalsoincreaseifcostoflivingincreasesandthewageshavetoberaised. 4. Interestcostonworkingcapitalmayriseifinresponsetodepreciationtheauthoritiesresortto monetarytightening. 5. Exchangeratechangesareusuallyaccompaniedbyifnotcausedbydifferenceininflationacross countries. Domestic inflation will increase the firms material and labour cost quite independentlyofexchangeratechanges.Thiswillaffectitscompetitivenessinallthemarkets butparticularlysoinmarketswhereitiscompetingwithfirmsofothercountries 6. Real exchange rate changes also alter income distribution across countries. The real appreciationoftheUSdollarvisvisdeutschemarkimpliesandincreasesinrealincomesofUS residentsandafallinrealincomesofGermans.ForanAmericanfirm,whichsellsbothathome, exportstoGermany,thenetimpactdependsupontherelativeincomeelasticitiesinadditionto anyeffecttorelativepricechanges.
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Thus, the total impact of a real exchange rate change on a firms sales, costs and margins depends upon the response of consumers, suppliers, competitors and the government to this macroeconomicshock. Ingeneral,anexchangeratechangewilleffectbothfuturerevenuesaswellasoperatingcosts and hence exchange rates changes, relative inflation rates at home and abroad, extent of competition in the product and input markets, currency composition of the firms costs as comparedtoitscompetitorscosts,priceelasticitiesofexportandimportdemandandsupply andsoforth.
1. Whatiscurrencyrisk?Enumeratethedifferenttypesofcurrencyriskswithexamples. Ans.Currencyriskarisesduetoexposuresexplainedinconcepts5to8 2. Discusstheexposureandriskoccurringduetothechangesin a) Interestrates b) Exchangerates Ans. a)Interestrateuncertaintyexposesafirmtothefollowingkindsofrisks: 1. Ifthefirmhasborrowedonafloatingratebasis,atveryresetdate,therateforthefollowing period would be set in line with the market rate. The firms future interest payments are thereforeuncertain.Anincreaseinrateswilladverselyaffectthecashflows. 2. Consider a firm, which wants to undertake a fixed investment project. Suppose it requires foreign currency financing and is forced to borrow on a floating rate basis. Since its cost of capitalisuncertain,anadditionalelementofriskisintroducedinprojectappraisal. 3. Ontheotherhand,considerafirm,whichhasborrowedonafixedratebasistofinanceafixed investmentproject.Subsequentlyinflationrateintheeconomyslowsdownandthemarketrate ofinterestdeclines.Thecashflowsfromtheprojectmaydeclineasaresultofthefallintherate ofinflationbutthefirmisloggedintohighcostborrowing. 4. Afundmanagerexpectstoreceiveasizableinflowoffundsinthreemonthstobeinvestedin fiveyearinterestratewillhavedeclinedthusreducingthereturnonhisinvestments. 5. A bank has invested in a sixmonth loan at 18% and financed it by means of a threemonth depositat16.5%.Attheendofthreemonthsitmustrefinanceitsinvestment.Ifdepositsrates goupinthemeanwhileitsmarginwillbereducedormayeventurnnegative. 6. Afundmanagerisholdingaportfoliofixedincomesecuritiessuchasgovernmentandcorporate bonds.Fluctuationsininterestratesexposeintotwokindsofrisks.Thefirstisthatthemarket valueofhisportfoliovariesinverselywithinterestrates.Thisistheriskofcapitalgainsorlosses. CompiledbyMANAGEMENTPARADISETEAM. Page115
Secondlyhereceivesperiodicinterestpaymentsonhisholdings,whichhavetobereinvested. Thereturnhecanobtainonthesereinvestmentsinuncertain. Ineachofthesecases,anadversemovementininterestrateshurtsthefirmbyeitherincreasing thecostofborrowingorbyreducingthereturnoninvestmentorproducingcapitallossesonits assets portfolio. During the early 80s investors preferences shifted towards floating rate instrumentsthusexposingborrowerstosubstantialinterestraterisks. FormostIndiancompaniestheideaofinterestrateriskisrelativelynew.Inanenvironmentof administered rates and fragmented, compartmentalized capital markets, neither investors nor borrowersfelttheneedtoworryfluctuationsininterestrates. With increasing resort to external commercial borrowings, Indian companies have had to recognize and learn to manage interest rate risk. Also, the Indian financial system is gradually movinginthedirectionofmarketdeterminedinterestraterisk.Also,theIndianfinancialsystem is gradually moving in the direction of market determined interest rates. During the last few years the environment has changed drastically. In particular, the steep rise in interest rates during19951996hasledtothepainfulrealizationthatcarefulmanagementoftheinterestrate riskiscrucialtoafirmsfinancialhealth.
Ans.2.b)Sameasdescriptivequestionno.1 3. Discuss the available tools to manage risk involved due to fluctuations in exchange rates and interestrates. Ans. Afirmmaybeabletoreduceoreliminatecurrencyexposurebymeansofinternalandexternalhedging strategies. INTERNALHEDGINGSTARTEGIES Invoicing
Afirmmaybeabletoshifttheentirerisktoanotherpartybyinvoicingitsexportsinitshomecurrency and insisting that its imports too be invoiced in its home currency, but in the presence of well functioning forwards markets this will not yield any added benefit compared to a forward hedge. At times,itmaydiminishthefirmscompetitiveadvantageifitrefusestoinvoiceitscrossbordersalesin thebuyerscurrency. Inthefollowingcasesinvoicingisusedasameansofhedging:
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1. Trade between developed countries in manufactured products is generally invoiced in the exporterscurrency. 2. Tradeinprimaryproductsandcapitalassetsaregenerallyinvoicedinamajorvehiclecurrency suchastheUSdollar. 3. Tradebetweenadevelopedandalessdevelopedcountrytendstobeinvoicedinthedeveloped countryscurrency. 4. If a country has a higher and more volatile inflation rate than its trading partners, there is a tendencynottousethatcountryscurrencyintradeinvoicing. Anotherhedgingtoolinthiscontextistheuseofcurrencycocktailsforinvoicing.Thusforinstance, BritishimporteroffertilizerfromGermanycannegotiatewiththesupplierthattheinvoiceispartlyin DEM&partlyinSterling.Thiswayboththepartiesshareexposure.Anotherpossibilityistouseoneof thestandardcurrencybasketssuchastheSDRortheECUforinvoicingtradetransactions. Basketinvoicingofferstheadvantageofdiversificationandcanreducethevarianceofhomecurrency value of the payable or receivable as long as there is no perfect correlation between the constituent currencies.Theriskisreducedbutnoteliminated.Also,thereisnowaybywhichtheexposurecanbe hedgedsincethereisnoforwardmarketsIthesecompositecurrencies.Asaresult,thistechniquehas notbecomeverypopular. NettingandOffsetting: Afirmwithreceivablesandpayablesindiversecurrenciescannetoutitsexposureineachcurrencyby matching receivables with payables. Thus a firm with exports to and imports from say Germany need notcovereachtransactionseparately;itcanuseareceivabletosettleallorpartofapayableandtakea hedgeonlyforthenetDEMpayableorreceivable.Evenifthetimingsofthetwoflowsdonotmatch,it mightbepossibletoleadorlagoneofthemtoachieveamatch. To be able to use netting effectively, the company must have continuously updated information on intersubsidiarypaymentspositionaswellaspayablesandreceivablestooutsiders.Onewayofensuring efficientinformationgatheringistocentralisecashmanagement. Leading and lagging: Another internal way of managing transactions exposure is to shift the timingofexposuresbyleadingorlaggingpayablesandreceivables.Thegeneralruleislead,i.e.advance payablesandlag,i.e.postponereceivablesinstrongcurrenciesand,conversely,leadreceivablesand lag payables in weak currencies. Simply shifting the exposure in time is not enough; it has to be combinedwithaborrowing/lendingtransactionoraforwardtransactiontocompletethehedge. Boththesetoolsexistasaresponsetotheexistenceofmarketimperfections. ExternalTools A.Usinghedgingforforwardsmarket:
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In the normal course of business, a firm will have several contractual exposures in various currenciesmaturingatvariousdates.Thenetexposureinagivencurrencyatagivendateissimplythe difference between the total inflows and the total outflows to be settled on that date. Thus suppose ABCCo.hasthefollowingitemsoutstanding: Item Value 800,000 90 180 60 60 60 90 Datestomaturity 60
1.USDreceivable 2.NLGpayable
2,000,000 100,000 200,000 300,000 250,000 1,000,000
3.USDinterestpayable 4.USDpayable
5.USDpurchasedforward 6.USDloaninstallmentdue 7.NLGpurchasedforward
ItsnetexposureinUSDat60daysis: (800,000+300,000)(200,000+250,000)=+USD650,000 WhereasithasanetexposureinNLGof1,000,000at90days. Theuseofforwardcontractstohedgetransactionsexposureatasingledateisquitestraightforward.A contractual net inflow of foreign currency is sold forward and a contractual net outflow is bought forward. This removes all uncertainty regarding the domestic currency value of the receivable or payable.Thusintheaboveexample,tohedgethe60dayUSDexposure,ABCCo.cansellforwardUSD 650,000whilefortheNLGexposureitcanbuyNLG1,000,00090dayforward. What about exposures at different date? One obvious solution is to hedge each exposure separately withaforwardsaleorpurchasecontractasthecasemaybe.Thusintheexample,thefirmcanhedge the60dayUSDexposurewithaforwardsaleandthe180dayUSDexposurewithaforwardpurchase. B.Hedgingwiththemoneymarket: Firms, which have access to international money markets for shortterm borrowing as well as investment,canusethemoneymarketforhedgingtransactionsexposure.
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E.g.:SupposeaGermanfirmABChasa90dayDutchGuilderreceivableofNLG10,000,000.Ithasaccess to Euro deposit markets in DEM as well as NLG. To cover this exposure it can execute the following sequenceoftransactions: 1. BorrowNLGintheeuroNLGmarketfor90days. 2. ConvertspottoDEM. 3. UseDEMinitsoperations,e.g.topayoffashorttermbankloanorfinanceinventory. 4. Whenthereceivableissettled,useittopayofftheNLGloan. Supposetheratesareasfollows: NLG/DEMSpot:101025/3590dayforward:1.1045/65 EuroNLGinterestrates:51/4/5 EuroDEMinterestrates:43/4/5.00 Comparingtheforwardcoveragainstthemoneymarketcover.Withforwardcover,eachNLGsoldwill giveaninflowofDEM(1/1.064)=DEM0.9038,90dayslater.Thepresentvalueofthis(at4.74%)is 0.9038/[1+(0.0475/4)]=DEM0.8931
Tocoverusingthemoneymarket,foreachNLGofreceivable,borrowNLG1/[1+(0.055/4)] =NLG0.9864,sellthisspottogetDEM(0.9864/1.1035) =DEM0.8939
PayofftheNLGloanwhenthereceivablesmature.Thusthemoneymarketscover;thereisanetgainof DEM0.0008perNLGofreceivableorDEM8000forthe10millionguilderreceivable. Sometimes the money market hedge may turn out to be the more economical alternative because of someconstraintsimposedbygovernments.Forinstance,domesticfirmsmaynotbeallowedaccessto the Euromarket in their home currency or nonresidents may not be permitted access to domestic moneymarkets.ThiswillleadtosignificantdifferentialsbetweentheEuromarketanddomesticmoney marketinterestratesforthesamecurrency.Sinceforwardpremia/discountsarerelatedtoEuromarket interestdifferentialsbetweentwocurrencies,such animperfectionwillpresentopportunitiesforcost saving. E.g.ADanishfirmhasimportedcomputersworth$5millionfromaUSsupplier.Thepaymentisduein 180days.Themarketratesareasfollows: DKK/USDSpot:5.5010/20 180daysforward:5.4095/5.4110 Euro$:91/2/9 Page119
EuroDKK:61/4/6 DomesticDKK:51/4/5
The Danish government has imposed a temporary ban on nonresidents borrowing in the domestic moneymarket.Foreachdollarofpayable,forwardcoverinvolvesanoutflowofDKK5.4110,180days fromnow.Insteadforeachdollarofpayable,thefirmcanborrowDKK502525at5.5%,acquit$0.9547 inthespotmarketandinvestthisat9.50%inaEuro$deposittoaccumulatetoonedollartosettlethe payable.ItwillhavetorepayDKK5.3969[=5.2525*1.0275],180dayslater.Thisrepresentsasavingof DKK0.0141perdollarofpayableorDKK70,500onthe$5millionpayable. Fromtheaboveexampleitisclearthatfromtimetotimecostsavingopportunitiesmayariseeitherdue tosomemarketimperfectionornaturalmarketconditions,whichanalerttreasurercanexploittomake sizeablegains.Havingdecidedtohedgeanexposure,allavailablealternativesfoeexecutingthehedge shouldbeexamined. C.HedgingwithCurrencyOptions: Currency options provide a more flexible means to cover transactions exposure. A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency whileaninflowcanbehedgedbybuyingaputoption.(Orwritingacalloption.Thisisacoveredcall strategy). Optionsareparticularlyusefulforhedginguncertaincashflows,i.e.Cashflowsthosearecontingenton otherevents.Typicalsituationsare: a. International tenders: Foreign exchange inflows will materialise only if the bid is successful. If execution of the contract also involves purchase of materials, equipments, etc. from third countries,therearecontingentforeigncurrencyoutflowstoo. b. Foreign currency receivables with substantial default risk or political risk, e.g. the host governmentofaforeignsubsidiarymightsuddenlyimposerestrictionsondividendrepatriation. c. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/bondscurrentlyworthsayDEM50million,whichheisplanningtoliquidatein6months time.IfhesellsDem50millionforwardandtheportfoliodeclinesinvaluebecauseofafalling Germanstockmarketandrisinginterestrates,hewillfindhimselftobeoverinsuredandshort inDEM. E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on September 1. The market rates are as follows: DEM/GBPSpot:2.8175/85 90daySwappoints:60/55
September calls with a strike of 2.82 (DEM/GBP) are available for a premium of 0.20p per DEM. Evaluatingtheforwardhedgeversuspurchaseofcalloptionsbothwithreferencetoanopenposition. CompiledbyMANAGEMENTPARADISETEAM. Page120
i. ii. iii.
Openposition:Supposethefirmdecidestoleavethepayableunhedged.Ifatmaturitythe poundsterling/DEMspotrateisSt.,thesterlingvalueofthepayableis(5,00,000)St. Forwardhedge:IfthefirmbuysDEM5,00,000forwardattheofferrateofDEM2.8130/PS orPS0.3557/DEM,thevalueofthepayableisPS(5,00,000*0.3557)=PS1,77,850. A Call option: Instead the firm buys call options on DEM 5,00,000 for a total premium expenseofPS1000. Atmaturity,itscashoutflowwillbe PS[(5,00,000)St+1025]forSt<=0.3546 andPS[5,00,000)(0.3546)+1025] =PS178325forSt>=0.3546. Here it is assumed here that the premium expense is financed by a 90 day borrowing at 10%.
D.Hedgingwithcurrencyfutures: Hedgingcontractualforeigncurrencyflowswithcurrencyfuturesisinmanyrespectssimilartohedging with forward contracts. A receivable is hedged by selling futures while a payable is hedged by buying futures. Afutureshedgediffersfromaforwardhedgebecauseoftheintrinsicfeaturesoffuturecontracts.The advantagesoffuturesare,iteasierandhasgreaterliquidity.Bankswillenterintoforwardcontractsonly withcorporations(andinrarecasesindividuals)withthehighestcreditrating.Second,afutureshedge ismucheasiertounwindsincethereisanorganizedexchangewithalargeturnover. A firm may be able to reduce or eliminate interest rate exposure by mean of following hedging strategies. ForwardrateAgreements: AFRAisanAgreementbetweentwopartiesinwhichoneofthem(ThesellerofFRA),contracts tolendtoother(Buyer),aspecifiedamountoffunds,inaspecificcurrency,foraspecificperiodstarting ataspecifiedfuturedate,ataninterestratefixedatthetimeofagreement.AtypicalFRAquotefroma bankmightlooklikethis: USD6/9months:7.207.30%P.a. Thisistobeinterpretedasfollows. ThebankiswillingtoacceptathreemonthUSDdepositstartingsixmonthsfromnow,maturing ninemonthsfromnow,ataninterestrateof7.20%P.a.(BidRate). Thebankiswillingtolenddollarsforthreemonths,startingsixmonthsfromnowatainterest rateof7.30%P.a.(AskRate). CompiledbyMANAGEMENTPARADISETEAM. Page121
Theimportantthingtonoteisthatthereisnoexchangeofprincipalamount.
Interestratefutures: Interestratefuturesareoneofthemostsuccessfulfinancialinnovationsinrecentyears.Theunderlying assetisadebtinstrumentsuchasatreasurybill,abond,andatimedepositinabankandsoon.Fore.g. theInternationalMonetaryMarket(apartofChicagoMercantileExchange)hasafuturescontractonUS governmenttreasurybills,threemonthEurodollartimedepositsandUStreasurynotesandbonds.The LIFFE has contracts on Eurodollar deposits, sterling time deposits and UK government bonds. The ChicagoBoardofTradeofferscontractsonlongtermUStreasurybonds. Interest rate futures are used by corporations, banks and financial institutions to hedge interest rate risk.AcorporationplanningtoissuecommercialpaperforinstancecanuseTBillfuturestoprotectitself againstanincreaseininterestrate.Acorporatetreasurerwhoexpectssomesurpluscashinnearfuture tobeinvestedinshortterminstrumentsmayusethesameasinsuranceagainstafallininterestrates.A fixedincomefundmanagermightusebondfuturestoprotectthevalueofherfundagainstinterestrate fluctuations.Speculatorsbetoninterestratemovementsorchangesinthetermstructureinthehopeof generatingprofits. InterestRateSwaps: A standard fixedtofloating interest rate swap, known in the market jargon as a plain vanilla coupon swap(alsoreferredtoasexchangeofborrowings)isanagreementbetweentwopartiesinwhicheach contracts to make payments to the other on particular dates in the future till a specified termination date.Oneparty,knownasthefixedratepayer,makesfixedpaymentsallofwhicharedeterminedatthe outset.Theotherpartyknownasthefloatingratepayerwillmakepaymentsthesizeofwhichdepends uponthefutureevolutionofaspecifiedinterestrateindex(suchasthe6monthLIBOR).Thekeyfeature ofthisis: TheNotionalPrincipal: The fixed and floating payments are calculated if they were interest payments on a specified amount borrowedorlent.Itisnotionalbecausethepartiesdonotexchangethisamountatanytime;itisonly usedtocomputethesequenceofpayments.Inastandardswapthenotionalprincipalremainsconstant throughthelifeoftheswap. InterestrateOptions: A less conservative hedging device for interest rate exposure is interest rate options. A call option on interestrategivestheholdertherighttoborrowfundsforaspecifieddurationataspecifiedinterest rate,withoutanobligationto doso.Aputoptiononinterestrategivesthe holdertheright toinvest funds for a specified duration at a specified return without an obligation to do so. In both cases, the buyeroftheoptionmustpaytheselleranupfrontpremiumstatedasafractionofthefacevalueofthe contact. As interest rate cap consists of a series of call options on interest rate or a portfolio of calls. A cap protects the borrower from increase in interest rates at each reset date in a mediumtolongterm floating rate liability. Similarly, an interest rate floor is a series or portfolio of put options on interest CompiledbyMANAGEMENTPARADISETEAM. Page122
rate,whichprotectsalenderagainstfallininterestrateonratedatesofafloatingrateasset.Aninterest ratecollarisacombinationofacapandafloor. Explaintheimportanceandrelevanceofhedginginforeignexchangemarket. Ans. ForeignExchangeMarket Theforeignexchangemarketisthemarketinwhichcurrenciesarebroughtandsoldagainsteachother. Itisthelargestmarketintheworld.Foreignexchangemarketisanoverthecountermarket.Thismeans there is no single market place or an organized market place or an organized exchange (like a stock exchange)wheretradersmeetandexchangecurrency.Thetraderssitintheoffices(foreignexchange dealingrooms)ofmajorcommercialbanksaroundtheworldandcommunicatewitheachotherthrough telephones,telex,computerterminalsandotherelectronicmeansofcommunication. Hedging: Hedging means a transaction undertaken specifically to offset some exposure arising out of the firms usualoperations.Inotherwords,atransactionthatreducesthepriceriskofanunderlyingsecurityor commoditypositionbymakingtheappropriateoffsettingderivativetransaction. Differenttypesofexposures Refertoconceptquestions10to13. Conclusion Henceafterlookingatthedifferenttypesofexposures,tradersfacesitisveryclearthatHedgingwith thehelpofderivativeswillensureasafetransactioninForeignexchangemarket. Isitpossibletohedgetheforeignexchangeriskintheforwardsmarket? Ans.Itisnotpossibletohedgeforexriskfully. Thisissobecauseaslongasthereexistscurrencyasamediumofexchangethepersonholding thecurrencyisexposedtodifferenttypesofriskse.g.political,financial, ThiscanbeexplainedwiththehelpofexampleofanIndianexporter.Ifhehascontractedfor exportsworth1000USDandthespotratewas45Rs./$foraperiodof6monthswithaco.in CompiledbyMANAGEMENTPARADISETEAM. Page123
USA.Hewouldreceivehispayments6monthsfromnow,thecommercialriskinvolvedhereis withrespecttothefluctuationsinexchangerates.Iftherates6monthsfromnowbecome50 Rs/$thenhewouldreceive50000USDi.e.heincursaprofitof5000USDandviceaversawhen thevalueofRs.appreciate. Inabovecase,ifwehedgeourpositionthecashflowwouldbecertain,butstillwehaveRs.i.e.a currencyinourhandwithwhichriskprevails. Here comes in the political risk i.e. even when the Indian exporter has the home currency. In casethecountryseconomycrashesthecurrencywilllooseallitvaluethroughouttheworld. Thus,withthehelpofabovee.g.itcanbeprovedthataslongascurrencyisinvolvedwehave risk. Whatfactorsdeterminethevalueofanoption? Ans.Thefactorsare a. b. c. d. Maturityofanoption:higherthepricehigherthevalueofanoptionandviceaversa Spotpriceofunderlyingassets: Strikepriceofunderlyingassets: Interest rate structure in the market: higher the interest rate structure in the market higherthevalueofanoptionandviceaversa e. Volatility:higherthevolatilityinthemarkethigherthevalueofanoptionandviceaversa. Thisissobecausehigherthevolatilityinthemarket,higherthepotentialforearningmore, thusthebuyerofanoptionhastopaymorepremium.
Explainwithexampleshowoptionsareusedtocoverexchangerisks? Ans. Currency options provide corporate treasurer another tool for hedging foreign exchange risks arisingoutoffirmsoperations.Unlikeforwardcontract,optionsallowthehedgertogainfromfavorable exchange rate movements, while been unprotected from unfavorable movements. However forward contractsarecostlesswhileoptionsinvolveupfrontpremiumcost. a)HedgingaForeignCurrencywithcalls. In late February an American importer anticipates a yen payment of JYP 100 million to a Japanese suppliersometimelateinMay.ThecurrentUSD/JYPspotis0.007739(whichimpliesaJYP/USDrateof 129.22.). A June yen call option on the PHLX, with strike price of $0.0078 per yen is available for a premium of 0.0108 cents per yen or $0.000108 per yen. Each yen contract is for JPY 6.25 million. Premiumpercontractistherefore:$(0.000108*6250000)=$675.
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Thefirmdecidestopurchase16callsforapremiumof$10800.Inadditionthereisabrokeragefeeof $20percontract.Thusthetotalexpenseinbuyingtheoptionis$11,120.Thefirmhasineffectensured thatitsbuyingrateforyenwillnotexceed$0.0078+$(11120/100,000,000)=$0.0078112peryen. Thepricethefirmwillactuallyenduppayingforyendependsonthespotrateatthetimeofpayment .Forfurtherclarificationthefollowing2e.g.areconsidered: 1. Yen depreciates to $0.0075 per yen (Yen / $ 133.33) in late May when the payment becomes due.Thefirmwillnotexerciseitsoptions.Itcansell16callsinthemarketprovidedtheresale valueexceedsthebrokeragecommissionitwillhavetopay.(TheJunecallswillstillhavesome positivepremium).Itbuysyeninthespotmarket.Inthiscasethepriceperyenitwillhavepaid is$0.0075+$0.0000112${(Saleofvalueoptions320)/100000000} Iftheresalevalueoftheoptionsislessthan$320,itwillsimplylettheoptionslapse.Inthiscasethe effectiveratewillbe$0.0075112peryenoryen133.13per$.Itwouldhavebeenbettertoleavethe payable uncovered. The forward purchase at $0.0078 would have fixed the rate at that value and wouldbeworsethantheoption. 2. Yenappreciatesto$0.08 Nowthefirmcanexercisetheoptionsandprocuretheyenatthestrikepriceof$0.0078.Inaddition, therewillbetransactioncostassociatedwiththeexercise.Alternatively,itcanselltheoptionand buytheyeninthespotmarket.AssumethatJuneyencallsaretradingat$0.00023peryeninlate May. With the latter alternative, the dollar will be $800000 $(0.00023 * 16* 6250000)+ $320= $777320.Includingthepremium,theeffectiveratethefirmhaspaidis$(0.0077732+0.0000112)= $0.0077844. b)HedgingareceivablewithaputoptionAGermanchemicalfirmhassuppliedgoodsworthPound26 million to a British customer. The payment is due in two months. The current DEM/GBP spot rate is 2.8356 and two month forward rate is 2.8050. An American put option on sterling with 3 month maturityandstrikepriceofDEM2.8050isavailableintheinterbankmarketwithapremiumofDEM 0.03persterling.Thefirmpurchasesaputoptiononpound26million.ThepremiumpaidisDEM(0.03* 26000000)=DEM780000.Therearenoothercosts. Effectively the firm has put a floor on the value of its receivable at approximately DEM 2.7750 per sterling(=2.80500.03).Againtwoe.g.areconsidered: 1. The pound sterling depreciates to DEM 2.7550 .The firm exercises its put option and delivers pound26milliontothebankatthepriceof2.8050.Theeffectiverateis2.7750.Itwouldhave beenbetteroffwithaforwardcontract. SterlingappreciatestoDEM2.8575.Theoptionhasnosecondarymarketandthefirmallowsittolapse. Itsellsthereceivableinthespotmarket.Netofthepremiumpaid,itobtainsaneffectiverateof2.8275, CompiledbyMANAGEMENTPARADISETEAM. Page125
which is better than forward rate. If the interest forgone on premium payment is accounted for, the superiorityoftheoptionovertheforwardcontractwillbeslightlyreduced.
FUTURES&OPTIONS
A futures contract is an agreement between two parties to buy or sell an asset at a certain specified timeinfutureforcertainspecifiedprice.Inthis,itissimilartoaforwardcontract.However,therearea numberofdifferencesbetweenforwardsandfutures.Theserelatetothecontractualfeatures,theway themarketsareorganized,profilesofgainsandlosses,kindsofparticipantsinthemarketsandtheways inwhichtheyusethetwoinstruments. Futures contracts in physical commodities such as wheat, cotton, corn, gold, silver, cattle, etc. have existed for a long time. Futures in financial assets, currencies, interest bearing instruments like Tbills and bonds and other innovations like futures contracts in stock indexes are a relatively new development dating back mostly to early seventies in the United States and subsequently in other marketsaroundtheworld. MajorFeaturesOfFuturesContracts Theprincipalfeaturesofthecontractareasfollows: CompiledbyMANAGEMENTPARADISETEAM. Page126
OrganizedExchanges
Unlike forward contracts which are traded in an overthecounter market, futures are traded on organized exchanges with a designated physical location where trading takes place. This provides a ready,liquidmarketinwhichfuturescanbeboughtandsoldatanytimelikeinastockmarket. Standardization Inthecaseofforwardcurrencycontracts,theamountofcommoditytobedeliveredandthematurity datearenegotiatedbetweenthebuyerandsellerandcanbetailormadetobuyer'srequirements.Ina futurescontractboththesearestandardizedbytheexchangeonwhichthecontractistraded.Thus,for instance,onefuturescontractinpoundsterlingontheInternationalMonetaryMarket(IMM),afinancial futures exchange in the US, (part of the Chicago Board of Trade or CBT), calls fore delivery of 62,500 BritishPoundsandcontractsarealwaystradedinwholenumbersi.e.youcannotbuyorsellfractional contracts. A threemonth sterling deposit on the London International Financial Futures Exchange (LIFFE)hasMarch,June,September,Decemberdeliverycycle.Theexchangealsospecifiestheminimum sizeofpricemovement(calledthe"tick")and,insomecases,mayalsoimposeaceilingonthemaximum price change within a day. In the case of commodity futures, the commodity in question is also standardizedforqualityinadditiontoquantityinasinglecontract. ClearingHouse Theexchangeactsasaclearinghousetoallcontractsstruckonthetradingfloor.Forinstance,acontract isstruckbetweenAandB.Uponenteringintotherecordsoftheexchange,thisisimmediatelyreplaced bytwocontracts,onebetweenAandtheclearinghouseandanotherbetweenBandtheclearinghouse. Inotherwords,theexchangeinterposesitselfineverycontractanddeal,whereitisabuyertoevery sellerandasellertoeverybuyer.TheadvantageofthisisthatAandBdonothavetoundertakeany exercise to investigate each other's creditworthiness. It also guarantees the financial integrity of the market.Theexchangeenforcesdeliveryforcontractshelduntilmaturityandprotectsitselffromdefault riskbyimposingmarginrequirementsontradersandenforcingthisthroughasystemcalled"markingto market". Margins Likeallexchanges,onlymembersareallowedtotradeinfuturescontractsontheexchange.Otherscan usetheservicesofthemembersasbrokerstousethisinstrument.Thus,anexchangemembercantrade onhisownaccountaswellasonbehalfofaclient.Asubsetofthemembersisthe"clearingmembers" ormembersoftheclearinghouseandnonclearingmembersmustclearalltheirtransactionsthrougha clearingmember. The exchange requires that a margin must be deposited with the clearinghouse by a member who entersintoafuturescontract.Theamountofthemarginisgenerallybetween2.5%to10%ofthevalue CompiledbyMANAGEMENTPARADISETEAM. Page127
ofthecontractbutcanvary.Amemberactingonbehalfofaclient,inturn,requiresamarginfromthe client.Themargincanbeintheformofcashorsecuritiesliketreasurybillsorbanklettersofcredit. MarkingToMarket The exchange uses a system called marking to market where, at the end of each trading session, all outstandingcontractsarerepricedatthesettlementpriceofthattradingsession.Thiswouldmeanthat some participants would make a loss while others would stand to gain. The exchange adjusts this by debitingthemarginaccountsofthosememberswhomadealossandcreditingtheaccountsofthose memberswhohavegained. Thisfeatureoffuturestradingcreatesanimportantdifferencebetweenforwardcontractsandfutures. In a forward contract, gains or losses arise only on maturity. There are no intermediate cash flows. Whereas,inafuturescontract,eventhoughthegainsandlossesarethesame,thetimeprofileofthe accruals is different. In other words, the total gains or loss over the entire period is broken up into a dailyseriesofgainsandlosses,whichclearlyhasadifferentpresentvalue. ActualDeliveryIsRare In most forward contracts, the commodity is actually delivered by the seller and is accepted by the buyer.Forwardcontractsareenteredintoforacquiringordisposingoffacommodityinthefuturefora gainatapriceknowntoday.Incontrasttothis,inmostfuturesmarkets,actualdeliverytakesplacein lessthanonepercentofthecontractstraded.Futuresareusedasadevicetohedgeagainstpricerisk and as a way of betting against price movements rather than a means of physical acquisition of the underlyingasset.Toachievethis,mostofthecontractsenteredintoarenullifiedbyamatchingcontract intheoppositedirectionbeforematurityofthefirst. Typesoffutures As is evident from the previous discussion, trading in futures is equivalent to betting on the price movementsinfuturesprices.Ifsuchbettingisusedtoprotectapositioneitherlongorshortinthe underlyingasset,itistermedashedging.Ontheotherhand,iftheactivityisundertakenonlywiththe objectiveofgeneratingprofitsfromabsoluteorrelativepricemovements,itistermedasspeculation.It must be noted that speculators provide liquidity to the markets by their willingness to enter open positions. Weshallbrieflylookatcurrency,interestrateandstockindexfutures.Thereareotherslikecommodity futuresaswellwhicharenotcoveredunderthissection. CurrencyFutures
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Weshalllookatbothhedgingandspeculationincurrencyfutures.Corporations,banksandothersuse currencyfuturesforhedgingpurposes.Theunderlyingprincipleisasfollows: Assumethatacorporationhasanassete.g.areceivableinacurrencyAthatitwouldliketohedge,it shouldtakeafuturespositionsuchthatfuturesgenerateapositivecashwhenevertheassetdeclinesin value. In this case, since the firm in long, in the underlying asset, it should go short in futures i.e. it shouldsellfuturescontractsinA.Obviously,thefirmcannotgainfromanappreciationofAsincethe gainonthereceivablewillbeeatenawaybythelossonthefutures.Thehedgeriswillingtosacrificethis potentialprofittoreduceoreliminatetheuncertainty.Conversely,afirmwithaliabilityincurrencyA e.g.apayable,shouldgolonginfutures. Inhedgingtoo,thecorporationhastheoptionofadirecthedgeandacrosshedge.ABritishfirmwitha dollar payable can hedge by selling sterling futures (same effect as buy dollar futures) on the IMM or LIFFE.Thisisanexampleofadirecthedge.Ifthedollarappreciates,itwillloseonthepayablebutgain onthefutures,asthedollarpriceoffutureswilldecline. Anexampleofacrosshedgeisasfollows: ABelgianfirmwithadollarpayablecannothedgebysellingBelgianfrancfuturesbecausetheyarenot traded.However,sincetheBelgianfranciscloselytiedtotheDeutschemarkintheEuropeanMonetary System(EMS).ItcansellDMfutures. An important point to note is that, in a cross hedge, a firm must choose a futures contract on an underlyingcurrencythatishighlypositivelycorrelatedwiththecurrencyexposurebeinghedged. Also,evenwhenadirecthedgeisavailable,itisextremelydifficulttoachieveaperfecthedge.Thisis duetotworeasons.Oneisthatfuturescontractsareforstandardizedamountsasthisisdesignedbythe exchange.Evidently,thiswillonlyrarelymatchtheexposureinvolved.Thesecondreasoninvolvesthe conceptofbasisrisk.Thedifferencebetweenthespotpriceatinitiationofthecontractandthefutures priceagreeduponiscalledthebasis.Overthetermofthecontract,thespotpricechanges,asdoesthe futures price. But the change is not always perfectly correlated in other words, the basis is not constant.Thisgivesrisetothebasisrisk.Basisriskisdealtwiththroughthehedgeratioandastrategy calleddeltahedging. Aspeculatortradesinfuturestoprofitfrompricemovements.Theyholdviewsaboutthefutureprice movements if these differ from those of the general market, they will trade to profit from this discrepancy.Theflipsideisthattheyarewillingtotaketheriskofalossifthepricesmoveagainsttheir viewsofopinions. Speculationusingfuturescanbeintheeitheropenpositiontradingorspreadtrading.Intheformer,the speculator is betting on movements in the price of a particular futures contract. In the latter, he is bettingonthepricedifferentialbetweentwofuturescontracts. CompiledbyMANAGEMENTPARADISETEAM. Page129
Anexampleofopenpositiontradingisasfollows: $/DMPrices Spot MarchFutures JuneFutures SeptemberFutures 0.5785 0.5895 0.5915 0.6015
ThesepricesevidentlyindicatethatthemarketexpectstheDMtoappreciateoverthenext67months. Ifthereisaspeculatorwhoholdstheoppositeviewi.e.hebelievesthattheDMisactuallygoingto depreciate.ThereisanotherspeculatorwhobelievesthattheDMwillappreciatebutnottotheextent that the market estimates in other words, the appreciation of the DM will fall short of market expectations.BoththesespeculatorssellaSeptemberfuturescontract(standardsizeDM125,000)at$ 0.6015. OnSeptember10,thefollowingratesprevail: Spot$/DM0.5940,SeptemberFutures0.5950 BothspeculatorsreversetheirdealwiththepurchaseofaSeptemberfuturescontract.Theprofitthey makeisasfollows: $(0.60150.5950)i.e.$0.0065perDMor$(125000x0.0065)i.e.$812.5percontract. Apointtobenotedintheaboveexampleisthatthefirstspeculatormadeaprofitinspitethefactthat his forecast was faulty. What mattered therefore, was the movement in September futures price relativetothepricethatprevailedonthedaythecontractwasinitiated. In contrast to the open position trading, spread trading is considered a more conservative form of speculation. Spread tradinginvolvesthepurchase ofonefuturescontractandthesaleofanother.An intracommodityspreadinvolvesdifferenceinpricesoftwofuturescontractwiththesameunderlying commodity and different maturity dates. These are also termed as time spreads. An intercommodity spreadinvolvesthedifferenceinpricesoftwofuturescontractswithdifferentbutrelatedcommodities. Theseareusuallywiththesamematuritydates. InterestRateFutures
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Interestratefuturesisoneofthemostsuccessfulfinancialinnovationsinrecentyears.Theunderlying asset is a debt instrument such as a treasury bill, a bond or time deposit in a bank. The International Monetary Market (IMM) a part of the Chicago Mercantile Exchange, has futures contracts on US Government treasury bonds, threemonth Eurodollar time deposits and medium term US treasury notes among others. The LIFFE has contracts on eurodollar deposits, sterling time deposits and UK Governmentbonds.TheChicagoBoardofTradeofferscontractsonlongtermUStreasurybonds. Interest rate futures are used by corporations, banks and financial institutions to hedge interest rate risk.AcorporationplanningtoissuecommercialpapercanuseTbillfuturestoprotectitselfagainstan increase in interest rate. A treasurer who is expecting some surplus cash in the near future to be investedinsomeshortterminvestmentsmayusethesameasinsuranceagainstafallininterestrates. Speculatorsbetoninterestratemovementsorchangesinthetermstructureinthehopeofgenerating profits. A complete analysis of interest rate futures would be a complex exercise as it involves thorough understanding and familiarity with concepts such as discount yield, yieldtomaturity and elementary mathematicsofbondvaluationandpricing. StockIndexFutures A stock index futures contract is an obligation to deliver on the settlement date an amount of cash equivalenttothevalueof500timesthedifferencebetweenthestockindexvalueatthecloseofthelast trading day of the contract and the price at which the futures contract was originally struck. For example,iftheS&P500StockIndexisat500andeachpointintheindexequals$500,acontractstruck at this level is worth $ 250,000 (500 * $500). If, at the expiration of the contract, the S&P 500 Stock Indexisat520,acashsettlementof$10,000istobemade[(520510)*$500]. Itmustbenotedthatnophysicaldeliveryofstockismade.Therefore,inordertoensurethatsufficient funds are available for settlement, both parties have to maintain the requisite deposit and meet the variationmargincallsasandwhenrequired. Options Aoptionsagreementisacontractinwhichthewriteroftheoptiongrantsthebuyeroftheoptionthe rightpurchasefromorselltothewriteradesignatedinstrumentforaspecifiedpricewithinaspecified periodoftime. The writer grants this right to the buyer for a certain sum of money called the option premium. An option that grants the buyer the right to buy some instrument is called a call option. An options that grantsthebuyertherighttosellaninstrumentiscalledaputoption.Thepriceatwhichthebuyeran exercisehisoptioniscalledtheexerciseprice,strikepriceorthestrikingprice.
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Options are available on a large variety of underlying assets like common stock, currencies, debt instrumentsandcommodities.Alsotradedareoptionsonstockindicesandfuturescontractswhere theunderlyingisafuturescontractandfuturesstyleoptions. Optionshaveprovedtobeaversatileandflexibletoolforriskmanagementbythemselvesaswellasin combination with other instruments. Options also provide a way for individual investors with limited capital to speculate on the movements of stock prices, exchange rates, commodity prices etc. The biggestadvantageinthiscontextisthelimitedlossfeatureofoptions. TypesOfOptions Asmentionedearlier,theunderlyingassetforoptionscouldbeaspotcommodityorafuturescontract onacommodity.Anothervarietyisthefuturesstyleoption. Anoptiononspotforeignexchangegivestheoptionbuyertherighttobuyorsellacurrencyatastated price (in terms of another currency). If the option is exercised, the option seller must deliver or take deliveryofacurrency. Anoptiononcurrencyfuturesgivestheoptionbuyertherighttoestablishalongorshortpositionina currencyfuturescontractataspecifiedprice.Iftheoptionisexercised,thesellermusttaketheopposite positionintherelevantfuturescontract.Forexample,supposeyouhadanoptiontobuyaDecember DMcontractontheIMMatapriceof$0.58/DM.YouexercisetheoptionwhenDecemberfuturesare tradingat$0.5895.Youcancloseoutyourpositionatthispriceandtakeaprofitof$0.0095perDMor, meet futures margin requirements and carry a long position with $ 0.0095 per DM being credited to yourmarginaccount.TheoptionsellerautomaticallygetsashortpositioninDecemberfutures. Futuresstyleoptionsarealittlebitmorecomplicated.Likefuturescontracts,theyrepresentabetona price. The price being betted on, is the price of an option on spot foreign exchange. Simply put, the buyerofthe optionhastopayapricetotheselleroftheoptioni.e.thepremiumorthe priceofthe option.Inafuturesstyleoption,youarebettingonthechangesinthisprice,which,inturndependson several factors including the spot exchange rate of the currency involved. For instance, a trader feels that the premium on a particular option is going to increase. He buys a futuresstyle call option. The seller of this call option is betting that the premium will go down. Unlike the option on the spot, the buyerdoesnotpaythepremiumtotheseller.Instead,theybothpostmarginsrelatedtothevalueof thecallonspot. OptionsTerminology To reiterate, the two parties to an options contract are the option buyer and the option seller, also calledtheoptionwriter.Forexchangetradedoptions,asinthecaseoffutures,oncetheagreementis reached between two traders, the exchange (the clearing house) interposes itself between the two parties becoming buyer to every seller and seller to every buyer. The clearing house guarantees performanceonthepartofeveryseller. CompiledbyMANAGEMENTPARADISETEAM. Page132
CallOption
AcalloptiongivestheoptionbuyertherighttopurchasecurrencyYagainstcurrencyX,atastatedprice X/Y, on or before a stated date. For exchange traded options, one contract represents a standard amount of the currency Y. The writer of a call option must deliver the currency if the option buyer choosestoexercisehisoption. PutOption AputoptiongivestheoptionbuyertherighttosellacurrencyYagainstcurrencyXataspecifiedprice onorbeforeaspecifieddate.Thewriterofaputoptionmusttakedeliveryiftheoptionisexercised. StrikePrice(alsocalledexerciseprice) Thepricespecifiedintheoptioncontractatwhichtheoptionbuyercanpurchasethecurrency(call)or sellthecurrency(put)YagainstX. MaturityDate The date on which the option contract expires is the maturity date. Exchange traded options have standardizedmaturitydates. AmericanOption Anoption,callorput,thatcanbeexercisedbythebuyeronanybusinessdayfrominitiationtomaturity. EuropeanOption AEuropeanoptionisanoptionthatcanbeexercisedonlyonmaturitydate. Premium(Optionprice,Optionvalue) The fee that the option buyer must pay the option writer at the time the contract is initiated. If the buyerdoesnotexercisetheoption,hestandstolosethisamount. Intrinsicvalueoftheoption Theintrinsicvalueofanoptionisthegaintotheholderonimmediateexerciseoftheoption.Inother words,foracalloption,itisdefinedasMax[(SX),0],wheresisthecurrentspotrateandXisthestrike rate.IfSisgreaterthanX,theintrinsicvalueispositiveandisSislessthanX,theintrinsicvaluewillbe CompiledbyMANAGEMENTPARADISETEAM. Page133
zero.Foraputoption,theintrinsicvalueisMax[(XS),0].InthecaseofEuropeanoptions,theconcept ofintrinsicvalueisnotionalastheseoptionsareexercisedonlyonmaturity. Timevalueoftheoption The value of an American option, prior to expiration, must be at least equal to its intrinsic value. Typically,itwillbegreaterthantheintrinsicvalue.Thisisbecausethereissomepossibilitythatthespot pricewillmovefurtherinfavoroftheoptionholder.Thedifferencebetweenthevalueofanoptionat anytime"t"anditsintrinsicvalueiscalledthetimevalueoftheoption. AttheMoney,IntheMoneyandOutoftheMoneyOptions AcalloptionissaidtobeatthemoneyifS=Xi.e.thespotpriceisequaltotheexerciseprice.Itisinthe money is S>X and outofthemoney is S<X. Conversely, a put option is atthemoney is S=X, inthe moneyifS<XandoutofthemoneyifS>X. OptionPricing Black & Scholes, in their celebrated analysis on option pricing, reached the conclusion that the estimatedpriceofacallcouldbecalculatedwiththefollowingequation: Pc=[Ps][N(d1)[Pe][antilog(Rft)[N(d2)] Where: Pcmarketvalueofthecalloption Pspriceofthestock Pestrikepriceoftheoption Rfannualizedinterestrate ttimetoexpirationinyears antilogtothebasee N(d1)andN(d2)arethevaluesofthecumulativenormaldistribution,definedasfollows: d1=Ln(Ps/Pe)+(Rf+0.5s2)t st d2=d1(st) where:
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Ln(Ps/Pe)isthenaturallogarithmof(Ps/Pe) s2istheisthevarianceofcontinuouslycompoundedrateofreturnonstockpertimeperiod.
Admittedly, the definitions of d1 and d2 are difficult to grasp for the reader as they involve complex mathematical equations. However, the basic properties of the BlackScholes model are easy to understand. What the model establishes is that the estimated price of options vary directly with an options term to maturity and with the difference between the stocks market price and the options strikeprice.Further,thedefinitionsofd1andd2indicatethatoptionpricesincreasewiththevariance oftherateofreturnonthestockprice,reflectingthatthegreaterthevolatility,higherthechancethat theoptionwillbecomemorevaluable. RelationshipBetweenTheOptionPremiumAndStockPrice It is obvious that the option premium fluctuates as the stock price moves above or below the strike price. Generally, option premiums rarely move point for point with the price of the underlying stock. Thistypicallyhappensonlyatparity,inotherwords,whentheexercisepriceplusthepremiumequals themarketpriceofthestock. Priortoreachingparity,premiumstendtoincreaselessthanpointperpointwiththestockprice.One reasonforthisarethatpointperpointincreaseinpremiumwouldresultinsharplyreducedleveragefor the option buyers reduced leverage means reduced demand for the option. Also, a higher option premiumentailsincreasedcapitaloutlayandincreasedrisk,onceagainreducingdemandfortheoption. Declining stock prices also do not result in a point per point decrease in option premium. This is because,evenasteepdeclineinthestockpriceinaspanofafewdayshasonlyaslighteffectonthe optionstotalvalueitstimevalue.Thistermtomaturityeffecttendstoexistastheoptionisawasting asset. OptionStrategies Thissectiondealswithsomeofthemostbasicstrategiesthatcanbedevisedusingoptions.Theideais to familiarize the reader with the flexibility of options as a risk management tool. In order to keep matterssimple,wemakethefollowingassumptions:

Weshallignorebrokerage,commissions,marginsetc. Weshallassumethattheoptionisexercisedonlyonmaturityandnotprematurelyexercisein otherwords,weassumethatweareonlydealingwithEuropeanoptions Allexchangerates,strikepricesandpremiawillbeintermsofdollarsperunitofacurrencyand theoptionwillbeassumedtobeononeunitofthecurrency.
CallOptions
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Acalloptionbuyer'sprofitcanbedefinedasfollows: AtallpointswhereS<X,thepayoffwillbec AtallpointswhereS>X,thepayoffwillbeSXc,where S=Spotprice X=Strikepriceorexerciseprice c=calloptionpremium Conversely,theoptionwriter'sprofitwillbeasfollows: AtallpointswhereS<X,thepayoffwillbec AtallpointswhereS>X,thepayoffwillbe(SXc) Toillustratethis,letuslookatanexampleandconstructthepayoffprofile.
Consider a trader who buys a call option on the Swiss Franc with a strike price of $ 0.66 and pays a premiumof 1.95cents($0.0195).The currentspot rateis0.6592.Hisgainorlossattime Twhenthe optionexpiresdependsuponthevalueofthespotrateatthattime. ForallvaluesofSbelow0.66,theoptionbuyerletstheoptionlapsesincetheSwissfrancscanbebough inthespotmarketatalowerprice.Hislossthenwillbelimitedtothepremiumhehaspaid.Forspot valuesgreaterthanthestrikeprice,hewillexercisetheoption. Letuslookatthepayoffprofileofthecalloptionbuyer. SpotRate 0.6000 0.6500 0.6600 0.6700 0.6795 0.6800 0.6900 0.7000 Gain(SXc) 0.0005 0.0105 0.0205 Loss(c) 0.0195 0.0195 0.0195 0.0195
Similarly,wecanconstructthepayoffprofileforthecallwriter.Thiswillbeasfollows: SpotRate Gain(c) Loss(SXc) Page136
0.6000 0.6500 0.6600 0.6700 0.6795 0.6800 0.6900 0.7000 PutOption Aputoptionbuyer'sprofitcanbedefinedasfollows: AtallpointswhereS<X,thepayoffwillbeXSp AtallpointswhereS>X,thepayoffwillbep,where S=Spotprice X=Strikepriceorexerciseprice p=putoptionpremium Conversely,theputoptionwriter'sprofitwillbeasfollows: AtallpointswhereS<X,thepayoffwillbe(XSp) AtallpointswhereS>X,thepayoffwillbep 0.0195 0.0195 0.0195 0.0195 0.0005 0.0105 0.0205
Forexample,letustakethecaseofatraderwhobuysaJuneputoptiononpoundsterlingatastrike priceof$1.7450,forapremiumof$0.05persterling.Thespotrateatthattimeis$1.7350. ForallvaluesofSgreaterthan$1.7450,theoptionwillnotbeexercisedasthesterlinghasahigherprice inthespotmarket.Forvaluesbetween$1.6950and$1.7450,theoptionwillbeexercised,thoughthere willstillbealoss.Heretheoptionbuyeristryingtominimizetheloss.Forvaluesofspotratebelow$ 1.6950,theoptionwillbeexercisedandwillleadtoanetprofit. Atexpiry,theputoptionbuyer'spayoffprofilecanbedepictedasfollows: SpotRate 1.6600 1.6800 Gain(XSp) 0.0350 0.0150 Loss(p) Page137
1.6900 1.6950 1.7400 1.7500 1.7800 1.8000 0.0050 0.0450 0.0500 0.0500 0.0500
Similarly, we can construct a payoff profile for the put option writer. His gains and losses will look as follows: SpotRate 1.6600 1.6800 1.6900 1.6950 1.7400 1.7500 1.7800 1.8000 Gain(p) 0.0450 0.0500 0.0500 0.0500 Loss(XSp) 0.0350 0.0150 0.0050
SpreadStrategies Spreadstrategieswithoptionsinvolvesimultaneoussaleandpurchaseoftwodifferentoptioncontracts. Theobjectiveinthesestrategiesistorealizeaprofitiftheunderlyingpricemovesinafashionthatis expectedandtolimitthemagnitudeoflossincaseitmovesinanunexpectedfashion.Evidently,these arespeculativeinnature.However,thesestrategiesaresuchthattheyprovidelimitedgainswhilealso ensuringlimitedlosses. Spread strategies involving options with same maturity but different strike prices are called vertical spreads or price spreads. The types of vertical spread strategies are bullish call spreads, bearish call spreads,bullishputspreadsandbearishputspreads.Theexpectationwhengoinginforthesestrategies isthattheunderlyingrateislikelytoeitherappreciateordepreciatesignificantly. Horizontalortimespreadstrategiesinvolvesimultaneousbuyingandsellingoftwooptionswhichare similarinallrespectsexceptinmaturity.Thebasicideabehindthisisthatthetimevalueoftheshort maturityoptionwilldeclinefasterthanthatofthelongmaturityoption.Theexpectationwhengoingfor CompiledbyMANAGEMENTPARADISETEAM. Page138
thisstrategyisthattheunderlyingpricewillnotchangedrasticallybutthedifferenceinpremiawillover time. VerticalSpreadStrategies Abullishcall consistsofsellingthecall withthehigherstrikepriceandbuyingthecallwiththelower strike price. The expectation is the underlying currency is likely to appreciate. The investor however, wouldliketolimithislosses. Sincealowerpricedcallisbeingboughti.e.higherpremiumispaidandahigherpricedcallisbeingsold i.e.lowerpremiumisreceived,theinitialnetinvestmentwouldbethedifferenceinthetwopremia.The maximum profit potential will be the difference in the strike prices minus the initial investment. The maximum loss is the initial investment. This strategy thus yields a limited profit if the currency appreciatesandalimitedlossifthecurrencydepreciates. Ontheotherhand,iftheinvestorexpectsthecurrencytodepreciate,hecangoinforthebearishcall spread.Thisisthereverseofthebullishspreadi.e.thecallwiththehigherstrikepriceisboughtandthat withthelowerstrikepriceissold.Themaximumgainwillbethedifferenceinthepremia.Themaximum losswillbethedifferenceispremiaminusthedifferenceinthestrikeprices. Abullishputspreadconsistsofsellingaputoptionwithhigherstrikepriceandbuyingaputoptionwith alowerstrikeprice.Inthiscase,ifthereisasignificantappreciationintheunderlyingrate,neitherput willbeexercisedandthenetgainwillbethedifferenceinpremia.Maximumlosswillbethedifference in strike prices minus the difference in premia. A bearish put spread is the opposite of a bullish put spread. An extension of the idea of vertical spreads is the butterfly spread. A butterfly spread involves three optionswithdifferentstrikepricesbutsamematurity.Abutterflyspreadisboughtbypurchasingtwo calls with the middle strike price and selling one call each with the strike price on either side. The investor's expectation is that there will be a significant movement in the underlying rate he is, however, unsure of the direction of this movement. This strategy yields a limited profit if there is a significant movement in the underlying rate appreciation or depreciation. But if the movements are moderateornotverysignificant,ittendstoresultinaloss. Sellingabutterflyspreadinvolvessellingtwointermediatepricedcallsandbuyingoneoneitherside.As opposed to the buyer of a butterfly spread, the seller here is betting on moderate or nonsignificant movements.Hedoesnotexpectdrasticmovementseitherway.Therefore,thisstrategyyieldsasmall profit if there are moderate changes in the exchange rate and a limited loss if there are large movementsoneitherside. HorizontalOrTimeSpreads
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As mentioned earlier, horizontal or time spread strategies involve simultaneous buying and selling of two options which are similar in all respects except in maturity. The basic idea behind this is that the timevalueoftheshortmaturityoptionwilldeclinefasterthanthatofthelongmaturityoption. StraddlesAndStrangles AStraddlestrategyconsistsofbuyingacallandaputbothwithidenticalstrikesandmaturity.Ifthereis a drastic depreciation, the investor gains on the put i.e. by exercising the option to sell. If there is a drasticappreciation,theinvestorexercisesthecallandpurchasesatthelowerprice.However,ifthereis amoderatemovementeitherway,theinvestorwillsufferaloss. Astrangleissimilartoastraddle.Itconsistsofbuyingacallwithstrikeabovethecurrentspotrateanda putwithastrikepricebelowthecurrentspot.Likethestraddle,ityieldsaprofitfordrasticmovements andalossformoderatemovements. Currencyoptionsthus,providethecorporatetreasureratoolforhedgingforeignexchangerisksarising out of the firm's operations. Unlike the forward contracts, options allow the hedger to gain from favorableexchangeratemovementswhilebeingprotectedagainstunfavorablemovements
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Swaps
Financial swaps are a funding technique, which permit a borrower to access one market and then exchange the liability for another type of liability. The global financial markets present borrowers and investors with a wide variety of financing and investment vehicles in terms of currency and type of coupon fixed or floating. Floating rates are tied to an index which could be the London Interbank borrowing rate (LIBOR), US treasury bill rate etc. This helps investors exchange one type of asset for anotherforapreferredstreamofcashflows. Itmustbenotedthatswapsbythemselvesarenotafundinginstrument;theyareadevicetoobtainthe desired form of financing indirectly. The borrower might otherwise have found this too expensive or eveninaccessible. Acommonexplanationforthepopularityofswapsconcernstheconceptofcomparativeadvantage.The basic principle is that some companies have a comparative advantage when borrowing in fixed rate marketswhileothercompanieshaveacomparativeadvantageinfloatingratemarkets.Thismayleadto some companies borrowing in fixed markets when the need is of a floating rate loan and vice versa. Swapsareusedtotransformthefixedrateloanintoafloatingrateloan. TypesOfSwaps All swaps involve exchange of a series of periodic payments between two parties. A swap transaction usually involves an intermediary who is a large international financial institution. The two payment streamsareestimatedtohaveidenticalpresentvaluesattheoutsetwhendiscountedattherespective costoffundsintherelevantmarkets. Thetwomostwidelyprevalenttypesofswapsareinterestrateswapsandcurrencyswaps.Athirdisa combinationofthetwotoresultincrosscurrencyinterestrateswaps.Ofcourse,anumberofvariations arepossibleundereachofthesemajortypesofswaps. InterestRateSwaps Aninterestrateswapasthenamesuggestsinvolvesanexchangeofdifferentpaymentstreamswhich fixedandfloatinginnature.Suchanexchangeisreferredtoasaexchangeofborrowingsoracoupon swap. In this, one party, B, agrees to pay to the other party, A, cash flows equal to interest at a predeterminedfixedrateonanotionalprincipalforanumberofyears.Atthesametime,partyAagrees topaypartyBcashflowsequaltointerestatafloatingrateonthesamenotionalprincipalforthesame periodoftime.Thecurrenciesofthetwosetsofinterestcashflowsarethesame.Thelifeoftheswap can range from two years to over 15 years. This type of a standard fixed to floating rate swap is also calledaplainvanillaswapinthemarketjargon.
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London Interbank Offer Rate (LIBOR) is often the floating interest rate in many of the interest rate swaps. LIBOR is the interest rate offered by banks on deposits from other banks in the Eurocurrency markets. LIBOR is determined by trading between banks and changes continuously as the economic conditionschange.JustasthePrimeLendingRate(PLR)isusedasthebenchmarkorthepegformany Indian floating rate instruments, LIBOR is the most frequently used reference rate in international markets. Usually, two nonfinancial companies do not get in touch with each other to directly arrange a swap. Theyeachdealwithafinancialintermediarysuchasabankwhothenstructurestheplainvanillaswapin suchawaysoastoearnthemamarginoraspread.Ininternationalmarkets,theytypicallyearnabout3 basispoints(0.03%)onapairofoffsettingtransactions. Atanygivenpointoftime,theswapspreadsaredeterminedbysupplyanddemand.Ifmoreparticipants intheswapmarketswanttoreceivefixedratherthanfloating,swapspreadstendtofall.Ifthereverseis true,theswapspreadstendtorise. Inreallife,itisdifficulttoenvisageasituationwheretwocompaniescontactafinancialinstitutionat exactly the same time with the proposal to take opposite positions in the same swap. Most large financial institutions are therefore prepared tow are house interest rate swaps. This involves entering intoaswapwithacounterparty,thenhedgingtheinterestrate riskuntilanoppositecounterpartyus found.Interestratefuturecontractsareresortedtoasahedgingtoolinsuchcases. CurrencySwaps Currencyswapsinvolvesexchangingprincipalandfixedrateinterestpaymentsonaloaninonecurrency forprincipalandfixedrateinterestpaymentsonanapproximatelyequivalentloaninanothercurrency. SupposethatacompanyAandcompanyBareofferedthefixedfiveyearratesofinterestinU.S.dollars andsterling.Alsosupposethatsterlingratesaregenerallyhigherthanthedollarrates.Also,companyA enjoysabettercreditworthinessthancompanyBasitisofferedbetterratesonbothdollarandsterling. Whatisimportanttothetraderwhostructurestheswapdealisthatdifferenceintheratesofferedto thecompaniesonbothcurrenciesisnotthesame.Therefore,thoughcompanyAhasabetterdealin both the currency markets, company B does enjoy a comparatively lower disadvantage in one of the markets. This creates an ideal situation for a currency swap. The deal could be structured such that companyBborrowsinthemarketinwhichithasalowerdisadvantageandcompanyAinwhichithasa higheradvantage.Theyswaptoachievethedesiredcurrencytothebenefitofallconcerned. A point to note is that the principal must be specified at the outset for each of the currencies. The principalamountsareusuallyexchangedatthebeginningandtheendofthelifeoftheswap.Theyare chosensuchthattheyareequalattheexchangerateatthebeginningofthelifeoftheswap. Like interest rate swaps, currency swaps are frequently warehoused by financial institutions that carefullymonitortheirexposureinvariouscurrenciessothattheycanhedgetheircurrencyrisk. CompiledbyMANAGEMENTPARADISETEAM. Page142
OtherSwaps
A swap in its most general form is a contract that involves the exchange of cash flows according to a predeterminedformula.Thereisnolimittothenumberofinnovationsthatcanbemadegiventhisbasic structureoftheproduct. Oneinnovationisthatprincipalinaswapagreementcanbevariedthroughoutthetermoftheswapto meettheneedsofthetwoparties.Inanamortizingswap,theprincipalreducesinapredeterminedway. This could be designed to correspond to the amortization schedule on a particular loan. Another innovation could be the deferred or forward swaps where the two parties do not start exchanging interestpaymentsuntilsomefuturedate. Another innovation is the combination of the interest and currency swaps where the two parties exchangeafixedratecurrencyApaymentforafloatingratecurrencyBpayment. Swapsarealsoextendable,whereonepartyhastheoptiontoextendthelifeoftheswaporputtable, where one party has the option to terminate the swap before its maturity. Options on swaps or Swaptions,arealsogaininginpopularity. Aconstantmaturityswap(CMS)isanagreementtoexchangeaLIBORrateforaswaprate.Foeexample, anagreementtoexchange6monthLIBORforthe10yearswaprateeverysixmonthsforthenextfive yearsisaCMS.Similarly,aconstantmaturitytreasuryswap(CMT)involvesswappingaLIBORratefora treasuryrate.Anequityswapisanagreementtoexchangethedividendsandcapitalgainsrealizedon anequityindexforeitherafixedorfloatingrateofinterest. These are only a few of the innovations in swaps that exist in the financial markets. The above have beenmentionedtounderscorethefactthatswapsandotherderivativesthathavebeendealtwithin thismoduleareallbornoutofnecessityorneedsofthemanyparticipantsintheinternationalfinancial market.
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BALANCEOFTRADE CompiledbyMANAGEMENTPARADISETEAM. Page3

ItisalsoworthrememberingthatBOPoncurrentaccountcoversallthereceiptsonaccountof earnings(oropposedtoborrowings)andallthepaymentsarisingoutofspending(asopposed tolending).ThereisnoreverseflowentailedintheBOPoncurrentaccounttransactions.

3. TransferPayments a. Official CompiledbyMANAGEMENTPARADISETEAM.

MANAGEDFLOATINGEXCHANGERATES Valueofthepounddeterminedbymarketdemandforandsupplyofthecurrencywith nopredeterminedtargetfortheexchangerateissetbytheGovernment Governmentsnormallyengageinmanagedfloatingifnotpartofafixedexchangerate system. Policypursuedfrom197390andsincetheERMsuspensionfrom19931998

NakedIntervention Acentralbanktypeofinterventionintheforeignexchangemarketwhichconsistsolelyofthe foreignexchangeactivity.Thistypeofinterventionhasamonetaryeffectonthemoneysupply andalongtermeffectonforeignexchange.

IMFFinancialPolicies IMFfinancialpoliciesgovernthemodalitiesfortheuseofitsfinancialresourcesunder existingIMFfacilities.Theseinclude:

700 600 500 400 300 200 100 0 1989

Unite d State s Unite d Kingdom Japan Singapore Ge rmany

Theory of Interest Rate Parity (IRP)

International Fisher Effect (IFE)

Comparativelyshortermaturity period Borrowerscanraisefundsintheeuro currencymarketveryquickly.

Aeurobondfinancinggenerallytakesmore time,althoughherethedifferenceis becominglesssignificant Nowhoweverthevolumeofeurobond offeringismore

InternationalCapitalMarkets CompiledbyMANAGEMENTPARADISETEAM. Page61

7.PetroDollar Duringtheoilcrisesof1973,theCapitalmarketshaveplayedaveryimportantrole.Theyacceptedthe dollardepositsfromoilexportersandchanneledthefundstotheborrowersinothercountries.Thisis calledrecyclingthepetrodollars. 8.JunkBonds CompiledbyMANAGEMENTPARADISETEAM. Page62

Yankeebondscanbeofferedunderrule144aofSec.Theseissuesareexemptfromelaborate registrationanddisclosurerequirementsbutrating,whilenotmandatoryishelpful.Finallylow Page63

Someprojectswillhaveexpensesandrevenuesthatinvolveseveralcurrencies.Asaresultthe exchangerateriskisveryhigh. Projectsmaybefinancedwithfloatingrates.Inviewofthevolatilityobservedontherateslike LIBOR,theinterestrateriskisalsosignificant.Thereforeitisnecessarytoplanthecoverageof alltheserisks.

Distillationandbrewingofalcoholicdrinks Cigarsandcigarettesoftobaccoandmanufacturedtobaccosubstitutes Electronicaerospaceanddefenceequipment;alltypes Page81

1. purchaseofsharesinaforeigncompany. 2. purchaseofbondsissuedbyaforeigngovernment. 3. acquisitionofassetsinaforeigncountry. Portfolioinvestmentispartofthecapitalaccountofbalanceofpaymentsstatistics.

WorldBank: InternationalBankforReconstructionandDevelopment(IBRD) InternationalDevelopmentAssociation(IDA)

Affiliates InternationalFinanceCorporation(IFC) MultilateralInvestmentGuaranteeAgency(MIGA) Page88

Sometypicalsituations,whichgiverisetotransactionsexposure,are: (a) Acurrencyhastobeconvertedinordertomakeorreceivepaymentforgoodsandservices; (b) Acurrencyhastobeconvertedtorepayaloanormakeaninterestpayment;or (c) Acurrencyhastobeconvertedtomakeadividendpayment,royaltypayment,etc.

2,000,000 100,000 200,000 300,000 250,000 1,000,000

5.USDpurchasedforward 6.USDloaninstallmentdue 7.NLGpurchasedforward

Tocoverusingthemoneymarket,foreachNLGofreceivable,borrowNLG1/[1+(0.055/4)] =NLG0.9864,sellthisspottogetDEM(0.9864/1.1035) =DEM0.8939

Similarly,wecanconstructthepayoffprofileforthecallwriter.Thiswillbeasfollows: SpotRate Gain(c) Loss(SXc) Page136

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