IMTS INTERNATIONAL BUSINESS MANAGEMENT (International finance mgmt)

I ns t i t ut eofManage me nt & Te c hni c alSt udi e s

I NTERNATI ONALFI NANCE MANAGEMENT

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IMTS (ISO 9001-2008 Internationally Certified) INTERNATIONAL FINANCE MANAGEMENT

INTERNATIONAL FINANCE MANAGEMENT

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INTERNATINAL FINANCE MANAGEMENT Chapter 01

01-25

Introduction – The International monetary system – The internationalization process

Chapter 02

26-34

Introduction to international financial system – Breton wood conference and afterwards – European monetary system

Chapter 03

35-64

International Financial Markets and instruments – International capital and money market instruments and their salient features – Integration of financial intermediaries.

Chapter 04

65-91

International money market instruments and institutions – GRDs, ADRs, IDRs, Euro Loans, Repos, CPSs, Derivatives – Floating rate instruments – Loan syndication and Euro Deposits – IMF, IBRD – Development Banks Chapter 05

92-104

Multinational financial management – Complexities and issues in managing financial function in international firm Chapter 06

105-118

Multinational working capital management – cash – Receivable and inventory – Management of short-term overseas financial sources Chapter 07

119-157

Foreign exchange – balance of payments – Exchange rates – The basic equations – Foreign exchange markets – Theories and empiricism on exchange rate movement – Definition of foreign exchange risk – Financial accounting and foreign exchange.

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Chapter 08

158-167

Hedging – Principles of exposure management – Internal techniques of exposure management – External techniques of exposure management Chapter 09

168-185

Derivatives – Swaps – Financial futures and foreign exchange – Currency options – Interest rate risk – Financial engineering.

Chapter 10

186-201

Foreign investment and financial decisions – Capital budgeting for multinational corporations – International financing sources and financial structure – Cost of capital for oversea investment.

Chapter 11

202-210

International financing – International debt instruments – Financing the multinational and its overseas subsidiaries – Project finance – Financing international trade and minimizing credit risk – other issues in international finance.

Chapter 12

211-219

International Accounting and Reporting – Foreign currency translation – Multinational transfer pricing and performance measurement – consolidated financial reporting.

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CHAPTER – 01 INTERNATIONAL MONETARY SYSTEM STRUCTURE

1.0. INTRODUCTION 1.1. THE INTERNATIONAL MONETARY SYSTEM 1.2. THE INTERNATIONALIZATION PROCESS 1.3. QUESTIONS 1.4. SUGGESTED READINGS

1.0. INTRODUCTION The International Monetary System encompasses the institutions, instrument, laws, rules, procedures for handling international payments, i.e., the procedures and institutions handling final settlement of inter country payments. Since money is an asset used for the final settlement of payments, therefore any asset that performs this task of settling payments may be termed as International Money 1.1. THE INTERNATIONAL MONETARY SYSTEM The international monetary system is the framework within which countries borrow, lend, buy, sell and make payments across political frontiers. The framework determines how balance of payments disequilibrium is resolved. Numerous frameworks are possible and most have been tried in one form or another. Today’s system is a combination of several different frameworks. The increased volatility of exchange rate is one of the main economic developments of the past 40 years. Under the current system of partly floating and partly fixed undergo real and paper fluctuations as a result of changes in exchange rates.

Policies for forecasting and reacting to exchange rate fluctuations are still evolving as we improve our understanding of the international monetary system, accounting and tax rules for foreign exchange gains and losses, and the economic effect of exchange rate changes on future cash flows and market values.

Although volatile exchange rate increase risk, they also create profit opportunities for firms and investors, given a proper understanding of exchange risk management. In order to manage foreign exchange risk, however, management must first understand how the international monetary system functions. The international monetary system is the structure within which foreign exchange rates are determined, international trade and capital flows are accommodated, and balance-of-payments (Bop) adjustments made. All of the instruments, institutions, and agreements that link together the world’s

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currency, money markets, securities, real estate, and commodity markets are also encompassed within that term.

Currency Terminology: Let us begin with some terms in order to prevent confusion in reading this unit: A foreign currency exchange rate or simply exchange rate is the price of one country’s currency in units of another currency or commodity (typically gold or silver). If the government of a country- for example, Argentina- regulates the rate at which its currency- the peso- is exchanged for other currencies, the system or regime is classified as a fixed or managed exchange rate regime. The rate at which the currency is fixed, or pegged, is frequently referred to as its par value. if the government does not interfere in the valuation of its currency in any way, we classify the currency as floating or flexible.

Spot exchange rate is the quoted price for foreign exchange to be delivered at once, or in two days for inter-bank transactions. For example, ¥114/$ is a quote for the exchange rate between the Japanese yen and the U.S. dollar. We would need 114 yen to buy one U.S. dollar for immediate delivery.

Forward rate is the quoted price for foreign exchange to be delivered at a specified date in future. For example, assume the 90-day forward rate for the Japanese yen is quoted as ¥112/$. No currency is exchanged today, but in 90 days it will take 112 yen to buy one U.S. dollar. This can be guaranteed by a forward exchange contract.

Forward premium or discount is the percentage difference between the spot and forward exchange rate. To calculate this, using quotes from the previous two examples, one formula is:

Where S is the spot exchange rate, F is the forward rate, and n is the number of days until the forward contract becomes due.

Devaluation of a currency refers to a drop in foreign exchange value of a currency that is pegged to gold or to another currency. In other words, the par value is reduced. The opposite of devaluation is revaluation. To calculate devaluation as a percentage, one formula is:

Weakening, deterioration, or depreciation of a currency refers to a drop in the foreign exchange value of a floating currency. The opposite of weakening is strengthening or appreciating, which refers to a gain in the exchange value of a floating currency.

Soft or weak describes a currency that is expected to devalue or depreciate relative to major currencies.

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It also refers to currencies whose values are being artificially sustained by their governments. A currency is considered hard or strong if it is expected to revalue or appreciate relative to major trading currencies.

The next section presents a brief history of the international monetary system form the days of the classical gold standard to the present time.

The Gold Standard, 1876-1913 Since the days of the Pharaohs (about 3000 B.C.), gold has served as a medium of exchange and a store of value. The Greeks and Romans used gold coins and passed on this through the mercantile era to the nineteenth century.

The great increase in trade during the free-trade period of the late nineteenth century led to a need for a more formalized system for settling international trade balances. One country after another set a par value for its currency in terms f gold and then tried to adhere to the so-called “rules of the game”.

This later came to be known as the classical gold standard. The gold standard as an international monetary system gained acceptance in Western Europe in the 1870s. The United States was something of a latecomer to the system, not officially adopting the standard until 1879.

The “rules of the game” under the gold standard were clear and simple. Each country set the rate at which its currency unit could be converted to a weight of gold. The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67 per ounce of gold (a rate in effect until the beginning of World War I). The British pound was pegged at £4.2474 per ounce of gold. As long as both currencies were freely convertible into gold, the dollar/pound exchange was:

Because the government of each country on the gold standard agreed to buy or sell gold on demand with anyone at its own fixed parity rate, the value of each individual currency in terms of gold-and therefore exchange rates between currencies- was fixed. Maintaining adequate reserves of gold to back its currency’s value was very important for a country under this system. The system also had the effect of implicitly limiting the rate at which any individual country could expand its money supply. Any growth in the amount of money was limited to the rate at which official authorities could acquire additional gold.

Inter-War Years and World War II, 1914 – 1944: After World War I, in twenties, the exchange rates were allowed to fluctuate. This was the result of large fluctuations in currency values. Consequently, the trade could not develop. Once a currency became weak, it was further weakened because of speculative expectations. The reverse happened with strong currencies, because of these unwarranted fluctuations in exchange rates, the trade volumes did not grow in proportion to the growth in GNP. Many attempts were made to return to gold standard. U.S. could adopt it in 1919, U.K. in 1925 and France in 1925. U.K. fixed pre-war parity. In 1934, U.S. modified

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the gold standard by revising the price of gold (from 20.67/ounce to $35/ounce) at which the conversions could be effected.

Till World War II practically the above practice remained in force. The gold standard to which countries returned in mid twenties was different than which existed prior to 1914. The major difference was that instead of two international reserve assets, there were several currencies, which were convertible to gold and could be termed as reserves. Apart from pound, French Francs, U.S. dollar had also gained importance. Whenever French accumulated because the government of each country on the gold standard agreed to buy or sell gold on demand with anyone at its own fixed parity rate, the value of each individual currency in terms of gold-and therefore exchange rates between currencies- was fixed.

Maintaining adequate reserves of gold to back its currency’s value was very important for a country under this system. The system also had the effect of implicitly limiting the rate at which any individual country could expand its money supply. Any growth in the amount of money was limited to the rate at which official authorities could acquire additional gold.

Inter-War Years and World War II, 1914 – 1944: After World War I, in twenties, the exchange rates were allowed to fluctuate. This was the result of large fluctuations in currency values. Consequently, the trade could not develop. Once a currency became weak, it was further weakened because of speculative expectations. The reverse happened with strong currencies, because of these unwarranted fluctuations in exchange rates, the trade volumes did not grow in proportion to the growth in GNP. Many attempts were made to return to gold standard. U.S. could adopt it in 1919, U.K. in 1925 and France in 1925. U.K. fixed pre-war parity. In 1934, U.S. modified the gold standard by revising the price of gold (from $20.67/ounce to $35/ounce) at which the conversions could be effected.

Till World War II practically the above practice remained in force. The gold standard to which countries returned in mid twenties was different than which existed prior to 1914. The major difference was that instead of two international reserve assets, there were several currencies, which were convertible to gold and could be termed as reserves. Apart from pound, French Francs, U.S. dollar had also gained importance. Whenever French accumulated pound sterling, they used to convert these into gold. The second difference was that Britain had returned to gold standard with a decline in relative costs and prices.

In 1931 the crisis began with the failure of a branch banking institution in Austria called Ke Kredit Anstalt. Had British, U.S. and French banks did not cooperated, this could have a small impact on world exchange rate environment, but French banks did not cooperate. Germans withdrew their money from Austria leading to deepening of crisis led to dismemberment of Gold Standard.

Bretton Woods and the International Monetary Fund (IMF), 1944-1973: Of paramount importance to the representatives at the 1944 meeting in Bretton Woods was the prevention of another breakdown of the international financial order, such as the one, which followed the

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peace after the First World War. From 1918 until well into the 1920s the world had witnessed a rise in protectionism on a grand scale to protect jobs for those returning the war, competitive devaluations designed for the same effect, and massive hyperinflation as the inability to raise conventional taxes led to use of the hidden tax of inflation: inflation shifts buying power from the holders of money, whose holdings buy less to the issuers of money, the central banks. A system was required that would keep countries from changing exchange rates to obtain a trading advantages and to limit inflationary policy. This meant that some sort of control on rate changes was needed, as well as a reserve base for deficit countries. The reserves were to be provided via an institution created for the purpose. The International Monetary Fund (IMF) was established to collect and allocate reserves in order to implement the Articles of Agreement signed in Bretton Woods.

The Articles of Agreement required IMF member countries (of which there were 178 as of March 1994) to: 1. Promote international monetary cooperation 2. Facilitate the growth of trade 3. Establish a system of multilateral payments 4. Create a reserve base The reserves were contributed by the member countries according to a quota system (since then many times revised) base on the national income and importance of trade in different countries. Of the original contribution, 25 percent was in gold- the so-called gold trance position- and the remaining 75 percent was in the country’s own currency. A country was allowed to borrow up to its gold-trance contribution without IMF approval and to borrow an additional 100 percent of its total contribution in four steps, each with additional stringent conditions established by the IMF. These conditions were designed to ensure that corrective macroeconomic policy actions would be taken. The lending facilities have been expanded over the years. Standby arrangements were introduced in 1952, enabling a country to have funds appropriated ahead of the need so that currencies would be less open to attack during the IMF’s deliberation of whether help would be made available. Other extensions of the IMF’s lending ability took the form of: a. The Compensating Financing Facility introduced in 1963 to help countries with temporarily inadequate foreign exchange reserves as a result of events such as crop failures. b. The Extended Fund Facility of 1974, providing loans for countries with structural difficulties that take longer to correct. c. The Trust Fund from the 1976 Kingston Agreement to allow the sale of goods, which was no longer to have a formal role in the international financial system. The proceeds of gold sales are used for special development loans. d. The Supplementary Financing Facility, also known as the Witteveen Facility after the then managing director of the IMF. This gives standby credits and replaced the 1974-1976 Oil Facility, which

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was established to help countries with temporary difficulties resulting from oil price increases. e. The Buffer Stock Facility, which grants loans to enable countries to purchase crucial inventories.

These facilities were supplemented by the 1980 decision allowing the IMF to borrow in the private capital market when necessary and by the extension of borrowing authority in the 1990 General Arrangements to Borrow, Which allows the IMF to lend to nonmembers. The scope of the IMF’s power to lend was further expanded in 1993, when new facilities to assist in exchange-rate stabilization were made available.

As we have seen, the most important feature of the Bretton Woods agreement was the decision to have the U.S. dollar freely convertible into gold and to have the values of other currencies fixed in U.S. dollars. The exchange rates were to be maintained within 1 percent on either side of the official parity, with intervention required as the support points. This required to the United States to maintain a reserve of gold, and other countries to maintain reserve of U.S. dollars. Because the initially selected exchange rates could have been incorrect for balance-of-payments (Bop) equilibrium, each country was allowed a revision of up to 10 percent within a year of the initial selection of the exchange rate. In this basic form the system survived until 1971.

The central place of the U.S. dollar was viewed by John Maynard Keynes as a potential weakness. Keynes preferred an international settlement system based on a new currency unit, the Bancor. However, the idea was rejected, and it was not until the 1960s that the inevitable collapse of the Bretton Woods arrangement was recognized by a Yale economist, Robert Triffin. According to the Triffin Paradox, in order for the stock of world reserves to grow along with world trade, the provider of reserves, the United States, had to run Bop deficits.

These deficits were the means by which other countries could accumulate dollar reserves.

Although the U.S. deficits were needed, the more they occurred, the more the holders of dollars doubted the ability of the United States to convert dollars into gold at the agreed price. This built-in paradox meant that the system was doomed. Among the more skeptical holders of dollars was France, which began in 1962 to exchange dollars for gold despite the objection of the United States. Not only were the French doubtful about the future value of the dollar but they also objected to the prominent role of the United States was political, and part was base on the seignior age gains that France believed accrued to the United States by virtue of the U.S. role as the world’s banker. Seignior age is the profit from “printing” money and depends on the ability to have people hold your currency or other assets at a noncompetitive yield. Every government which issues legal-tender currency can ensure that it is held by its own citizens, even if it offers no yield at all. For example, U.S. citizens will hold Federal Reserve notes and give up goods or services for them, even though the paper the notes are printed on costs very little to provide.

The United States was in a special position because its role as the leading provider of well as U.S. citizens would hold U.S. dollars. However, most reserves of foreign central banks were and are kept in securities such as treasury bills, which yield interest. If the interest that is paid on the reserve assets is

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a competitive yield, then the seignior age gains to the United State from foreign holding U.S. dollar assets is small. Indeed, with sufficient competition from (1) alternative reserves of different currencies and (2) alternative dollar investments in the United States, seignior age gains would be competed away.

Nevertheless, the French continued to convert their dollar holdings into gold. This led other countries to worry about whether the United States would have sufficient gold to support the U.S. dollar the French had finished selling their dollars: under a fractional reserve standard, gold reserves are only a fraction of dollars held. By 1968, the run on gold was of such a scale that a March meeting in Washington, D.C., a two-tier gold-pricing system was established. While the official U.S. price of gold was to remain at $35 per ounce, the private-market price of gold was to be allowed to find its own level. After repeated financial crises, including a devaluation of the pound from $2.80/ÂŁ to $2.40/ÂŁ in 1967, some relief came in 1970 with the allocation of Special Drawing Rights (SDRs). The SDRs are book entries that are credited to the Accounts of IMF member countries according to their established quotas.

They can use to meet payments imbalances, and they provide a net addition to the stock of reserves without the need for any country to run deficits or mine gold. From 1970 to 1972, approximately $9.4 billion worth of the SDRs (or paper gold) was created, and there was no further allocation until January 1, 1979, when SDR 4 billion was created. Similar amounts were created on January 1, 1980, and on January 1, 1981, bringing the total to over SDR 20 billion. No allocations of SDRs have occurred since 1981. A country can draw on its SDRs as long as it maintains an average of more than 30 percent of its cumulative allocation, and a country is required to accept up to 3 times its total allocation. Interest is paid to those who hold SDRs and by those who draw down their SDRs, with the rate based on an average of money-market interest rates in the United States, the United Kingdom, Germany, Japan, and France.

The SDR was originally set equal in value to the gold content of a U.S. dollar in 1969, which was 0.888571 grams, or 1/35 oz. The value was latter revised first being based on a weighted basket of 16 currencies and subsequently being simplified to 5 currencies. The amount of each currency and the U.S. dollar equivalents are the currency basket and the weights are revised every 5 years according to the importance of each country in international trade. The value of the SDR is quoted daily.

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If the SDR had arrived earlier, it might have prevented or postponed the collapse of the Bretton Woods system, but by 1971, the fall was imminent. After only two major revisions of exchange rates in the 1950s and 1960s- the floating of the Canadian dollar during the 1950s and the devaluation of sterling in 1967- events suddenly began to unfold rapidly. On August 15, 1971, the United States responded to a huge was placed on imports, and a grogram of wage and price controls was introduced. Many of the major currencies were allowed to float against the dollar, and by the end of 1971 most had appreciated, with the German mark and the Japanese yen both up 12 percent. The dollar had begun a decade of decline.

On August 15, 1971, the United States made it clear that it was no longer content to support a system based on the U.S. dollar. The costs of being a reserve currency were perceived as having begun to exceed any benefit in terms of seignior age. The 10 largest countries were called together for a meeting at the Smithsonian Institution in Washington in Washington, D.C. As a result of the Smithsonian Agreement, the United States raised the price of gold to $38 per ounce (that is, devalued the dollar). Each of the other countries in return revalued its currency by an amount of up to 10 percent. The band around the new official parity values was increased from 1 percent to 21/4 on either side, but several European Community countries kept their own exchange rates within a narrow range of each other while jointly allowing the 41/2 percent band vis-à-vis the dollar. As we have seen, the “snake,” as the European fixedexchange rate system was called, became, with some minor revisions, the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) in 1979.

The dollar devaluation was insufficient to restore stability to the system. U.S. inflation had become a serious problem. By 1973 the dollar was under heavy selling pressure even at its devalued or depreciated rates, and in February 1973, the price of gold was raised 11 percent, from $38 to $42.22 per ounce. By the next month most major currencies were floating. This was the unsteady sate of the international financial system as it approached the oil crisis of the fall of 1973.

Exchange Rate Regime 1973-85: In the wake of the collapse of the Bretton Woods exchange rate system, the IMF appointed the

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Committee of Twenty that suggested for various options for exchange rate arrangement. Those suggestions were approved at Jamaica during February 1976 and were formally incorporated into the text of the Second Amendment to the Articles of Agreement that came into force from April 1978.

The options were broadly: 1. Floating-independence and managed 2. Pegging of currency 3. Crawling peg 4. Target-zone arrangement Floating Rate System: In a floating-rate system, it is the market forces that determine the exchange rate between two currencies. The advocates of the floating-rate system put forth two major arguments. One is that the exchange rate varies automatically according to the changes in the macro-economic variables.

As a result, there does not appear any gap between the real exchange rate and the nominal exchange rate. The country does not need any adjustment that is often required in a fixed-rate regime and so it does not have to bear the cost of adjustment (Friedman, 1953). The other is that this system possesses insulation properties meaning that the currency remains isolated of the shocks emanating from other countries. It also means that the government can adopt an independent economic policy without impinging upon the external sector performance (Friedman, 1953).

However, the empirical studies do not necessarily confirm these views. MacDonald (1988) finds that the exchange rates among the countries on floating rate system during 1973-85 were much more volatile than warranted by changes in fundamental monetary variables. Dunn (1983) finds absence of insulation properties. During early 1980s, when the USA was practicing tight monetary policy through raising interest rates, the European countries raised interest rates so as to prevent large outflow of capital to the USA. Again, since the nominal exchange rate tendered to adjust more rapidly than the market price of goods, nominal exchange rate turbulence was closely related to real exchange rate turbulence (Frenkel and Mussa, 1980). Cushman (1983) feels that uncertainty in real exchange rate did affect trade among several industrialized countries. Dunn (1983) gives an example of Canadian firms borrowing long-term funds from the USA that faced heavy losses due to 14 percent real depreciation of Canadian dollar during 1976-79. He also finds that large appreciation in the real value of pound in late 1970s had led to insolvency of many UK firms as their products turned uncompetitive in world market.

Besides, developing countries in particular do not find floating rates suitable for them. Since their economy is not diversified and since their export is subject to frequent changes in demand and supply, they face frequent changes in exchange rates. This is more especially when foreign demand for the products is price-inelastic. When the value of their currency depreciates, export earnings usually sag in view of inelastic demand abroad. Again, greater flexibility in exchange rates between a developed and a developing country generates greater exchange risk in the latter. It is because of low economic profile of

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the developing countries and also because they have limited access to forward market and to other riskreducing mechanisms.

Floating rate system may be independent or managed. Theoretically speaking, the system of managed floating involves intervention by the monetary authorities of the country for the purpose of exchange rate stabilization. The process of intervention interferes with market forces and so it is known as “dirty” floating as against independent floating which is known as “clean” floating. However, in practice, intervention is global phenomenon. Keeping this fact in mind, the IMF is of the view that while the purpose of intervention in case of independent floating system is to moderate the rate of change, and to prevent undue fluctuation, in exchange rate; the purpose in managed floating system is to establish a level for the exchange rate.

Intervention is direct as well indirect. When the monetary authorities stabilize exchange rate through changing interest rates, it is indirect intervention. On the other hand, in case of direct intervention, the monetary authorities purchase and sell foreign currency in the domestic market. When they sell foreign currency, its supply increases. The domestic currency appreciates against the foreign currency.

When they purchase foreign currency, its demand increases. The domestic currency tends to depreciate vis-à-vis the foreign currency. The IMF permits such intervention. If intervention is adopted for preventing long-term changes in exchange rate away from equilibrium, it is known as “learning-against-the-wind” intervention. Intervention helps move up or move down the value of domestic currency also through the expectations channel. When the monetary authorities begin supporting the foreign currency, speculators begin buying it forward in the expectation that it will appreciate. Its demand rises and in turn its value appreciates vis-à-vis domestic currency.

Intervention may be stabilizing or destabilizing. Stabilizing intervention helps move the exchange rate towards equilibrium despite intervention. The former causes gains of foreign exchange, while the latter causes loss of foreign exchange. Suppose rupee depreciates from 33 a dollar to 36 a dollar. The Reserve Bank sell US $ 1000 and rupee improves to 33. The RBI will be able to replenish the lost reserves through buying dollar at Rs.33/US $. The gain will be US $ (36000/33-1000) or US $ 91. But after intervention, if rupee falls to 40 a dollar, the loss will be US $ (36000/40-1000) or US $ 100.

The monetary authorities do not normally go for destabilizing intervention, but it is very difficult to know in advance whether intervention would be really destabilizing. The empirical studies show both the stabilizing and destabilizing intervention. Long worth’s study (1980 finds stabilizing intervention in case of Canadian dollar, while Taylor (1982) finds destabilizing intervention in case of some European countries and Japan during 1970s.

Again, intervention may be sterilized or non-sterilized. When the monetary authorities purchase foreign currency through created money, the money supply in the country increases. It leads to inflation.

This is example of non-sterilized intervention, but if simultaneously, securities are sold in the market to mop up the excess supply of money, intervention does not lead to inflation. It takes the form of sterilized

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intervention. The study of Obstfeld (1983) reveals that non-sterilized intervention is common, for sterilized intervention is not very effective in view of the fact that it does not change very evidently the ratio between the supply of domestic currency and that of the foreign currency. However, on the whole, Loopesko (1984) confirms the effect of the intervention on the exchange rate stabilization. Last but least, there has also been a case of co-ordinated intervention. As per the Plaza Agreement of 1985, G-5 nations had intervened in the foreign exchange market in order to bring US dollar in consistence with the prevailing economic indicators.

Normally, a developing country pegs its currency to a strong currency or to a currency with which it has a very large part of its trade. Pegging involves fixed exchange rate with the result that the trade payments are stable. But in case of trading with other countries, stability cannot be guaranteed. This is why pegging to a singly currency is not advised if the country’s trade is diversified. In such cases, pegging to a basket of currency is advised. But if the basket is very large, multi-currency intervention may prove costly. Pegging to SDR is not different insofar as the value of SDR itself is pegged to a basket of five currencies. Ugo Sacchetti (1979) observes that many countries did not relish pegging to SDR in view of its declining value. Sometimes pegging is a legislative commitment which is often known as the currency board arrangement. Again, it is a fact that the exchange rate is fixed in case of pegging, yet it fluctuates within a narrow margin of at most + 1.0 percent around the central rate. On the contrary, in some countries, the fluctuation band is wider and this arrangement is known as “pegged exchange rates within horizontal bands”.

Crawling Peg: Again, a few countries have a system of crawling peg. Under this system, they allow the peg to change gradually over time to catch up with the changes in the market-determined rates. It is a hybrid of fixed-rate and flexible-rate systems. So this system avoids too much of instability and too much of rigidity.

Edwards (1983) confirms this advantage in case of a sample of some developing countries. In some of the countries opting for the crawling peg, crawling bands are maintained within which the value of currency is maintained.

In a target-zone arrangement, the intra-zone exchange rates are fixed. An opposite example of such an arrangement is the European Monetary Union (EMU) which was earlier known as the European Monetary System (EMS). There are cases where the member countries of a currency union do not have their own currency; rather they have a common currency. Under this group, come the member countries of Eastern Caribbean Currency Union, Western African Economic and Monetary Union and Central African Economic and Monetary Community. The member countries of European Monetary Union too will come under this group if Euro substitutes their currency by the year, 2002.

Global Scenario of Exchange Rate Arrangements: The firms engaged in international business must have an idea about the exchange rate arrangement prevailing in different countries as this will facilitate their financial decisions. In this context, it

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can be said that over a couple of decades, the choice of the member countries has been found shifting from one from of exchange rate arrangement to the other, but, on the whole, the preference for the floating-rate regime is quite evident. At present, as many as 50 of a total of 185 countries are having independent float, while other 27 countries are having managed floating system. The other 11 countries have crawling peg, while 53 countries have the system of peg of different kinds. The EMU countries have target-zone arrangement where they will have a common currency, Euro by 2002. The other 20 countries of Africa and Caribbean region come under some kind of economic and monetary integration scheme in which they have a common currency. Lastly, seven countries do not have their own currency as a legal tender. We may refer to an IMF publication (IMF, 2001) that provides a broad list of such arrangements among 185 countries.

1985 to date: The Era of the Managed Float:

By March 1985 the dollar had hit its peak. The US current account deficit was at the unheard of level of over USD 100 billion a year. Most economists agreed that the dollar was far above its long-term PPP equilibrium level. The arguments of why this was so ranged from the Downburst sticky hypothesis to fiscal irresponsibility to the reassuring argument that the high exchange rate was a sign of confidence in the US economy. Whatever the reason, it was decided that the dollar had to come down in order to defuse protectionist sentiment in the US Congress that was that was mounting with the mounting trade deficit.

Intervention in the foreign exchange markets was the method to be used to achieve this goal. In September 1985 the Group of Five- the United States, France, Japan, Great Britain and West Germanycame up with the Plaza Agreement, named after the Hotel in New York where they met. This was essentially a coordinated program to force down the value of the dollar against the other major currencies. The policy worked like a charm. In fact, it worked too well. The dollar fell like a stone, losing close to 11 percent of its SDR value in 1985. The Group of Five reversed field and began to support the dollar in 1986, to no avail. The dollar lost another 10 percent in 1986. The Group of Five plus Canada and Italy, now called the Group of Seven (G-7) countries to slow the dollar’s fall by coordinating their economic policies and supporting the dollar on the exchange markets within some undisclosed target range.

This seemed to work for a while. The United States promised to cut the budget deficit and reduce the rate of growth of the money supply while Japan and Germany promised to stimulate their economies.

Although the US did manage to reduce the rate of growth of the money supply, the budget cuts were not forthcoming, and neither did Germany and Japan come through with their promised stimulatory measures. When worldwide stock markets crashed in October 1987 all pretense of policy coordination collapsed. The flooded the markets with dollars and the dollar fell nearly 10 percent against the SDR in the last quarter of 1987.

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The IMF’s Exchange Rate Regime Classifications: The International Monetary Fund classifies all exchange rate regimes into eight specific categories (listed here with the number of participating countries as of October 2001). The eight categories span the spectrum of exchange rate regimes from rigidly fixed to independently floating: 1. Exchange Agreements with No Separate Legal Tender (39): The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union which the same legal tender is shared by the members of the union.

2. Currency Board Arrangement (08):A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligations.

3. Other Conventional Fixed Peg Arrangement (44): The country pegs its currency (for mall or de facto) at a fixed rate to a major currency or a basket of currencies (a composite), where the exchange rate fluctuates within a narrow margin or at most + 1 percent around a central rate.

4. Pegged Exchange Rates within Horizontal Bonds (6): The value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than + 1 percent around a central rate.

5. Crawling Pegs (4): The currency is adjusted periodically in small amounts at a fixed, pre-announced rate or in response to changes in selective quantitative indicators.

6. Exchange Rates within Crawling Pegs (5): The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed pre-announced rate or in response to change in selective quantitative indicators.

7. Managed Floating with No Pre-Announced Path for the Exchange Rate (33): The monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying or pre-committing to a pre-announced path for the exchange rate.

8. Independent Floating (47): The exchange rate is market-determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it.

Fixed Vs Flexible Exchange Rates: A nation’s choice as to which currency regime to follow reflects national priorities about all factors of the economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible rates may change over time as priorities change.

At the risk of over-generalizing, the following points partly explain why countries pursue certain exchange rate regimes. They are based on the premise that, other things being equal, countries would

Stable prices aid in the growth of international trade lessens risks for all businesses.

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Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth.

international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. An international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations. , once in place, can be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes and its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively- usually too late, too highly publicized, and too large a one-time cost to the nation’s economic health.

Determination of Exchange Rate: The most common type of foreign transaction involves the payment and receipt of the foreign exchange within two business days after the day the transaction is agreed upon. The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad and complete requirements under the forex regulations. This type of transactions is called a spot transaction, and the exchange rate at which the transaction takes place is called the spot rate. Besides spot transaction, there are forward transactions. A forward transaction involves an agreement today to buy or sell a specified amount of a foreign currency at a specified future date at a rate agreed upon today (the forward rate). The typical forward contact is for one month; three months; or six months, with three months being most common.

Forward contracts for longer periods are not as common because of the great uncertainties involved. However, forward contract can be renegotiated for one or more periods when they become due.

The equilibrium forward rate is determined at the intersection of the market demand and supply forces of foreign exchange for future delivery. The demand for the supply of forward foreign exchange arises in the course of hedging, from foreign exchange speculation, and from covered interest arbitrage.

Spot Market: Features: In the spot market, currencies are traded for immediate delivery at a rate existing on the day of transaction. For making book-keeping entries, delivery takes two working days after the transaction is complete. If a particular market is closed on Saturday and Sunday and if transaction takes place on Thursday, delivery of currency shall take place on Monday. Monday in this case is known as the value date or settlement date. Sometimes there are short-date contracts where the time zones permit the delivery of the currency even earlier. If the currency is delivered the same day, it is known as the valuesame-day contract. If it is done the next day, the contract is known as the value-next-day contract.

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In view of the huge amounts involved in the transactions, there is seldom any actual movement of currencies. Rather, debit and credit entries are made in the bank accounts of the seller and the purchaser. Most of the markets do the transfer of funds electronically thus saving time and energy. The system existing in New York is known as the Clearing House Inter-Bank Payment System (CHIPS).

Currency Arbitrage in Spot Market With fast development in the telecommunication system, rates are expected to be uniform in different foreign exchange markets. Nevertheless, inconsistency exists at times.

The arbitrageurs take advantage of the inconsistency and garner profits by buying and selling of currencies. They buy a particular currency at cheaper rate in one market and sell it at a higher rate in the other. This process is known as currency arbitrage. The process influences the demand for, and supply of, the particular currency in the two markets which leads ultimately to removal of inconsistency in the value of currencies in two markets.

Suppose, in New York: $ 1.9800 – 10/£; and In London: $ 1.9710 – 10/£.

The arbitrageurs will buy the dollar in New York and sell it in London making a profit of $ 1.9800 – 1.9710 = $ 0.009 pound sterling.

Speculation in the Spot Market: Speculation in the spot market occurs when the speculator anticipates a change in the value of a currency, especially an appreciation in the value of foreign currency. Suppose the exchange rate today is Rs.49/US $, the speculator anticipates this rate to become Rs.50/US$ within the coming three months. Under these circumstances, he will buy US $ 1,000 for Rs.49,000 and hold the amount for three months, although he is not committed to this particular time horizon. When the target exchange rate is reached, he will sell US $ 1,000 at the new exchange rate that is at Rs.50 per dollar and earn a profit of Rs.50,000 – 49,000 = Rs.1,000.

Forward Market: The 1- or 2-day delivery period for spot transactions is so short that when comparing spot rates with forward exchange rates we can usefully think of spot rates as exchange rates for undelayed transactions. On the other hand, forward exchange rates involve an arrangement to delay the exchange of currencies until some future date. A useful working definition is: The forward exchange rate is contracted today for the exchange of currencies at a specified date in the future. Forward rates are generally expressed by indicating premium/discount on the spot rate for the forward period. Premium on one country’s currency implies discount on another country’s currency. For instance if a currency (say the US dollar) is at a premium vis-à-vis another currency (say the Indian rupee), it obviously implies that the Indian rupee is at a discount vis-à-vis the US dollar. The forward market is not located at any specified place. Operations take place mostly by telephone/telex, etc., through brokers. Generally, participants in the market are banks, which want to cover orders for their clients. Though a rader may quote the forward rate for any future date, the normal practice is to quote them for 30 days (1 month), 60 days (2 months), 90 days (3 months) and 180 days (6 months).

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Quotations for forward rates can be made in two ways. They can be made in terms of the exact amount of local currency at which the trader quoting the rates will buy and sell a unit of foreign currency.

This is called ‘outright rate’ and traders in quoting to customers use it. The forward rates can also be quoted in terms of points of premium or discount on the spot rate, which used in interbank quotations. To find the outright forward rates when premium or discount on quotes of forward rates are given in terms of points, the points are add to the spot price. If the foreign currency is trading at a forward premium; the points are subtracted from spot price if the foreign currency is trading at a forward discount.

The traders know well whether the quotes in points represent a premium or a discount on the spot rate. This can be determined in a mechanical fashion. If the first forward quote (the bid or buying figure) is smaller than the second forward quote (the offer or the asking or selling figure), then there is a premium.

In such a situation, points are added to the spot rate. Conversely, if the first quote is greater than the second then it is a discount. If, however, both the figures are the same, then the trader has to specify whether the forward rate is at premium or discount. This procedure ensures that the buy price is lower than the sell price, and trader profits from the spread between the prices.

The World Bank: The International Bank for Reconstruction and Development (IBRD), better known as the World Bank, was established at the same time as the International Monetary Fund (IMF) to tackle the problem of international investment. Since the IMF was designed to provide temporary assistance in correcting the balance of payments difficulties, an institution was also needed to assist long-term investment purposes.

Thus, IBRD was established for promoting long-term investment loans on reasonable terms.

The World Bank (IBRD) is an inter-governmental institution, corporate in form, whose capital stock is entirely owned by its member governments. Initially, only nations that were members of the IMF could be members of the World Bank; this restriction on membership was subsequently relaxed.

Functions: The principal functions of the IBRD are set forth in Article 1 of the agreement as follows: 1. To assist in the reconstruction and development of the territories of its members by facilitating the investment of capital for productive purposes.

2. To promote private foreign investment by means of guarantee of participation in loans and other investments made by private investors and when private capital is not available on reasonable terms, to make loans for productive purposes out of its own resources or from funds borrowed by it.

3. To promote the long-term balanced growth of international trade and the maintenance of equilibrium in balances of payments by encouraging international investment for the development of the productive resources of members.

4. To arrange loans made or guaranteed by it in relation to international loans through other channels so that more useful and urgent projects, large and small alike, will be dealt with first. It appears that the

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World Bank was created to promote and not to replace private foreign investment. The Bank considers its role to be a marginal one, to supplement and assist foreign investment in the member countries.

A little consideration will show that the objectives of the IMF and IBRD are complementary. Both aim at increasing the level of national income and standard of living of the member nations. Both serve as lending institutions, the IMF for short-term and the IBRD for long-term capital. Both aim at promoting the balanced growth of international trade.

Organization: Like the Fund’s the Bank’s structure is organized on a three-tier basis; a Board of Governors, Executive Directors and a president. The Board of Governors is the supreme governing authority. If consists of one governor (usually the Finance Minister) and one alternate governor (usually the governor of a central bank), appointed for five years by each member. The Board is required to meet once every year. It reserves to itself the power to decide important matters such as new admissions, changes in the bank’s stock of capital, ways and means of distributing the net income, its ultimate liquidation, etc. For all technical purposes, however, the Board delegates its powers to the Executive Directors in the day-to-day administration.

At present, the Executive Directors are 19 in number, of which five are nominated by the five largest shareholders- the U.S.A., the U.K., Germany, France and India. The rest are elected by the other member. The Executive Directors elect the President who becomes their ex-officio Chairman holding office during their pleasure. He is the chief of the operating staff of the Bank and subject to the direction of the Executive Directors on questions of policy and is responsible for the conduct of the ordinary business of the Bank and its organization.

European Monetary System: The Birth of a European Currency: The Euro The 15 members of the European Union are also members of the European Monetary System (EMS). This group has tried to form an island of fixed exchange rates among themselves in a sea of major floating currencies.

Members of the EMS rely heavily on trade with each other, so they perceive that the day-to-day benefits of fixed exchange rates between them are great. Nevertheless the EMS has undergone a number of major changes since it’s Inception in 1979, including major crises and reorganizations in 1992 and 1993 and conversion of 11 members to the euro on January 1, 1999 (Greece joined in 2001). In December 1991, the members of the European Union met a Maastricht, the Netherlands, and finalized a treaty that changed Europe’s currency future.

Time table: The Maastricht treaty specified a timetable and a plan to replace all individual ECU currencies with a single currency, call euro. Other steps were adopted that would lead to a full European Economic and Monetary Union (EMU).

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Convergence criteria: To prepare for the EMU, the Maastricht Treaty called for the integration and coordination of the member countries’ monetary and fiscal policies. The EMU would be implemented by a process called convergence. Before becoming a full member of the EMU, each member country was originally expected to meet the following convergence criteria: 1. Nominal inflation should be no more than 1.5 percent above the average for the three members of the EU with the lowest inflation rates during the previous year.

2. Long-term interest rates should be no more than 2 percent above the average for the three members with the lowest inflation rates.

3. The fiscal deficit should be no more than 3 percent of gross domestic product.

4. Government debt should be no more than 60 percent of gross domestic product.

Strong central bank. A strong central bank, called the European Central Bank (ECB), was established in Frankfurt, Germany, in accordance with the Treaty. The bank is modeled after the U.S. Federal Reserve

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System. This independent central bank dominates the countries’ central banks, which continue to regulate banks resident within their borders; all financial market intervention and the issuance of euros will remain the sole responsibility of the ECB. The single most important mandate of the ECB is to promote price stability within the European Union.

As part of its development of cross-boarder monetary policy, the ECB has formed TARGET is the mechanism by which the ECB will settle all cross border payments in the conduct of EU banking business and regulation. It will the ECB to quickly and costlessly conduct monetary policy and other intrabanking system capital movements.

Monetary System: The Treaty signed at Paris on 18 April 1951 to establish European Coal and Steel Community (ECSC) was the first step towards the unification of Europe. The signatories to this treaty were Belgium, France, Italy, Luxembourg, the Netherlands and then Federal Republic of Germany. The same six countries later signed the Treaty of Rome on 25 March 1957 to create the European Economic Community (EEC). The objective of this treaty was to establish (i) a Custom Union, and (ii) free movement of goods, manpower and capital. In 1972, three other countries, namely, Denmark, Ireland and the UK, also joined, thus taking the strength of the Community to nine. Later, Greece in 1979, and Spain and Portugal in 1986 also joined the Community. At the moment, the European Union has 15 countries as its members after the joining in of Austria, Finland and Sweden.

In 1978, the European Council decided to establish a European Monetary System (EMS). With effect from 1 January 1993, the International European Market has become operational. In 1989, at the Strasbourg Summit, it was decided to convene an inter-governmental conference, whose role would be to revise the treaties relating to the European Community in order to include therein an Economic and Monetary Union (EMU). This Conference has led to the signing of the Maastricht Treaty on 7 February 1992 that aimed, among other things, at the creation of institutions permitting establishment of the EMU. After the Maastricht Treaty, EEC has been renamed as European Union (EU).

Objectives of the European Monetary System: The primary objective of the EMS is to promote and enhance monetary stability in the European Community. Its other objectives include working towards the improvement of the general and economic situation f the countries of the European Union in terms of growth, full employment, standard of living, reduction of regional disparities, etc. Above all, it also aims at bringing about a stabilizing effect on international economic and monetary relations.

EMS vis-Ă -vis Balance of Payments (BOP): The formation of EMS has the following implications for countries having surplus balance of payment. First, the countries dealing with member countries of the European Union may weaken the pace of appreciation of their currencies. This is likely to happen as the relative stability of exchange rates inside the EMS is expected to avoid the distortions between various currencies of the European Union. Second,

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deceleration in the rate of appreciation of currencies may step up exports of such countries. Increased exports, obviously, have salutary effects on the profitability of enterprise on the one hand and higher growth of their economies on the other. This assertion is based on the fact that the surplus countries faced negative effect of continuing re-evaluation (appreciation) of their currencies, vis-Ă -vis, and the currencies of the member countries of the European Union (EU). In particular, the effect was more marked on external trade with the EU as it constituted 40-50 percent of their total external business.

In the case of the deficit BOP situation, the EMS stipulates that the country concerned would be required to initiate appropriate economic and monetary policy measures to overcome their BOP problems. The EMS has the provision of providing assistance as well as short-term monetary support for the purpose.

Characteristics of the EMS: The following are the major characteristics of the EMS: 1. There is a single uniform monetary unit of the European Union, namely, the European Currency Unit (ECU); 2. A stable but adjustable exchange rate has emerged.

European Currency Unit (ECU): The ECU is the central element of the EMS. It is a basket composed of different currencies of the European Union, weighted according to the economic strengths of each one of them. (a) Relative weightage of each member country currency with respect to the ECU; the composition of the ECU is shown in the following Table. (b) Another important premise is that central banks of parties to the EMS are required to defend the fluctuations in the exchange rates of their currencies.

Initially, this range was + 2.25 percent around central parties. Some ember countries found it extremely difficult to maintain the fluctuations of their currencies within this range. Therefore, in August 1993, it was raised to 15 percent. (c) There is a built-in mechanism to help one another in times of need. Necessary finances for the purpose are to be appropriated from the assets constituted at the level of each central bank.

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Table Composition of the ECU as on 21st September 1989

It is apparent form the above Table that economically strong currencies have a very high weightage. For instance, the first three currencies (Deutschmark, French Franc, and Pound) among them account for nearly two third of the total weightage. It may be noted that the number of countries included in the above Table is eleven. However, with effect from 1st January 1996, the number of countries has gone up to fifteen. He constitution of the ECU should obviously reflect the relative weightage of the economies of all these countries. But, with the coming into effect of the Maastricht Treaty on 1

st

November 1993, the composition of the ECU has been frozen. It will continue at the frozen level till the adoption of a single currency. This measure is likely to bring about a greater stability of the ECU. The ECU is a unit of payment among central banks of the European Union. It is also used for according financial assistance to member states which face economic difficulties due to BOP. ‘Private ECU’ has also found a greater instruments (such as, long-term borrowings and inter-bank commercial paper, Euro-bonds, Euro-credits, etc.), can be documented in ECU. There exist future contracts in ECUs too. In the international capital markets, the ECU occupies an important place. On a commercial plane, some enterprises have adopted it as the currency of billing; the accounts of some multinationals are made in ECUs. European Bank of Investment (EBI): The European Bank of Investment was created in 1958 by the Treaty of Rome with the major objective of balanced development of different regions of the European Union. The text of the Maastricht has further reinforced its role to serve the goal of economic and social cohesion. This is the European banking institution to provide long-term financing. It is an integral part of the EU structure and has its own organization of decision-making. The Bard of Governors consisting of one minister of each member state

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(generally the Finance Minister) gives general orientation and nominates other members of the decisionmaking body. The board of governors decides about lending, borrowing and interest rates on the proposal of the Managing Committee. This committee is an executive organ of the EBI. European Monetary Union (EMU): The Heads of the State and governments of the countries of the EU decided at Maastricht on 9th and 10th December 1991 to put in place the European Monetary Union (EMU). Adhering to the EMU means irrecoverable fixed exchange rates between different currencies of the Union. The setting up of EMU has been a step towards the introduction of a common currency in the member states of EU, as per the Maastricht Treaty. It has ratified by all the 12 countries, which constituted the Union at that point of time. The EMU completes the mechanism that started with the Customs Union of the Treaty of Rome and the big Common Market of the Single Act. Foreign Exchange Markets: The foreign Exchange Market is the market in which currencies are bought and sold against each other. It is the largest market in the world. In this market where financial paper with a relatively short maturity is traded. However, the financial paper traded in the foreign exchange market is not all denominated in the same currency. In the foreign exchange market, paper denominated in a given currency is always traded against paper denominated in another currency. One justification for the existence of this market is that nations have decided to keep their sovereign right to have and control their own currencies. Unlike the money market and capital markets, the foreign exchange market deals not in credit but in means of payment. This brings one to a fundamental point. While foreign exchange deals frequently take place between residents of different countries, the money being traded never actually leaves the country of the currency.

Thus, when a US company exports to a foreign country of India, for example, foreign exchange is required. The people manufacturing and performing services in the United States must be paid in local currency, US dollars. The people consuming the goods and services in India have only their local currency, Rupees with which to pay. There are now two possibilities for settling the account between the United States and India. The US exporter bills the Indian importer either in US dollars or in Rupees. a) If the US exporter bills in dollars, the Indian importer must sell Rupees to purchase dollars in the foreign exchange market. b) If the US exporter bills in Rupees, the exporter must sell rupees to purchase dollars.

As one can see, whatever the currency for invoicing is, somebody has to go into the foreign exchange market to sell rupees and purchase dollars. In contrast to a spot transaction, a forward foreign exchange contract calls for delivery at a fixed future date of a specified amount of one currency for specified amount of another currency. By borrowing money in one currency, buying a second currency spot, placing the funds in a deposit in the foreign currency and simultaneously selling the foreign currency forward, an arbitrageur can profit if the domestic interest rate does not equal the foreign interest rate,

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adjusted for the forward premium or discount. Dealing business across national boundaries means dealing with more than one currency and therefore involves exchange risk. Exchange risk is the additional systematic risk to a firm’s flows arising from exchange rate changes.

MBA- H4030 International Business Finance Players in the Foreign Exchange Market: The main participants in the foreign exchange market are commercial banks. Indeed, one say that it is the commercial banks that “make a market” in foreign exchange. Next in importance are the large Corporations with foreign trade activities. Finally, central banks are present in the foreign exchange market. (i) Commercial Banks Commercial banks are normally known as the lending players in the foreign exchange scene, we are speaking of large commercial banks with many clients engaging in exports and imports which must be paid in foreign currencies or of banks which specialize in the financing of trade. Commercial banks participate in the foreign exchange market as an intermediary for their corporate customers who wish to operate in the market and also on their own account. Banks maintain certain inventories of foreign exchange to best service its customers. (ii) Non-financial Corporations The involvement of Corporations in the foreign exchange market originates from two primary sources. International trade and direct investment. International trade usually involves the home country of the corporation. In this regard, the concern of the corporation is not only that foreign currency be paid or received, but also that the transaction be done at the most advantageous price of foreign exchange possible. A business also deals with the foreign exchange market when it engages in foreign direct investment. Foreign direct investments involve not only the acquisition of assets in a foreign country, but also the generation of liabilities in a foreign currency. So, for each currency in which a firm operates, an exposure to foreign exchange risk is likely to be generated. That is, given that a company will have either a net asset or a net liability position in the operations in a given currency, any fluctuation that occurs in the value of that currency will also occur in the value of the company’s foreign operations. (iii) Central Banks Central Banks are not only responsible for the printing of domestic currency and the management of the money supply, but, in addition, they are often responsible for maintaining the value of the domestic currency vis-à-vis the foreign currencies. This is certainly true in the case of fixed exchange rates.

However, even in the systems of floating exchange rates, the central banks have usually felt compelled to intervene in the foreign exchange market at least to maintain orderly markets. Under the system of freely floating exchange rates, the external value of the currency is determined like the price of any other good in a free market, by the forces of supply and demand. If, as a result of international transactions between the residents and the rest of the world, more domestic currency is offered than is demand, that is, if more

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foreign currency is demanded than is offered, then the value of the domestic currency in terms of the foreign currencies will tend to decrease. In this model, the role of the central bank should be minimal, unless it has certain preferences i.e. it wishes to protect the local export industry.

1.3. INTERNATIONALIZATION PROCESS Trade and exchange are probably older than the invention of money, but in the absence of this wonderful contrivance the volume of trade and gains from specialization would have been rather miniscule. What is true of trade and capital flows within a country is true, perhaps more strongly, of international trade and capital flows. Both require an efficient world monetary order to flourish and yield their full benefits.–).

From the point of view of a firm with world wide transactions in goods, services and finance, an efficient multilateral financial system is a prerequisite for efficient operation. By this we mean a world monetary and financial organization that facilitates transfer of funds between parties, conversion of national currencies into one another, acquisition and liquidation of financial assets, and international credit creation. The international monetary system is an important constituent of the global financial system.

The purpose of this chapter is to familiarize the reader with the organization and functioning of the international monetary system. Our approach will be partly analytical and partly descriptive. The discussion still be structured around the following aspects of the system which we consider to be the key areas a finance manger must be acquainted with: 

Exchange rate regimes, current and past.



International liquidity i.e. the volume and composition of reserves, adequacy of reserves, etc. The International Monetary Fund, its evolution, role and functioning.



The adjustment process i.e. how does the system facilitate the process of coping with payments imbalances between trading nations?



Currency blocks and unions such as the Economic and Monetary Union (EMU) and European Currency Union (ECU) in Europe.

A deeper analysis of these aspects belongs to the discipline of International Monetary

Economics. Here we wish to provide an introductory treatment to serve as background to the discussion in the rest of the book. For a more in-depth treatment, the reader should consult a standard text in International Economics as Carbaugh (2000).

1.4. QUESTIONS Section - A Very Short Answer 1. Define IMS.

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2. What is Gold Standard?

3. What is SDR? 4. What is floating rate system?

5. What is spot market?

6. What is BOP? 7. What is ECU? 8. What is EBI? 9. What do mean by Non-financial Corporations?

Section – B Short Answer 1. Explain Crawling Peg. 2. What are the features of spot markets?

3. Mention the five functions of World Bank.

4. What are the Objectives of the European Monetary System?

5. What are the Characteristics of the EMS? Section – C Long Answer 1. What is an international monetary system (IMS)? Why do you feel the need of an efficient and sound IMS? 2. What are the various pre requisites for an international monetary system to be effective?

3. What do you understand by gold standard exchange rate? How are the exchange rates determined in this system? Why this system failed?

4. Do you think the gold is a proper reserve component? Support your answer with arguments.

5. What are SDRs? Why SDRs could not replace dollars as international currency inspite of the fact that it has the backing of IMF. 6. What do you think the role of multinational agencies in solving the balance of payment problem?

1.5. SUGGESTED READING 1. The Gold Standard Bretton woods and other monetary regimes: a historical appraisal, review federal reserve bank, St. Louis.

2. International liquidity Chrystal K.A. 3. Multinational Financial Management, Prentice- Hall, Fourth

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CHAPTER – 02 INTERNATIONAL FINANCIAL SYSTEM STRUCTURE 2.0

INTRODUCTION

2.1

BRETON WOOD CONFERENCE AFTERWARDS

2.2

EUROPEAN MONETARY SYSTEM

2.3

QUESTIONS

2.4

SUGGESTED READINGS.

2.0. INTRODUCTION The financial markets of the world consist of sources of finance, and uses for finance, in a number of different countries. Each of these is a capital market on its own. On the other hand, national capital markets are partially linked and partially segmented. National capital markets are of very different stages of development and size and depth, they have very different prices and availability of capital.

Hence, the international financier has great opportunities for arbitrage – finding the cheapest source of funds, and the highest return, without adding to risk. It is because markets are imperfectly linked, the means and channels by which foreigners enter domestic capital markets and domestic sources or users of funds go abroad, are the essence of this aspect of international financial management.

The other aspect is the fact that domestic claims and liabilities are denominated in national currencies. These must be exchanged for another for capital to flow internationally; since relative values depend on supply and demand, the international financier faces exchange risk. Finally, the past few decades have seen a new phenomenon; the separation of currency of denomination of assets and liabilities from country of jurisdiction.

There are three sets of markets – home, foreign and euro markets – faced by every investor or borrower, plus the fourth market, the foreign currency market, which must be crossed as one enters the world of finance. Each country has more or less imperfect linkages with every other country and with the euro market, both the segment in its own currency and Euro-market segments in other currencies. The linkages of each country with its Euromarkets segment are very important, since domestic and euro markets instrument are close substitutes and no foreign exchange market comes between them. The links among segments of the euro markets are also very important, since no national controls come between them - in other words, linkages within the euro markets are perfect, being differentiated only by currency of denomination. They are linked through the spot and forward foreign exchange markets.

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International finance is thus concerned with: (i) Domestic Capital Markets The international role of a capital market and the regulatory climate that prevails are closely related. Appropriate regulation can and does make markets more attractive. However, the dividing line between regulatory measures that improve markets and those that have just the opposite effect is very thin. (ii) Foreign Financial Markets Major chunk of the savings and investments of a country take place in that country’s domestic financial markets. However, many financial markets have extensive links abroad – domestic investors purchase foreign securities and invest funds in foreign financial institutions. Conversely, domestic banks can lend to foreign residents and foreign residents can issue securities in the national market or deposit funds with resident financial intermediaries.

The significant aspect of traditional foreign lending and borrowing is that all transactions take place under the rules, usances and institutional arrangements prevailing in the respective national markets. Most important, all these transactions are directly subject to public policy governing foreign transactions in a particular market. For example, when savers, purchase securities in a foreign market, they do so according to the rules, market practices and regulatory percepts that govern such transactions in that particular market. Likewise, foreign borrowers who wish to issue securities in a national market must follow the rules and regulations of that market. Frequently, these rules are discriminatory and restrictive. The same is true with respect to financial intermediaries; the borrower who approaches a foreign financial institution for a loan obtains funds at rates and a condition imposed by the financial institutions of the foreign country and is directly affected to foreign residents. (iii) Euromarkets and their linkages: Euro currencies – which are neither currency nor are they necessarily connected with Europe – represent the separation of currency of denomination from the country of jurisdiction. Banks and clients make this separation simply by locating the market for credit denominated in a particular currency outside the country where that currency is legal tender. For example, markets for dollar denominated loans, deposits and securities in jurisdictions other than in the United States effectively avoid US banking and securities regulations. These markets are referred to as “Euro” or, more properly, as external markets in order to indicate that they are not part of the domestic or national financial system. As in the domestic markets, the euromarkets consist of intermediated funds and direct funds. Intermediated credit in channel through banks is called the “Euro Currency Market”.

A domestic market, usually with special and unique aspects and institutions stemming from historical and regulatory differences. A foreign segment attached to the national market, where nonresidents participate as supplier and takers of funds, frequently playing both roles simultaneously, but always under the specific conditions, rules and regulations established for foreign participants in a

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particular national market. An external segment that is characterized by being in a different political jurisdiction, with only the currency used to determine the financial claims being the essential link to the national market. As a result, the various external markets have more features in common with each other than with the respective national markets. Therefore, they are properly discussed as a common, integrated market where claims denominated in different currencies are exchanged.

International financial system: unique markets: Foreign exchange market The functions of foreign exchange markets-conversion of currencies, obviously, one currency can be converted into another only if the exchange rate is known. It is the functions of foreign exchange markets to establish these exchange rates dependent on the forces of demand and supply. With the future movements in exchange rates being highly uncertain it is clear that holder of foreign exchange faces the risk of adverse movements in the exchange rate. Event those who have to receive a specified amount of foreign currency sometime in the future face the risk of downward movement in the exchange rate.

So, there have developed what we call ‘forward’ and ‘future’ markets to tackle the uncertain movement in exchange rates.

Forward market: A forward market for foreign exchange is simply a market for foreign currencies that are to be delivered in the future. The operations can be compared with the forward market for commodities, which allows purchases and sales one any forward date. Forward markets enable participants to cover or hedge against the risk that exchange rated will vary during a [particular period, i.e., the rated at which currencies will be exchanged in future are decided in advance. Such rated are called forward rates.

All of us know that money has time value, as it is capable of earning interest. Hence, the differential between present market rates and forward rates will usually reflect the differential interest rates in the two currencies. What is more important, however is that some degree of certainty has been introduced, though at a cost,. The cost is the difference between the spot rated and the forward rate for that currency. They may be intermediaries, such as bank involved in bringing together the parties to a forward transaction Futures market: Future markets allow additional facilities as compared to forward markets. The crucial advantage is that of tradability. Such contracts are openly traded on organized exchanges. Tradability is made easier by specifying standard sizes and settlement dates for future contracts. It is worth mentioning here that there is three other markets that have gained importance in the recent past as crucial components of the international financial system.

These three are: Option market, Euro market and inter bank market

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Options Markets The options market is another market to hedge risks arising form variable exchange rates. Here risk is traded separately from the financial instrument carrying this risk what takes place at the options market?

First, let us concentrate on the word options. An option, by definition, is a choice available to the investor. What is the choice regarding? The choice, dependent on a pre-specified price, is regarding honoring the contract to buy or sell a currency at some future date. Thus in a contract to buy, if the market price prevailing at that future date is higher than the pre-specified price, one will go in for the purchase of the currency at the contract price, ie., the contract will be honored. However, if the market price at that date is lower than the contract price, it would be advantageous not to honor the contract. The reverse is the position in the case of a sale contract. Now, you will remember that this facility is not available in the forward market. Both future market and options market have grown to provide the much needed flexibility to the forward market Cross-border dealing between market participants, more so between institutional players, has lead to the development of Euro market. These are market without any nationality, that is financial instruments is such markets are denominated in currencies different form the currency of the country where the market. For example, dollar deposits that are accepted by an American bank in London are Euro dollars. Such marker’s are also free from national regulations and there by enjoy a great degree of independence. Users of Europe markers therefore are able to move funds at their discretion. The Euro market can be loosely divided into a Euro currency market for short-term finance and a Eurobond markets for longer-term financing A loan raised in the Euro currency market normally has maturates up to six months, though facilities for medium-term financing are also becoming available. With the Euro currency market, the most important and widely used currency is the Eurodollar, which is largely a reflection of the economic importance of USA in the world economy. Eurobonds are denominate in one or more of the Euro currencies and arranged by international underwriting syndicated or investment banks. They can be sold in several countries simultaneously so that not only the underwriters but also the investors come from many countries.

Inter bank Market: In foreign exchange market’s, as you will recall, different currencies are traded. But except in some European centers, one does not see, the market anywhere. This is because most participants in the foreign exchange market find it convenient to conduct their business via the large commercial banks.

It is these banks that comprise the inter bank market. Most large corporations find that the inter bank market provides a reasonably priced service that is not worth by passing with other arrangements for direct access to the foreign exchange market. The role of bank is to act as ‘market makers’ that is they stand ready to by and sell foreign currencies. Hence we can define and inter bank markets as one where dealings in foreign currencies take place between banks themselves. Most of the inter bank business is conducted by a small number of banks that have a worldwide network of branched. Is their room for

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more? Well as international trade grows, more and more banks will find it profitable to develop the expertise to handle foreign currencies Innovations in Financial Instruments: The uncertainty in the movement of foreign exchange rates has, as explained earlier led to the development of various markets such as the forward market, futures markets, options market, Europe market and the inter bank market. New financial instruments have also been introduced in response to the uncertain movement in exchange rates. The objective was to maintain the attractiveness of long-term instruments, as these were the one, which faces increased uncertainty and volatility in exchange rates.

Floating Rate Notes (FRS): Floating rate notes were first issued in 1978 in the Euromarkets. But just what are floating rate notes? Floating rate notes are debt instruments on which interest rates are set usually semi-annually, at a margin above a specified inter bank rate. The usual benchmark is the London inter bank offered rate (LIBOR). Because the interest rate payable on the instrument rises with the general rise in interest rates as indicated by LIBOR or some other inter bank market rate, the investor risk to that extend minimized.

So we see the risk due to the adverse movement in exchange rates is reduced owing to the changing interest rate payable on the instrument.

Multiple Currency Bonds: Multiple currency bonds are denominated in cocktails of currencies. They are popular because they reduce currency risk below the level that would prevail if the bond were denominated in a single currency. Depreciation of one currency can be offset against appreciation in other over the maturity of the bond.

You wonder in what currency the investor is paid at the expiry of the maturity period of the instrument.

Well the investor is paid according to the contractual agreement, which may stipulate payment in one or several currencies.

Zero Coupon Bonds: Zero coupon bonds are just what they state. They carry no coupon payments or interest payments over the life of the instrument.

Then why does anyone want to purchase these instruments? The answer is the deep discount at which instruments are sold in the market place. The payment at maturity will be the face value of the instruments; the difference between the purchase price and the repayment value amounting to implicit interest. Therefore, this bond is useful for an investor who wishes to hold the instrument until maturity and avoid frequent reinvestment of interest payment. Some tax advantages may also be available.

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Bonds with Warrants: These are fixed rate bonds with a detachable warrant allowing the investors to purchase further fixed rate bonds at a specified rate at or before a specified future date. The investor holding this warrant has the option of holding it until maturity or of selling it in what is called a ‘derivative market’. This is a new term, isn’t it?

Let us know its meaning first.

A derivative market is one in which risk is traded separately from the financial instrument.

Example are warrants of course; but besides that we have options- a term you have come across before as also swaps about which you will learn more in the subsequent paragraphs.

The value of the warrant you would agree depends on interest rate movements. If interest rates rise sharply subsequent to the issue of bonds, there obviously will not be buyers to purchase this bond.

The value of the warrant then shall become zero.

Convertible Bonds: A convertible bond comprises an ordinary bond plus an option to convert at some data into common stock or some other tradable instrument at a prespecified price. The option by the investor shall be exercised only if the market price at the date of conversion is higher than the pre-specified price.

The advantage derived from conversion is likely to eliminate the cost of uncertainty arising from variable exchange rates.

Swaps: Swaps have gained immense importance in the derivative market. This is encase swaps allow arbitrage between market, between instruments, and between borrowers without having to wait for the market themselves to cast down the barriers. There are as many different swap arrangements as there are varieties of debt financing and with the volatile exchange rates of the 1980s, demand for them is high Here we shall describe the basics of two kinds of swaps: interest rate Swap and currency swap.

In an interest rate swap, two unrelated borrowers borrow identical amounts with identical maturates from different lender and then exchange the interest repayment cash flow via an intermediary which may be a commercial bank The currency swap operated in a similar fashion to the interest rate swap but each party becomes responsible for the others currency payments. The currency swap principle can therefore be used by bowers to obtain currencies form which they are otherwise prevented because of excessive costs or foreign exchange risk One must remember that the above list of variations on the basic bond market is not exhaustive.

With growing uncertainty the number of new instruments also is growing. The nineties will definitely see much newer innovations compared to the eighties. Already, we have instruments like swap options, i.e., options on swaps.

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2.1. BRETTON WOODS AND AFTERWARDS As a result of agreement at Bretton Woods, New Hampshire, in 1944, a new International Monetary System was created. The prime movers of this system were John Maynard Keynes and Hary Dexter White. Keynes represented British government while Hary was representative of 'U.S.A. The broad outcomes of the agreement were: 

International Monetary Fund (IMF) was to be established to promote consultations and collaborations on international monetary problems and to lend currencies to member countries in need due to recurring balance of payment deficits.



Each member would establish, with the approval of IMF, a par value of its currency and would undertake to maintain exchange rate for its currency within one percent of the declared par value.



Member would change their par value only after getting approval of IMF.



Each IMF member would pay a quota into IMF pool-one quarter in gold and the rest in their own currency.



IMF would lend to the members from this pool to meet the balance of payment deficits.



Dollar was to be convertible to gold and would provide liquidity to the system till an international instrument is introduced.



International Bank of Reconstruction and Development (IBRD) was created to rehabilitate wartorn countries and help developing countries in their development.

Under this agreement, Allies adopted gold standard. The new system was dollar based and dollar

was convertible to gold at pre-War price ($35 /ounce). The agreement also provided for the creation of International Monetary Fund which would address the problem of balance of payment of various countries. The World Bank was also the result of this agreement.

Under the Bretton Woods agreement, all member countries were to fix the value of their currencies in terms of gold but were not required to exchange their currencies for gold only. Dollar was convertible to gold. The currencies were thus linked to dollar via their par value. All participants in the exchange rate system were required to maintain their currencies with in one percent of par value either by buying or selling of dollar or gold to maintain exchange rate. Devaluation could not be resorted arbitrarily as a matter of policy. However, when the balance of payment problem became structural, i.e. repetitive and could not be corrected through monetary and fiscal policies, the IMF could ask for devaluation.

Devaluation up to ten percent could be done by central bank without the approval of IMF. For larger devaluation, the approval of IMF was needed. This was done only when the fluctuations indicated fundamental or structural disequilibrium.

Under Bretton Woods’s system, each currency was thus tied to dollar directly or indirectly. The price stability was the responsibility of the U.S. As long as the currency remained with in the band, the currencies were subject to same rate of inflation as the U.S. dollar faced. upper or lower limit, fiscal and monetary policies come into play to push the exchange rate within the target zone. But in this case, these

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limits are sustained for some time and if it is felt that economic indicators are being disturbed the monetary authorities let the exchange rate depreciate or appreciate as the case may be. Figure 5.5(a) shows the movement of exchange rate leading to depreciation i.e. when there is a sustained increase in demand for foreign exchange relative to its supply and Fig. 5.5(b) shows the appreciation (in this case the supply of foreign exchange goes on increasing relative to demand). The exchange rate, in this case may also move in steps, but the steps, unlike pegged exchange rate system, will be smaller.

Advantages and Disadvantages of Crawling PEG Crawling peg offers two comparative advantages: (a) the system potentially avoids the economic instability associated with the infrequent but discrete adjustments which characterize the fixed exchange rate, and (b) they reduce uncertainty due to volatility characterizing floating, exchange rate.

Some time it is difficult to realize in practice the above advantages if crawling peg generating substantial currency flows in anticipation of exchange rate realignment. These flows might prompt monetary authorities to accelerate their currency realignments, therefore creating an erotic adjustment process and exposing market operators to unsystematic economic costs.

2.2. EUROPEAN MONETARY SYSTEM (EMS) Till 1978, the conditions worsened, and the need to create a system which could provide stability to adjustment mechanism was felt. In March 1979, nine members of the EEC established the European Monetary System (EMS). This system consisted of four components. W creating an exchange rate mechanism (ERM), (ii) setting of central exchange rates among member currencies, (iii) creation of European Currency Unit (ECU), and (iv) The establishment of rules Lf intervention.

Creating Exchange Rate Mechanism (ERM): This is the process by which member countries maintain and manage exchange rates. ERM consists of the countries who actively manage their currencies in order to maintain EMS parities. Only Greece and Portugal remain non-ERM participants. The ERM has three features: (a) It stipulates that there is bilateral responsibility of member countries for the maintenance of Exchange rates, (b) the resources to support parities in ERM were to be made available from a fund created for the purpose, and (c) as a last resort the realignment of currencies were to be accepted by the member countries when currencies irretrievably diverge from parities_ Setting Central Exchange Rates: The central rates of EMS are specified-bilateral exchange rates among all member currencies.

This actually consists of a grid of bilateral exchange rates among member countries. Each currency is allowed to fluctuate around the central rate to the tune of 2.25%. If currency fluctuations reached these bounds, then the indicator of divergence is calculated. If the indicator of divergence indicates 75% of deviation in absolute value, the governments a-re asked by European Central Bank to intervene.

The formula for the indicator of divergence is defined as:

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INTERNATIONAL FINANCE MANAGEMENT DI - = (D / Max. D) x 100 We see that when D = Max. DI then DI 100%

2.3. QUESTIONS Section – A Very short Answer 1. What do you mean by international financial market?

2. Mention the Domestic Capital Markets.

3. What is Foreign Financial Markets?

4. What is Foreign Exchange Market?

5. Define Options Markets.

6. What is Inter bank Market?

Section – B Short Answer 1. What are the innovations in financial instruments?

2. Explain the Swaps.

3. Give any five advantages of Crawling PEG 4. Explain European monetary system. (EMS) Section – C Long Answer 1. Explain in detail about international financial system 2. Why Bretoon Woods Agreements started collapsing in 1968? Give reasons.

3. Explain about European monetary system.

4. What do you understand by Gold Exchange rate?

2.4. SUGGESTED READINGS 1. Multinational enterprises and economic analysis - Caves. R 2. International financial management - Madura Jeff 3. International financial management – A K Seth

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CHAPTER – 03 INTERNATIONAL FINANCIAL MARKETS STRUCTURE

3.0. INTRODUCTION 3.1. INTERNATIONAL FINANCIAL MARKET AND INSTRUMENTS 3.2. INTERNATIONAL CAPITAL AND MONEY MARKET 3.3. INTERNATIONAL FINANCIAL MARKET INSTRUMENTS 3.4. QUESTIONS 3.5. SUGGESTED READINGS

3.0. INTRODUCTION The financial markets of the world consist of sources of finance, and uses for finance, in a number of different countries. Each of these is a capital market on its own. On the other hand, national capital markets are partially linked and partially segmented. National capital markets are of very different stages of development and size and depth, they have very different prices and availability of capital.

Hence, the international financier has great opportunities for arbitrage – finding the cheapest source of funds, and the highest return, without adding to risk. It is because markets are imperfectly linked, the means and channels by which foreigners enter domestic capital markets and domestic sources or users of funds go abroad, are the essence of this aspect of international financial management.

3.1. INTERNATIONAL FINANCIAL MARKETS NATURE AND FUNCTIONS International financial markets undertake intermediation by transferring purchasing power from lenders and investors to parties who desire to acquire assets that they expect top yield future benefits.

International financial transactions involve exchange of assets between residents of different financial centers across national boundaries. International financial centers are reservoirs of savings and transfer them to their most efficient use irrespective of where the savings are generated.

There are three important functions of financial markets. First, the interactions of buyers and sellers in the markets determine the prices of the assets traded which is called the price discovery process. Secondly, the financial markets ensure liquidity by providing a mechanism for an investor to sell a financial asset. Finally, the financial markets reduce the cost of transactions and information.

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3.2. MONEY AND CAPITAL MARKET Like their domestic counterpart, international financial markets may be divided into money and capital markets. Money markets deal with assets created or traded with relatively short maturity, say less than a year. Capital markets deal with instruments whose maturity exceeds one year or which lack definite maturity. Again on lines similar to domestic markets in the international financial markets also we have primary and secondary markets dealing with issue of new instruments and trading in existing instruments and trading in existing instruments and negotiable debt instruments, respectively. In international financial markets as the domestic markets there is a symbiotic relationship between primary and secondary markets.

Categories of Markets: According to Garbbe, international financial markets consist of international markets for foreign exchange, Euro currencies and Euro bonds. In view of the development and rapid growth of swaps and globalization of equity markets, international financial markets have been categorized into five markets here: foreign exchange market: lending by financial institutions; issue and trading of negotiable instruments of debt; issue and trading of equity securities; and lastly internationally arranged swaps. The rates of foreign exchange as well as interest rates fluctuate and to hedge against the risk of loss arising out of changes in them derivative instruments are traded in the organized exchanges as well as in over the counter markets. Most of the derivatives except the interest rate swaps are short term in nature.

Derivatives involve creation of assets that are based on other financial assets.

International Money Market: A money market is a market for instruments and a means of lending (or investing) and borrowing funds for relatively short periods, typically regards as from one day to one year. Such means and instruments include short term bank loans. Treasury bills, bank certificates of deposit, commercial paper, banker’s acceptances and repurchase agreements and other short term asset backed claims. As a key elements of the financial system of a country, the money market plays a crucial economic role that if reconciling the cash needs of so called deficit units (such as farmers needing to borrow in anticipation of their later harvest revenues), with the investment needs of surplus units (such as insurance companies wanting to invest cash productively prior to making long term investment choices). Holding or borrowing liquid claims is more productive than holding cash balances. A smoothly functioning money market can perform these functions very efficiently if borrowing lending spreads (or bid offers spreads for traded instruments) are small (operational efficiency), and if funds are lent to those who can make the most productive use of them (allocation efficiency). Both borrowers and lenders prefer to meet their short term needs without bearing the liquidity risk or interest rate risk that characterizes longer term instruments, and money market instruments allow this. In addition money market investors tend not to want to spend much time analyzing credit risk, so money market instruments are generally characterized by a high degree of

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safety of principal. Thus the money market sets a market interest rate that balances cash management needs, and sets different rates for different uses that balance their risks and potential for productive use.

Unlike stock or futures markets, the money markets of the major industrial countries have no central location; they operate as a telephone market that is accessible from all parts of the world. The international money market can be regarded as the market for short term financing and investment instruments that are issued or traded internationally. The core of this market is the Eurocurrency market, where bank deposits are issued and traded outside of the country that issued the currency. Other instruments to be discussed in this chapter such as Euro commercial paper and floating rate notes, serve some what different purposes and attract a different investment clientele. However, each is to a degree a substitute for each of the other instruments, and the yield and price of each are sensitive to many of the same influences, se we may feel justified in lumping them together in something called a market.

The fact that many of the other instruments of the international money market are priced off LIBOR, the interest rate of Eurodollar deposits, suggest that market participants themselves regard the different instruments as having a common frame of reference. Today many domestic cash and derivative instruments, such as US. Treasury bills and Eurocurrency futures contracts are traded globally and so are effectively parts of the international money market. Euromarkets instruments simply represent part of a spectrum of financial claims available in the money market of a particular currency, claims that are distinguished by risk, cost and liquidity just like domestic money market instrument.

However domestic money markets are called upon to play public as well as private roles. The latter include the following three functions. 

The money market, along with the bond market, is used to finance the government deficit.



The transmission of monetary policy (including exchange rate policy) is typically done through the money market, either through banks or through freely traded money market instruments.



The government uses the institutions of the money market to influence credit allocation toward favored uses in the economy.

Returns on Money Market Instruments: The manager of cash will wish to consider the alternative money market instruments she has at her disposal by comparing their returns, risks and other characteristics. In principle, the rage includes all the instruments in two dozen or so domestic money markets open to international investors. Realistically, through one would normally limit one’s attention to a few major currencies and to the more liquid instruments.

For some the starting point would be US Treasury bills and some will be constrained to that class of risk. Most international investors will look for a better return than can be had in government Treasury bills, however, so their staring point would be short term Euro deposits. To compare instruments one should be able to express their returns on a comparable basis. Doing so is complicated by the different

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maturities and payment characteristics of even the limited range of investments considered here, and by the different delivery and accrued interest calculations adopted by participants in different markets.

The basis idea of a retunes is that you invest a sum of money today and you get some more back at a later date. The increase, expressed as an annualized percentage of the original investment, is typically how we measure return. Thus if you invest Y100 today and you receive Y107 in one year the return is 7 percent. In practice this idea takes three different forms.

1. The bank discount rate 2. The add on yield 3. The yield to maturity, known in the Euromarkets as the bond equivalent yield.

1. The bank discount rate method is a formula devised to make calculations easy to do by hand but its use persists in these days of financial calculations and computers for money market instruments such as Treasury bills, banker’s acceptances and commercial paper. These carry no coupon but are sold on a discount basis from a face principal value of 100.

Where Discount is the dollar amount of discount from the fact value of $100 and Days is the actual number of days to maturity.

2. The add on yield is used in Eurodollar – and Euro currency deposit calculations because these are typically issued at a price of 100 and the coupon added on at the end. The formula change to

Where Interest payment is the dollar amount of payment made at maturity on an investment of $100.

Days is the number of days to maturity, for example, if the interest payment on a 90 day Eurodollar deposit is $ 2.5, then the add on yield is 10 percent The trouble with the add on yield is that it ignores compounding, which car be important because a one year Euro deposit that pays interest semiannually is more desirable than one that pays annually. To take compounding into amount we need the yield to maturity or the bond equivalent yield.

1. The bond equivalent yield or yield to maturity is the rate that equates the present value of all future interest and principal payments with the market price of the instrument. If as in the Eurobond market, interest is paid annually, we can solve the following equation for r, the yield to maturity:

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Where P is the present market price of the instrument C is the annual coupon payment N is the number if years to maturity FV is the face value of the instrument (usually 100) For portion of a year we use the 30/160 conversion, which assumes that each month has 30 days ad each year 360 days.

Eurocurrency Time Deposits and Certificates of Deposit: The overwhelming majority of bank deposits in the Eurocurrency market take the forms of non negotiable time deposits. An investor puts her money in credit suiss, London branch, today: she get is back, plus interest in three months time. Canceling a time deposit is awkward and expensive, so the investor sacrifices liquidity. Those who want greater liquidity invest in shorter maturities. A very high proportion of Eurodollar time deposits, especially in the inter bank market, mature in one week or less.

Alternatively, the invest can buy a negotiable Euro certificate of deposit (Euro CD), which is simply a time deposit that is transferable and thus has the elements of a security. Some banks are a little reluctant to issue CDs, because they would prefer not to have their paper traded in a secondary market, especially at times when the bank might be seeking additional short term funding. The secondary paper might compete with the primary paper being offered. Other will issue CDs readily if investors prefer them, perhaps paying ¼ percent or ore below their equivalent time deposit rate to reflect the additional liquidity and the somewhat greater documentary inconvenience of CDs. Other banks (particularly if they wish to have their names better known in the market) might deliberately undertake a funding program using Euro CDs. In this circumstance, the CDs are to be distributed like securities, so as to increase awareness of the issuers name and raise a larger volume of funds for longer maturities than might be possible in the conventional eurodeposit market.

Bankers Acceptances and Letters of Credit: Banker’s acceptances are money market instruments arising, typically, from international trade transactions that are financed by banks. The banker’s acceptance (BA) itself represents an obligation be a specific bank to pay a certain amount on a certain date in the future. To simplify a bit, it is a claim ob the bank that differs little from other short term claims such as CDs. Indeed Bas, when they are traded in a secondary market, trade at a return that seldom deviates much from comparable CDs issued by the same bank.

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Letters of credit (L/C) are documents issued by banks in which the bank promises to pay a certain amount on a certain date, if and only if documents are presented to the bank as specified in the terms of the credit. A letter of credit is generally regarded as a very strong legal commitment on the part of a bank to pay if the conditions of trade documents are fulfilled.

In a typical export transaction, the exporter will want to be paid once the goods arrive (and are what they are supposed to be) in the foreign port. So the exporter asks for acceptance is the importers bank of a time draft (essentially an invoice that requests payment on a future date). Upon acceptance by the importers bank, the innocuous little time draft becomes a valuable document, a banker acceptance.

Acceptance means that the bank obliges itself to pay the face amount upon the due date.

The means by which an exporter gets paid is be selling this BA to its own bank, which can hold it as an investment or sell it in the secondary market, when it becomes a money market instrument.

Bankers acceptances are sold at a discount from face value, like Treasury bills and commercial paper, and yields are quoted as discount yields. Why should the bank pay the exporter? The reason is that it has promised the exporter hat it will do so upon presentation of documents conveying title to the goods. That promise is what we gave described as the letter of credit.

Stand by letters of credit are related instruments entailing a commitment to pay on the part of a bank, but they normally do not involve the direct purchase of merchandise or the presentation of title documents.

Euro notes and Euro commercial Paper: These instruments are short term unsecured promissory notes issued by corporations and banks.

Euro notes, the more general term, encompasses note issuance facilities, those that are underwritten, as well as those that are not underwritten. The term Euro commercial paper is generally taken to mean notes that are issued without being backed by an underwriting facilities that is, without out the support of a medium term commitment by a group of banks to provide funds in the event that the borrower is unable to roll over its Euro notes on acceptable terms. The Euro notes market takes the form of non underwritten Euro commercial paper (ECP), so the actual paper that an investor will find available for investment is likely to be ECP. Like US commercial paper, Euro notes and ECP are traded by conversion on a discount basis, and interest is calculated as “actual/360,� meaning that the price is set as 100 minus the discount interest rate multiplied by the actual number of days to maturity, over 360.

3.3. INTERNATIONAL FINANCIAL MARKET INSTRUMENTS Funds are raised from the international financial market also through the sale of securities, such as international equities or Euro equities, Euro bonds, medium term and short term Euro notes and Euro commercial papers.

International Equities: International equities or the Euro equities do not represent debt, nor do they represent foreign

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direct investment. They are comparatively a new instrument representing foreign portfolio equity investment. In this case, the investor gets the divided n and not the interest as in case of debt instruments. On the other hand, it does not have the same pattern of voting right that it does have in the case of foreign direct investment. In fact, international equities are a compromise between the debt and the foreign direct investment. They are the instruments that are presently on the preference list of the investors as well as the issuers.

Benefit to Issuer/ Investor: The issuers issue international equities under certain conditions and with certain objectives. First, when the domestic capital market is already flooded with its shares, the issuing company does not like toad further stress to the domestic stock of shares since such additions will cause a fall in the share prices. In order to maintain the share prices, the company issues international equities. Secondly, the presence of restriction on the issue of shares in the domestic market facilitates the issue of Euro equities.

Thirdly the co company issues international equities also for the sake of gaining international recognition among the public. Fourthly, international equities bring in foreign exchange which is vital for a firm in a developing country. Fifthly, international capital is available at lower cost though the Euro equities.

Sixthly, funds raised through such an instrument do not add to the foreign exchange exposure.

From the viewpoint of the investors, international equities bring in diversification benefits and raise return with a given risk or lower the risk with a given return. If investment is made in international equalities along with international bonds, diversification benefits are still greater.

Procedure of Issue: When a company plans to issue international equity, it decides about the size of the issue, the market where the equities are to be issued, the price of the issue, and about many other formalities. It approaches the lead manager normally an investment bank – which has a better knowledge of the international financial market. The lead manager examines the risk factors of the issue as well as its prospect. It suggest about the details of the issue as also whether the shares are to be routed through the American depository or through the global depository. When the lead manager gives a green signal, the issuing company prepares the prospectus, etc. and takes permission from the regulatory authorities. After getting approval from the regulatory authorities, it deposits the shares to be issued with the custodian bank located in the domestic country. The custodian bank is appointed by the depository in consultation with the share issuing company.

When the shares are deposited with the custodian bank, the latter asks the depository located in a foreign country to issue depository receipts in lieu of the shares held. The ratio between the number of shares and the number of depository receipt is decided well before the actual issue, In fact, the fixing up of the issue price or the ratio between the depository receipts and the shares depends upon a host of economic variables. Generally the issues are priced at discount insofar as the earning per share drops in proportion to the increase in capital. The market price of depository receipt in international market is

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largely dependent upon earnings potential, industry fundamental, and macro economic fundamentals.

The depository, which is a bank or financial institution situated in a international financial centre, functions as a link between the issuing company and the investor. O getting information from the issuing company about the launch, the depository issues the depository receipts. The American depository issues American depository receipts (ADRs), while the depository in the international financial market outside the USA issues global depository receipts (GDRs).

When GDRs are purchased by the investors, the proceeds flow from the depository to the custodian bank and from the custodian bank to the issuing company. The company enters the name of the investor in the register of the shareholders. The investor has the right to surrender GDRs and to take back the investment. For the surrender, the investor deposits the GDRs with the depository who in turn informs the custodian who will issue the share certificates in exchange for the GDRs. The proceeds from the sale of shares are converted into foreign investors. It may be noted here that once the GDR is surrendered in exchange for the shares, such shares cannot be converted back into GDRs. Again the investors can sell the GDR back in the issuing company’s domestic capital market. In order to discourage this practice, the issuer introduced a clause, known as lock in period, during which this practice is prohibited. In the process of the issue, the role of underwriting and listing is very important.

The lead manager functions normally as an underwriter and charges underwriting fee, the listing agent, who is normally the lead manager, makes an application to the stock exchange for listing. The agent guides the issuing company and helps it file the required documents with the stock exchange. After the formalities are complete, GDRs are traded on the stock exchange. There are also international clearing houses, such as Euro – clear and CEDEL that facilitate the settlement of transactions.

The question of voting rights is also important. Since GDR investors keep changing from time to time, they do not seem very much interested in the voting rights even though these cannot be denies to them. There are different procedures followed in this respect. One is that the issuing company and the overseas depository enter into an agreement which enables a depository to vote either with the majority voters or according to the wishes of the management. In the other procedure, it is understood that the depository votes in the same proportion as the rest of the shareholders do. Again, there is one more alternative where the depository votes in accordance with the instructions of a nominee of the management.

The cost of international equity is normally not large, although commission, management fee, etc, are paid to the lead manager according to the different functions performed by it. The depository incurs some expenses. Theses approximate to 3 – 4 per cent of the issue amount.

Documentation: There are many documents used in the process of the issue of international equity.

These are: 1. The prospectus containing detailed information about the issue and the issuer.

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2. The depository agreement the agreement between the issuing company and the depository – that contains, among other things, the rules followed for converting the shares into GDRs and back.

3. The underwriting agreement concluded between the issuing company and the underwriter, normally the lead manager, accompanies the issue.

4. A copy of the agreement concluded between the custodian and the depository is also enclosed.

5. A copy of the trust deed is enclosed which provides for the duties and responsibilities of the trustee regarding servicing of the issue.

6. A copy of the agreement with the listing stock exchange is annexed so that the investors are well aware of the secondary market for the issue.

Besides a subscription agreement is also enclosed the means of which the lead manager and the syndicate members agree to subscribe to the issue.

International Bonds: International bonds are a debt instrument. They are issued by international agencies, governments and companies for borrowing foreign currency for a specified period of time. The issuer pays interest to the creditor and makes repayment of capital. There are different types of such bonds. The procedure of issue is very specific. All these need some explanation here.

Types of International Bonds: Foreign bonds and Euro bonds - International bonds are classified as foreign bonds and Euro bonds. There is a difference between the two, primarily on four counts. First, in the case of foreign bond, the issuer selects a foreign financial market where the bonds are issued in the currency of that very country. If an Indian company issues bond in New York and the bond is denominated in a currency other than the currency of the country where the bonds are issued. If the Indian company’s bond is denominated in US dollar, the bonds will be used in any country other than the USA. Then only it will be called Euro bond. Secondly, foreign bonds are underwritten normally by the underwriters of the country where they are issued. But the Euro bonds are underwritten by the underwriters of multi nationality.

Thirdly, the maturity of a foreign bond is determined keeping in mind the investors of a particular country where it is issued. On the other hand, the Euro bonds are tailored to the needs of the multinational investors. In the beginning, the Euro bond market was dominated by individuals who had generally a choice for shorter maturity, but now the institutional investors dominate the scenes who do not seek Euro bond maturity necessarily to march their liabilities. The result is that the maturity of Eurobonds is diverse. In England, Euro bonds with maturity between 8 and 12 years are known as intermediate Euro bonds.

Fourthly, foreign bonds are normally subjected to governmental regulations in the country where they are issued. For example in the case of Yankee bonds (the bonds issued in the USA), the regulatory thrust lies on disclosures. In some of the European countries, the thrust lies on the resource allocation

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and on monetary control. Samurai bonds (bonds issued in Japan) involved minimum credit rating requirements prior to 1996. But the Euro bonds are free from the rules and regulations of the country where they are issued. The reason is that the currency of denomination is not the currency of that country and so it does not have a direct impact on the balance of payments.

Global bonds: It is the World Bank which issued the global bonds for the first time in 1989 ands 11990. Since 1992, such bonds are being issued also be companies. Presently, there are seven currencies in which such bonds are denominated namely, the Australian dollar, Canadian dollar, Japanese yen, DM, Finnish markka, Swedish krona and Euro. The special features of the global bonds are: They carry high ratings - They are normally large in size - They are offered for simultaneous placement in different countries - They are traded on “home market� basis in different regions.

Straight bonds: The straight bonds are the traditional type of bonds. In this case, interest rate is fixed. The interest rate is known as coupon rate. It is fixed with reference to rates on treasury bonds for comparable maturity. The credit standing of the borrower is also taken into consideration for fixing the coupon rate.

Straight bonds are of many varieties. First, there is bullet redemption bond where the repayment of principal is made at the end of the maturity and not in installments every year. Second, there is rising coupon bond where coupon rate rises over time. The benefit is that the borrower has to pa small amount of interest payment during early years of debt. Third, there are zero coupon bonds. It carries no interest payment. But since there is no interest payment, it is issued at discount. It is the discount that compensates for the loss of interest faced by the creditors. Such bond was issued for the first time in 1981. Fourth in case of bond with currency options, the investor has the right to receive payments in a currency other than the currency of the issue. Fifth, bull and bear bonds are indexed to some specific benchmark and are issued in two trenches. The bull bonds are those where the amount of redemption rises with a rise in the indeed. The bear bonds are those where the amount of redemption falls with a fall in the index. Finally, debt warrant bonds have a call warrant attached with them. (Warrants are zero coupon bonds.) The creditors have the right to purchase another bond at a given price.

Floating rate notes: Bonds, which do not carry fixed rate of interest, are known as floating rate notes (FRNs). Such bonds were issued for the first time in Italy during 1970 and they have become common in recent times.

The interest rate is quoted as a premium or discount to a reference rate which is invariably LIBOR. The interest rate is revised periodically, say, at every three month or every six month period, depending upon

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the period to which the interest rate is referenced to. For example, if the interest rate is referenced to one month LIBOR, it would be revised every month.

FRNs are available in different forms. In the case of perpetual FRNs, the principal amount is never repaid. This means they are like equity shares. They were popular during mid 1980s, but when the investors began to ask for higher rate of interest, many issuers could not afford paying higher rates of interest. Such bonds lost their popularity. Secondly, there are minimax FRNs where minimum and maximum rates are mentioned. The minimum rate is beneficial for the investors, while the maximum rate is beneficial for the issuer. If LIBOR rises beyond the maximum rate, it is only the maximum rate that is payable. Similarly, the minimum rate is payable even if LIBOR falls below the minimum.

The third form is the drop lock FRN where the investor has the right to convert the FRN into a straight bond. Sometimes the conversion is automatic if the reference rate drops below a mentioned floor rate.

Fourthly, there is flop FRN. It was first issued b the World Bank. In this case, the investor has the option of converting FRN into a three month note with a flat three month yield. Again the note cab is converted into a perpetual note after the completion of the three month period.

Fifthly, there are mismatch FRNs. In this case, the interest rate is fixed monthly, but interest is paid six monthly. In such a situation, the investor may go for arbitrage on account of difference in interest rates. Such FRNs are also known as rolling rate FRNs. Sixthly, one of the recent innovations has come in form of hybrid fixed rate reverse floating rate notes. They were used in Deutsch mark segment of the market in 1990. These instruments paid a high fixed interest rate for a couple of years. The investors received the difference between LIBOR and even a higher fixed interest rate. They reaped profits with the lowering of LIBOR.

Convertible bonds: International bonds are also convertible bonds meaning that these variant are convertible into equity shares. Some of the convertible bonds have detachable warrants involving acquisition rights. In other cases, there is automatic convertibility into a specified number of shares.

Convertible bonds command a comparatively high market value because of the convertibility privilege. The value is the sum of the naked value existing in the absence of conversion and the conversion value. The conversion price per share is computed by dividing the bonds face value by the conversion factor, where the conversion factor represents the number of shares into which each bond could be exchanged. Suppose, a bond having a face value of $ 1000 can be exchanged for 15 shares the conversion price will be equal to; 1000/15 = $ 66.66 Thus, if the market price of share is less than $ 60, bondholders will not be interested in

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converting the bond into equity share. This is so because for a bond of $ 1000, a creditor will get 15 shares or $ 900 only. But if the market price of share is $80, the investors will convert the bond into equity shares and sell the equity shares in the market. This way each bond for $ 1000 will fetch $ 1200. In other words, the price of convertible bonds depends upon the price of the equity shares. In the case of bonds with detachable warrants, the warrant can be detached from the bond and cab be traded independently.

The issuer has a double source of financing. The bonds remain outstanding even if the warrants are exercised.

From the viewpoint of the borrowers, convertible bonds cost less because they have lower coupon. They also help decrease the debt equity after conversion. From the investor’s point of view, convertible bonds represent a better option as the investors get a fixed income in the form of interest prior to conversion. After conversion, they become the owner of the company.

Cocktail bonds: Bonds are often denominated in a mixture of currency. Such bonds are known as cocktail bonds.

There are two forms of cocktail bonds – one is denominated in SDRs represent a weighted average of five currencies, while the Euro represents a basket of 11 currencies. The investors purchasing the cocktail bonds get automatically the currency diversification benefits. The foreign exchange risk on account of depreciation of any one currency is offset be appreciation of another currency.

Procedure of Issue: There are different stages involved in the issue of international bonds. Since the issuer– normally a government or a company – does not have a detailed idea about the international financial market, nor it is easy for the issuer to perform several formalities, it approaches a lead manager who advises the issuer on different aspects of the issue. Normally, the lead manager is a commercial bank or an investment bank. The issuer selects a particular lead manager on the reports published by different agencies about the performance of the investment banks I the area of lead managing. The lead manager advises the issuer regarding the main features of the issue, the timing, price, maturity and the size of the issue and bout the buyer’s potential. The lead manager takes help from the co-manager, although the bulk of the work is done by itself.

After getting advice from the lead manager, the issuer prepares the prospectus and other legal documents. In this process, the issuers own accountant, auditors, legal counsel are very important for designing the issue in accordance with the financial need of the company as well as with regulatory provisions existing in the country. Sometimes the advice of the lead manager is also sought in order to make the issue suitable for indicators prevailing in the international financial market. The lead manager charges fee for the advice. The fee is known as management fee. When all this is over, the issuer takes approval from the regulatory authorities. After the approval, it launches the issue.

The second stage begins when the issue is launched. Investors look at the credit rating of the issuer as well as who is underwriting the issue. This is why the lead manager along with co managers

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helps in the credit rating of the issuer by a well recognized credit rating institution. At the same time, it functions as an underwriter and charges underwriting fee.

The third stage begins after the underwriting process is complete. This stage includes the process of selling the bonds. More often, the lead manager functions as a selling group and for that it charges commission at varying rates.

The investors, on the other end, are individuals. They are institutions, such as investment trust, banks and companies. They often purchase the bond through their buying agents. There are also trustees who are usually a bank appointed by the issuer. Their duty is to protect the interest of the investors, especially in vase of default by the borrower.

Sometimes the lead manager acts as a trustee. Finally, there are listing institutions. They enlist the bonds for secondary marketing. The secondary market for international bonds is mainly an over the counter market, although the bonds are listed with the stock exchanges. It may be noted that the entire procedure of the international bond issue is complete within a specified time span. After the press release of the prospectus, it takes 27 days. The first 12 days are spent on sales campaign which is known as the th

offering period. On the 12 day, underwriting agreement is signed, which is known as the pricing day.

During the following 15 days, bonds are sold and delivered and the necessary payments made.

Documentation: Documentation requirements for a bonds issue are complex. There are seven documents that are required. The first is the prospectus. It informs about the issuer, its management and about it’s past, present and future operation. It also covers the political and economic make up of the country. The second is the subscription agreement. It comprises denomination, coupon rate, issue price and maturity of the bond, underwriting commitments, details of selling arrangements, closing date and the terms of payment, names of the paying agents and trustees, details of lilting conditions under which agreement cab be terminated, the legal jurisdiction and rules regarding compensation in case of misrepresentations or breach of warranties. The third important document is the trust deed which is an agreement between the issuer and the trustee for an orderly servicing of the bond. The fourth document is the listing agreement that shows listing centers. The fifth document is the paying agency agreement executed between the issuer and the bank that pays the agent for servicing of the bond. The sixth document is the underwriting agreement that brings in confidence among the investors. The last document is a copy of the selling group agreement that tells about the agencies involved in the sale of the bond. All these documents accompany the bond certificate.

Secondary Market Operation: Facilitates do exist for secondary market operation for foreign bonds and Euro bonds. In the case of the former, listing is done on a particular stock exchange in a particular country. But for Euro bonds, many financial centers are involved. This is why transaction takes place in over the counter market.

However listing with international stock exchange helps Euro bonds in determination their price,

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depending upon the performance of the issuer and the demand for the issue. When the price is determined and the issue is ready for sale, the stock exchange helps the deal. Normally, there is spread of one half of one per cent between bid and offer prices. Settlement instructions are routed through the clearing house located in Brussels and Luxembourg, and delivery of bonds is made against payment.

Clearing may also take place through book entries.

Sometimes, before the secondary market starts functioning, the particular Euro bond is in great demand. Such trading is known as grey trading, although such cases are rare. For smooth operation of the clearing houses and operation of the secondary market, there is an Association of International Bond Dealers, which was set up under Swiss law as far back as in 1969. It frames rules for smooth operation.

Development of International Bond Market: Foreign bonds emerged on a substantial scale as early as in 1950s. The US dollar as then the strongest currency. In order to obtain US dollar, issuers from different countries issued bonds in the US financial market. These Yankee bonds were very popular. However, with weakening balance of payments, the US Government imposed restrictions on the issue of Yankee bonds in 1960s. The restrictions provided impetus for the emergence of Euro bonds. The first Euro bond was issued b an Italian borrower, Autos trade in 1963. Many other Euro bonds were issued subsequently. But since bank lending dominated the financial scene till early 1980s, sizeable growth in Euro bond market took place only thereafter. The total bond volume increased from US $ 38 billion in 1980 to US $169 billion in 1985 and to US $ 230 billion in 1990 (BIS, 1992).

During 1990s, owing to greater liberalization in the international financial market, which was more apparent in Germany, France and Japan, the size of the bond market grew at a faster rate. By March 1995, the amount involved was over US $ 2210 billion. In 1995, the straight bonds dominated the scene as they accounted for over three fourths of the issue. FRNs accounted for around one – seventh. The rest was accounted for by convertible bonds. Again, it was found that Japanese yen denominated bonds were mainly fixed rate bonds, while floating rate bonds were denominated mainly in A British pound. The Swiss franc denominated bonds were normally the convertible bonds (BIS 1997). Yet again, around two fifths of the total issues in 1995 were denominated in US dollar, a little less than one fifth in Japanese yen, about one seventh in DM, and the rest of the bonds were denominated in other currencies. In the case of bonds issued by the firms and governments of developing countries, 57 per cent of the issue was represented by US dollar and over one- quarter was denominated in Japanese yen.

The share of DM was hardly one- tenth. The value of yen bonds increased during 12990s because may Latin American Brady bonds came to be denominated in yen in view of greater attraction for them among Japanese investors (BIS 1997). In 1995 the average size of maturity of international bonds was 4.3 years, but subsequently, it rose due to longer term bonds issued by many corporations. Again, after the Mexican crisis of 1994, some of the Latin American governments tried to re establish benchmarks in international financial market and issued international bonds. This resulted in the growth of sovereign bonds during

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these years.

Short – Term and Medium – Term Instruments: Euro Notes: Euro Notes are like promissory notes issued by companies for obtaining short term funds. They emerged in early 1980s with growing securitization in the international financial market. They are denominated in any currency other than the currency of the country where they are issued. They represent low cost funding route. Documentation facilities are the minimum. They can be easily tailored to suit the requirements of different kinds of borrowers. Investors too prefer them in view of short maturity.

When the issuer plans to issue Euro notes, it hires the services of facility agents or the lead arranger. On the advice of the lead arranger, it issues the notes, gets them underwritten and sells them through the placement agents. After the selling period is over the underwriter buys the unsold issues.

When the issuer plans to issue Euro notes, it hires the services of facility agents or the lead arranger. On the advice of the lead arranger, it issues the notes, gets them underwritten and sells them through the placement agents. After the selling period is over, the underwriter buys the unsold issues.

The Euro notes carry three main cost components: 1, underwriting fee; 2, one time management fee for structuring, pricing and documentation; and 3, margin on the notes themselves. The margin is either in the form of spread above/below LIBOR or built into the note price itself.

The documentation is standardized. The documents accompanying notes are usually underwriting agreement, paying agency agreement, and information memorandum showing, among other things, the financial position of the issuer. The notes are settled either through physical delivery or through clearing.

In course of time, a few variants of Euro notes issue system have evolved. The first is the revolving underwriting facility in which there is a sole placement agent who allocates the notes among investors at a uniform pre set yield. The second is the tender panel system in which the placement agent forms a panel of banks for placing Euro notes on behalf of the issuer. The tender panel members submit tenders to the placement agent indicating the amount and price of notes they would like to acquire. In this case, price is set by open competition and so it goes in favour of the issuer. But the placement agent may not have the same level of commitment as it is found in the case of the sole placement agent. The third variant is continuous tender panel in which the underwriters constitute a tender panel for each draw down of notes. They buy them, if left unsold, during the offer period. This system brings in competition among the underwriters.

Euro Commercial papers: Another attractive form of short term debt instrument that emerged during mid – 1980s came to be known as Euro commercial paper (ECP). It is a promissory note like the short term Euro notes although it is different from Euro notes in some ways. It is not underwritten, while the Euro notes are underwritten. The reason is that ECP is issued only by those companies that possess a high degree of

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rating. Again, the ECP route for raising funds is normally investor driven, while the Euro notes is said to be borrower driven.

ECP came up on the pattern of domestic market commercial papers that had a beginning in the USA and then in Canada as back as in 1950s. The prefix “Euro� means that the ECP is issued outside the country in the currency in which it is denominated. Most of the ECPs are denominated in US dollars, but they are different from the US commercial papers on the sense that the ECPs have longer maturity going up to one year. Moreover, ECPs are structured on the basis of all in costs, whereas in US commercial papers, various charges, such as front end fee and commission are collected separately. The detailed features of ECPs vary from one country to another. They involve market based interest rate, LIBOR. The issue is normally arranged through placement agents as in the case of Euro notes. The amount varies from US $ 10 million to US $ 1 billion or above.

The ECPs are issued either in interest bearing form or in a discounted form with interest built in the issue price itself. On completion of the maturity, they are settled generally at the clearing houses, such as Cedel (Luxembourg) Euro clear (Brussels), First Chicago (London) or Chases Manhattan (London) so that the physical delivery is avoided. The settlement is complete normally within two days.

ECPs face minimal documentation. Over and above, they are not underwritten. This is why their use has been large since their very inception. The outstanding amount of transaction through ECPs rose from US $ 13.9 billion in 1986 to US $ 79.6 billion in 1991. By March 1995, the amount was US $ 81.3 billion, over three fourths of which were denominated in the US dollar (BIS, 1997).

Medium- term Euro Notes: Medium term Euro notes are just an extension of short term Euro notes as they fill the gap existing in the maturity structure of international financial market instruments. They are a compromise between short term Euro notes and long term Euro bonds as their maturity ranges between one year and five to seven years. The short term Euro notes are allowed to roll over repeatedly over five to seven years. Every three or six months, the short term Euro notes are redeemed and a fresh issue is made.

Alternatively, a medium term Euro note is issued to get medium term Euro note is issued to get medium term funds in foreign currency without any need for redemption and fresh issue. Medium term Euro notes are not underwritten, yet there is provision for underwriting. This is for ensuring the borrowers that they get the funds even if they lack sufficient creditworthiness. They are issued broadly on the pattern of US medium term notes that are found there since early 1970s. Medium term Euro notes carry fixed rate of interest, although floating rates are also there. In recent years, multicurrency structure has come up.

The issuers are mainly banks, sovereigns and international agencies.

The medium term Euro notes been popular. The outstanding amount, which was just US $ 0.4 billion at the end of 1986, grew to US $ 9.6 billion by 1990 and to US $ 347.1 billion by March 1995 (BIS, 1997). The galloping growth in such issues shows the tremendous popularity of this instrument.

Of late, the Euro market has come up with global medium term note issues. Under this

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programme, issues of different credit ratings are able to raise funds through accessing retail as well as institutional investors. This is a comparatively new programme.

Overview of the Financial International Financial Market: When a multinational enterprise finalizes its foreign investment project, it needs to select a pparticular source, or a mix of sources of funds to finance the investment project.

Here it may be noted that a ,multinational enterprise position itself on a better footing than a domestic firm as far as the procurement of funds is concerned. A domestic firm gets funds normally from domestic sources. It does get funds from the international financial market too but it is not as easy as in case of a multinationals enterprise. The latter can use the parent companies funds for its foreign investment project. It can also get funds from the host country financial market, but more importantly, it tries to get funds from the international financial market. It selects a particular source or a mix of sources or a particular type or types of funds that suits its corporate objectives.

Factors behind Emergence of Euro Banks: It may be mentioned that after Stalins death, the then USSR moved away from the closed economic policy and its trade with the West and the South began to expand since the later 1950s or the early 1960s. Those days the US dollar was the most desired currency in international transactions, so the USSR earned US dollars through trade and tried to earn more of this currency in view of its great strength in international transaction. Since the cold was between the two super powers was then at its peak, it preferred to keep its earned dollars in a bank outside the USA. London and a few other European financial centers were the best choice as they possessed the requisite infrastructure and a stable political climate. Those dollar deposits in London and other European country based banks came to be known as Euro dollars and the banks accepting such deposits came to be known as Euro banks. In the wake of the foreign exchange crisis of 1955 – 57, the British government placed restrictions on the use of pound sterling for external transactions and the dollar was in great demand in the UK for external transactions, in view of the readily available supply of dollars. Moreover, the emerging convertibility of some European currencies by late 1950s led to the emergence of an active foreign exchange market in Europe linking the US dollar with those European currencies. These links enhanced in turn, the use of the US dollar by the banks located in Europe.

The emergence of Euro banking got support from some capital control measures by the US government in the wake of the balance of payments crisis in the 1960s. In early 1965, the introduction of voluntary foreign directly to the non residents, whereas this provision did not apply to foreign branches of the US banks. As a result, the foreign operation of the US banks shifted from those located in the USA to those located in other countries, mainly ion Europe. Statistics show that the number of US banks having foreign branches rose from 11 in 1964 to 125 in 1973, the number of foreign branches of those banks moved up from 181 to 699 during this period and the assets of those branches whet up from US $ 7.0 billion to US $ 118 billion during the same period (Johnston, 1982).

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Some of the European governments imposed restrictions on holding of deposits by non residents in domestic currency and on paying of interest on non resident deposits. This encouraged the non residents to hold deposits in Euro banks that were not subject top such regulations. The US Government too imposed an interest rate ceiling when credit was tight and the market interest rate had risen. The US banks could not raise the interest rate. On the contrary, the Euro banks that were not under the purview of such ceilings, raised interest rate on deposits and attracted depositors away from the US based banks.

Again, when domestic credit was restricted, companies borrowed from Euro banks normally at lower rates of interest, and the increased lending and deposits contributed to the growth of the Euro banks. It was not only that the US banks came to be based in Europe; the European banks too spread their branches overseas perhaps as a defensive measure. Statistics reveal that the number of overseas branches increased from 1860 in 1961 to 3764 in 1973. The number of foreign branches of UK based banks alone rose from 1105 to 1973 during the same period (Bhatt, 1991).

Syndication of Lending: Another structural change that took place during the 1970s was evident in the form of syndicated lending. In the wake if the international oil price rise, a number of oil – importing countries experienced huge deficit on their current account. Consequently, they had to resort to bigger loans that were normally not within the capacity of a single bank to provide. The banks joined hands for providing these large loans. They did it so also re reduce the individual risk of lending. Besides, from the borrower’s point of view, the cost of the syndicated loans was smaller than the sum of the cost of individual loans borrowed from many banks. Whatever the reasons for the coming together of the banks, such lending came to be known as syndicated lending. Such loans served the interest of both lenders and borrowers and so they took a great leap forward. Taking birth in early 1970s, they crossed US $ 88 billion mark by 1980 and reached US $ 320 billion by 1995 (IMF, 1997).

Syndicated loans are different from general loans in that one of the lending banks is the lead manager who originates the transaction, structures it, selects the lending members, supervises the documentation, and in many cases, services the loan after agreement is complete. It serves as a link between the borrower and the other banks of the syndicate. It collects interest and principal from the borrower and disburses the collected amount among the co-leaders. For its functions, the lead bank charges and additional fee.

Selection of Sources and Forms of Funds: When a firm selects a particular source or form of funds, it does so in order to suit its corporate objectives. Some of the major objectives are the minimization of the effective cost of funds, matching the raised funds with target debt- equity, and the target current-liability long- term-liability ratio, and avoidance of lengthy legal and procedural formalities.

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Short term and Long term Instruments: 1 International Financial Markets and Instruments The gap between savings and investment is widening gradually in the developing countries. The growing demand for capital inflows in the developing countries forced them to depend on external sources for debt or equity capital. The need for external borrowings in a country's economy can be gauged from the national income and balance of payment position. From the macro economic theories, the current account surplus or deficit in BOP of a country is nothing but the difference between the domestic savings and domestic investments. If the domestic savings exceed domestic investment a surplus in current account would result increasing the reserves of the country. A deficit in current account would emerge if the domestic savings is less than domestic investment.

To recall from the chapter on BOP, national income can be defined in the following formats.

If (X – M) gives the net of foreign exchange inflows/outflows of the current account in BOP statement we can conclude in a broader perspective, that the gross domestic savings are equal to the sum of gross domestic capital formation and foreign investment.

Basing on BOP position of a country, the sources of external funds can be broadly classified into the following categories: i. External assistance in the form of aid. ii. Commercial borrowings. iii. Short-term credit.

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iv. Foreign direct investment.

The flow of external funds into a country depends on various factors like the policy guidelines of the country on commercial borrowings by individual entities, the exchange control regulations of the country, the interest rate ceilings in the financial sector and the structure of taxation. The integration of financial markets across countries has opened up the international markets and large varieties of financial instruments have merged to suit the changing needs of the international investor. In this chapter, we briefly discuss various instruments that are available in international financial markets. The financial markets across countries facilitate the financial intermediation / disintermediation and transfer of surplus funds from the savers to the deficit units. The gradual liberalization of the financial sector in the developing countries initiated in early '70s started providing multiple instruments to the savers and the issuers converging the needs of suppliers of the resources with that of the users of the resources.

Origin of International Financial Markets: The genesis of the present international markets can be traced back to 1960s, when there was a real demand for high quality dollar-denominated bonds from wealthy Europeans (and others) who wished to hold their assets outside their home countries or in currencies other than their own. These investors were driven by the twin concerns of avoiding taxes in their home country and protecting themselves against the falling value of domestic currencies. The bonds which were then available for investment were subjected to withholding tax. Further, it was also necessary to register the ownership of the bonds.

Dollar denominated Euro-bonds were designed to address these concerns. These were issued in bearer forms and so, there was no record of ownership and no tax was withheld. Also, until 1970, the International Capital Market focused on debt financing and the equity finances were raised by the corporate entities primarily in the domestic markets. This was due to the restrictions on cross-border equity investments prevailing until then in many countries. Investors too preferred to invest in domestic equity issues due to perceived risks implied in foreign equity issues either related to foreign currency exposure or related to apprehensions of restrictions on such investments by the regulators.

Major changes have occurred since the '70s which have witnessed expanding and fluctuating trade volumes and patterns with various blocks experiencing extremes in fortunes in their exports/imports.

This was the period which saw the removal of exchange controls by countries like the UK, France and Japan which gave a further boost to financial market operations. In addition to this, the application of new technology to financial services, the institutionalization of savings and the deregulation of markets have played an important role in channelizing the funds from surplus units to deficit units across the globe. The international capital markets also became a major source of external finance for national with low internal savings. The markets were classified into Euro Market, American Market and Other Foreign Markets.

The following figure shows the various sources of external finance and various channels for accessing external funds.

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India's presence in International Markets: India has made its presence felt in the international financial markets though to a very small extent. There has been a total turnaround in the market sentiment for Indian paper since 1991-1992 – albeit with a difference.

So far the traditional avenues for raising capital abroad have been through bank borrowings, syndicated loans, lines of credit, bonds and floating rate notes. Access to the international capital markets was only through debt instruments and was mostly limited to financial institutions and public sector units, although there were a few cases of private companies also. With the downward revision of India's credit rating to the non-investment grade, borrowing in the international capital markets dried up with most of the Lenders being off limits (crossing the exposure limit) on India. The picture has since changed. There were a variety of reasons for the international markets to view India differently reforms. *

Improved perception of India's economic reforms

*

Improved export performance

*

Modest to healthy economic indicators

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Inflation contained to single digit

*

Improved Forex reserves position

*

Improve performance of Indian companies

*

Improved confidence of the FIIs in the economy

*

Lack of investment opportunities worldwide and

*

Decline in rate of return on investments in developed markets.

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It was in March 1992, that the government first permitted a few Indian companies to tap the international equity market and till date a number of Indian companies have successfully taken the equity / equity-related route.

Instruments Available in the International Financial Markets: As in any domestic capital structuring we can segregate international financing into two broad categories. These are: i. Equity financing and ii. Debt financing.

The various instruments used to raise funds abroad include; Equity, straight debt or hybrid instruments. The following figure shows the classification of international capital markets based on instruments used and market(s) accessed.

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Debt Instruments: The issue of bonds to finance cross-border capital flows has a history of more than 150 years. In the 19th century, foreign issuers of bonds, mainly governments and railway companies, used the London market to raise funds.

International bonds are classified broadly under two categories: Foreign Bonds: These are the bonds floated in the domestic market denominated in domestic currency by non-resident entities. Dollar denominated bonds issued in the US domestic markets by non-US companies are known as Yankee Bonds, Yen denominated bonds issued in Japanese domestic market by non-Japanese companies are known as Samurai Bonds and Pound denominated bonds issued in the UK by non-UK companies are known as Bulldog Bonds. Similarly, currency sectors of other foreign bond markets have special names like Rambrand Dutch Guilder, and Matador Spanish Peseta etc.

Eurobonds: The term 'Euro' originated in the fifties when the USA under the Marshall Plan was assisting the European nations in the rebuilding process a after the devastation caused by the Second World War. The dollars that were in use outside the US came to be called as "Eurodollars". In This context the term ‘Euro’ signifies a currency outside its home country. The term 'Eurobonds' thus refer to bonds issued and sold outside the home country of the currency. For example, a dollar denominated bond issued in the UK is a Euro (dollar) bond, similarly, a Yen denominated bond issued in the US is a Euro (Yen) bond. The companies wishing to come out with shorter maturities have an option to issue Euro notes in the European Markets. The important ones being Commercial Paper (CP), Note Issuance Facilities (NIF) and Medium-Term Notes (MTNs).

Euro-Commercial Paper issued with maturity of up to one year, are not underwritten and are unsecured .Note Issuance Facilities (NIFs) are underwritten and have a maturity of up to one year.

Standby NIFs are those formally designated instruments which back Commercial Paper to raise shortterm finances. A variation of NIF is the Multiple Component Facility (MCF), where a borrower is enabled to draw funds in a number of ways, as a part of overall NIF program. These options are referred to as short-term advances and banker's acceptances, and afford opportunities for choosing the maturity, currency and interest rate basis.

Medium-Term Notes, on the other hand, are non-underwritten and are issued for maturities of more than one year with several trances depending upon the preferred maturities. It is to be noted that in similar circumstances, a typical CP program allows for a series of note issues having regard to the maturity of the overall program.

The borrowings in the international capital markets are in the form of Euro Loans which are basically loans from the bank to the companies which need long-term and medium term funds. Broadly, two distinct practices of arranging syndicated credits have emerged in Euromarkets, club loans and syndicated loans. The Club Loan is a private arrangement between lending banks and a borrower. When

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the loan amounts are small and the parties are familiar with each other; lending banks form a club and advance a loan hence the name of club loan. Syndicated Euro credit, however, has a full-fledged public arrangement for organizing a loan transaction. It is treated as an integral part of the financial market mechanism with a wide network of banks participating in the transaction over the globe. Typically, a syndicated loan is available for a maturity of seven years with shorter period transactions having a maturity of 3 to 5 years.

Equity Instruments: Until the end of 1970s, International Capital Markets focused on debt financing and the equity finances were raised by the corporate entities primarily in the domestic markets.

This was due to restrictions on cross-border equity investments prevailing until then in many countries. Inventors too preferred to invest in domestic equity issues due to perceived risks implied in foreign equity issue either related to foreign currency exposure or related to apprehensions of restrictions on such investments by the national authorities. Early '80s witnessed liberalization of many domestic economies and globalization of the same. Issuers from developing countries, where issue of dollar/foreign currency denominated equity shares are not permitted, are now able to access international equity markets through the issue of an intermediate instrument called 'Depository Receipt'.

A Depository Receipt (DR) is a negotiable certificate issued by a depository bank which represents the beneficial interest in shares issued by a company. These shares are deposited with a local 'custodian' appointed by the depository, which issues receipts against the deposit of shares.

According to the placements planned, DRs are referred to as (i) Global Depository Receipts (GDRs) (ii) American Depository Receipts (ADRs) and (iii) International Depository Receipts (IDRs). Each of the Depository Receipt represents a specified number of shares in the domestic markets. Usually, in countries with capital account convertibility, the GDRs and domestic shares are convertible (may be redeemed) mutually. This implies that, an equity shareholder may deposit the specified number of shares and obtain the GDR and vice versa. The holder of GDR is entitled to a dividend on the value of the underlying shares of the GDR (issued normally in the currency of the investor country). As far as Indian companies are concerned, the dividends are announced as a percentage of the value of GR sans premium in rupee terms converted at the prevailing exchange rate. However, until the global Depository Receipts (GDRs)/American Depository Receipts (ADRs/International Depository Receipts (IDRs) are converted, the holder cannot claim any voting right and also, there is no foreign exchange risk for the company. These types of instruments are ideal for companies which prefer a large shareholder base and international presence. The company will be listed at the prescribed stock exchange providing liquidity for the instrument.

Quasi-instruments: These instruments are considered as debt instruments for a time-frame and are converted into equity at the option of the investor (or at company's option) after the expiry of that particular time-frame.

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The examples of these are Warrants, Foreign Currency Convertible Bonds (FCCBs), etc. Warrants are normally issued along with other debt instruments so as to act as a 'sweetener'.

FCCBs have a fixed coupon rate with a legal payment obligation. It has greater flexibility with the conversion option - at the choice of the investor – to equity. The price of the conversion of FCCB closely resembles the trading price of the shares at the stock exchange. Also, the company may incorporate a 'call option' at the choice of the issuer to obtain FCCBs before maturity. This may be due to the adverse market conditions, changes in the shareholding pattern, changes of tax laws etc. A Euro Convertible Bond is issued for investment in Europe. It is a quasi-equity issue made outside the domestic market and provides the holder with an option to convert the instrument from debt to equity. An added feature now-adays is to allow conversion of Euro Convertible Bond into GDR. Till conversion, interest is paid in US dollars and bond redemption is also done in US dollars, thus while the investor would prefer the convertible bond as an investment instrument, the issuing company tends to prefer a GDR. An investor can exercise the conversion option at any time or at specified points during the convertible life. The investor exchanges the convertible bond for a specified number of shares.

Players in the International Financial Markets: Borrowers/Issuers, Lenders/Investors and Intermediaries are the major players of the international markets. The role of these players is discussed below.

Borrowers/Issuers: These primarily are corporate, banks, financial institutions, government and quasigovernment bodies and supranational organizations, which need Forex funds for various reasons. The important reasons for corporate borrowings are, need for foreign currencies for operation in markets abroad, dull/saturated domestic market and expansion of operations into other countries. Governments borrow in the global financial market for adjusting the balance of payments mismatches, to gain net capital investments abroad and to keep a sufficient inventory of foreign currency reserves for contingencies like supporting the domestic currency against speculative pressures.

Further, the supranational organizations like the International Monetary Fund (IMF), World Bank, International Finance Corporation, Asian Development Bank, etc., borrower usually, long-term funds to finance diversified financing, sometimes linked to swaps for hedging current/interest rate exposures.

These supranational are also typical examples of large entities appearing in the global markets as both issuers and borers.

Lenders / Investors: In case of Euro-loans, the Lenders are mainly banks who possess inherent confidence on the credibility of the borrowing corporate or any other entity mentioned above. In case of a GDR, it is the institutional investors and high net worth individuals (referred as Belgian Dentists) who subscribe to the equity of the corporate. For an ADR, it is the institutional investor or the individual investor through the Qualified Institutional Buyer who puts in the money in the instrument depending on the statutory status

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attributed to the ADR as per the statutory requirements of the land. Investors in the global markets come in a large range who invests to suit their own requirements, investment objectives, risk taking abilities and liabilities. The investor range includes private individuals investing through Swiss banks, the IMF and the World Bank. The other major investors are insurance companies, professional pension fund managers and investment trusts. In the United Kingdom, with London still a major force in the international finance market, it is the pension fund and insurance companies which are the major investors in the equity markets and bond markets. In the USA and Japan, the private player has an important role in the equity markets. In Germany, on the other hand, commercial banks play a dominant role as investors.

Institutional investors can also be classified as: Market Specific Investors: Specialize in specific instruments like equity, convertibles, fixed interest bonds, floating rate bonds, etc.

Time Specific Investors: Specialize in specific maturity instruments like long-term, medium-term, shortterm etc.

Industry Specific Investors: Specialize in specific industries like chemical, pharmaceutical, steel, automobiles etc.

Intermediaries: The intermediaries involved in International Capital Markets include Lead managers/Co-lead Managers, Underwriters, Agents and Trustees, lawyers and Auditors, Listing Agents and Stock Exchanges, Depository Banks and Custodians.

An overview of the functions performed by each of them is given below: Lead and Co-managers: The responsibilities of a Lead Manager include undertaking due diligence and preparing the offer circular, marketing the issues including arranging the road shows. Lead manger, sometimes in consultation with the issuer, can choose to invite a syndicate of investment banks to buy some of the Bonds/DRs and help sell the remainder to other investors. 'Co-managers' are thus invited to join the deal, each of whom agrees to take a substantial portion of the issue to sell to their investor clients. Quite often there will be more than one lead manager as mandates are sometimes jointly won, or the investment bank which actually won the mandate from the issuer may decide that it needs another institution to ensure a successful launch.

Two or more managers may also reflect the fact that a geographical spread of placing power is required or deemed appropriate.

One of the lead manager will 'run the books' for the issue. This essentially involves arranging the whole issue, sending out invitation telexes, allotting Bonds/DRs etc. ii) Underwriters: The lead manager(s) and co-managers act as underwriters for the issue, taking on the risk of interest rate / markets moving against them before they have placed Bonds/DRs. Lead manager(s) may also invite additional investment banks to act as sub-underwriters, thus forming a larger underwriting

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group. A third group of investment banks may also be invited to join the issue as members of selling group, but these institutions only receive a commission in respect of any Bonds /DRs sold and do not act as underwriters. The co-managers and the underwriters are also members of the selling group.

The Selling Group: Lead Co-Manager Underwriting Selling Group Manager Group iii) Agents and Trustees: These intermediaries are involved in the issue of bonds/convertibles. The issuer of bonds/convertibles, in association with the lead manager, must appoint 'paying agents' in different financial centers, who will arrange for the payment of interest and principal due to investors under the terms of the issue. These paying agents will be banks. iv) Lawyers and auditors: The lead manager will appoint a prominent firm of solicitors to draw up documentation evidencing Bond/DRs issue. The various draft documents will be scrutinized by lawyers acting for the issuer and in due course by the co-managers and any other party signing a document related to the issue. Many of these documents are prepared in standard forms, but each needs to be reviewed carefully to ensure that all parties to the transactions are fully satisfied with the wording. The issuer will also appoint legal advisors to seek advice on matters pertaining to Indian/English/American law and to comment on necessary legal documentation. Auditors or reporting accountants will become involved as well, supplying financial information summaries and an audit report which will be incorporated into the 'offering circular'. The auditors provide comfort letters to the lead manager on the financial health of the issuer. Further, they also provide a statement of difference between the UK and the Indian GAAP in case of GDR issue. v) Listing Agents and Stock Exchanges: The listing agent facilitates the documentation and listing process for listing on stock exchange and keeps on file information regarding the issuer such as Annual Reports,

Articles

of

Association,

the

Depository

Agreement,

etc.

The

Stock

Exchange

(Luxembourg/London/AMEX/NYSE as the case may be) reviews the issuer’s application for listing of the bonds/DRS and provides comments on offering circular prior to accepting the securities for listing. vi) Depository Bank: Depository Bank is involved only in the issue of D Rs. It is responsible for issuing the actual D Rs. disseminating information from the issuer to the DR holders, paying any dividends or other distributions and facilitating the exchange of D Rs into underlying shares when presented for redemption. vi) Custodian: The custodian holds the shares underlying D Rs on behalf of the Depository and is responsible for collecting rupee dividends on the underlying shares and repatriation of the same to the Depository in US dollars/foreign currency.

vii) Printers: The printers are responsible for printing and delivery of the preliminary and final offering circulars as well as the DRs/Bond certificates.

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Resource Mobilization - The Decision Criteria: Resource mobilization at competitive cost is a critical issue which confronts every management.

In the past, Indian companies could access only the domestic capital market. Liberalization process has opened new avenues for Indian companies in terms of markets and instruments. i. Currency Requirements: A decision has to be taken about the currency needs of the company, keeping in view the future expansion plans, capital imports, export earnings/potential export earnings. A conscious view on the exchange rate also needs to the taken. ii. Pricing: Pricing of an international issue would be a factor of interest rates and the value of the underlying stock in the domestic market. Based on these factors, the issue price conversion (for convertible) premium would be decided. Given the arbitrage available between interest rates in rupees and say, US dollars, and given the strength of the rupee, as well as the resilience a company can have in its operations against exchange fluctuation risk, due to export earnings, it is possible to take advantage of the low interest rates that are prevailing in the international markets. The above is possible without dilution of the value of the underlying stock. This is so, because, in the case of international issues, open pricing/book building is possible, which has the advantage of allowing the company to maximize the proceeds, enabling the foreign investors to set the premium ensuring transparency and creating price tension. iii. Investment: AT present greater flexibility is available in structuring an international issue in terms of pure equity offering, a debt instrument or a hybrid instrument like Foreign Currency Convertible Bond (FCCB). Each company can take a view on instrument depending upon the financials of the company and its future plans. iv. Depth of the Market: Relatively larger issues can be floated, marketed and absorbed in international markets more easily than in the domestic markets. v. International Positioning: Planning for an international offering has to be a part of the long-term perspective of a company. An international issue positions the issuing company, for a much higher visibility and an international exposure. Besides, it opens up new avenues for further fund-raising activities.

vi. Regulatory Aspects: For an international issue, approvals are required from the government of India and the Reserve Bank of India, whereas for a domestic issue the requirements to be satisfied are those of the SEBI and the stock exchanges. vii. Disclosure Requirements: The disclosure requirements for an international issue are more stringent as compared with a domestic issue. The requirements would, however, differ depending upon the market addressed and the place where listing is sought. viii. Investment Climate: The international offering would be affected by factors like the international liquidity and the country risk, which will not have an effect in a domestic issue. With the current country

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rating, companies have to depend on the strength of their balance sheets to raise funds at competitive rates the international markets.

3.4. QUESTIONS Section – A Very short Answer 1. What do you mean by money market?

2. Define capital market.

3. What is Eurocurrency time deposit?

4. What is Letters of credit?

5. What is a Euro note?

6. What is ECP? 7. What do you mean by Documentation?

8. Define Bond.

9. What do you mean by Global bond?

10. What is floating rate notes?

Section – B Short type question answers 1. What are the different other foreign markets?

2. What are the different types of Euro Finance?

3. What are the recent Innovations in financial Instruments?

4. Explain the following short questions. (a)American Depository Receipt (ADR) (b)Global Depository Receipt (GDR) 5. What are the different financial instruments in the financial markets?

Section – C Long type question answers 1. Explain briefly the origin and growth of Eurodollar Market.

2. Explain the nature of international financial markets.

3. What are the functions of international financial markets?

4. Explain the types of international bonds.

5. Explain the short term and medium term instruments.

6. What are the factors behind emergence of euro banks?

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INTERNATIONAL FINANCE MANAGEMENT 3.5. SUGGESTED READINGS 1. Multinational enterprises and economic analysis - Caves. R 2. International financial management - Madura Jeff 3. International financial management – A K Seth

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INTERNATIONAL FINANCE MANAGEMENT

CHAPTER – 4 INTERNATIONAL MONEY MARKET STRUCTURE 4.0. INTRODUCTIONS 4.1. CREATION OF EURO-MONEY 4.2. INTERNATIONAL BANKING 4.2.1. Reasons for the growth of Euro-Money (Euro- Deposits) market 4.2.2. Euro – Deposits 4.2.3. Euro Loans 4.3. BASIC OPERATIONAL FEATURES OF INTERNATIONAL BANKING 4.3.1. Risks of euro-banks 4.3.2. Default risk and International Banking 4.4. RISKINESS OF BANK'S FOREIGN CLAIMS AND PORTFOLIO THEORY 4.5. ASSESSING RISKINESS OF LOANS TO GOVERNMENT (THE SOVEREIGN RISK) 4.6. INTERNATIONAL BANKING: THE ORGANISATIONAL STRUCTURE EXAMPLE 4.6.1. An Example of Hypothesized Consortium Bank 4.7. LOAN SYNDICATE (SYNDICATION) 4.7.1. Loan syndication procedure in India 4.7.2. Advantages and disadvantages of loan syndication 4.8. WHY THE BANKING HAS BECOME MULTINATIONAL 4.9. SOME SETTLEMENT SYSTEMS IN THE WORLD 4.10. PROBLEMS OF MULTINATIONAL BANKING 4.11. EURO-NOTE MARKET 4.12. COMPETITIVE ENVIRONMENT OF MULTINATIONAL 4.13. EURO-BANKING AND THE CENTRAL BANKS 4.14. QUESTIONS 4.15. SUGGESTED READINGS

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4.0. INTRODUCTION Euro-currency markets constitute the short to medium term debt part of the international capital market-structure. The market consists of banks and other financial institutions that accept deposits anti loans in a currency or currencies other than that of the country in which they are located. The later characteristic of the financial institution defines structure of Euro-currency market. These institutions are non domestic financial intermediaries. Such institutions have grown world wide, such as in London, New York, Luxembourg, Hong Kong, Singapore, etc. These markets are also called offshore money markets.

As most of the economies are opening, therefore the offshore market is expected to grow to an unimaginable dimension. The three fundamental questions that are required to be asked about these markets are: 1. What separates the Euro-currency market from the domestic currency market?

2. Why were they needed, and how could this grow so fast when sophisticated domestic markets already existed?

3. There is an offshore money creation analogous to money creation at home banking system. What affect this have on world inflation?

4.1. CREATION OF EURO-MONEY Narrow definition of money requires four characteristics for an asset for being a money unit: (i) it should be capable of being used as means of payment (medium of exchange), (ii) it is possible to store value through the asset (store of value), (iii) it serves as unit of account, and (iv) it can also used as means of deferred payment. We know that, out of these four, first two are prime characteristics. As per this definition of money, the components of domestic money are: currency and demand deposits. Money stock is currency plus demand deposits (narrow definition). In the same way, Euro-money comprises of Euro-deposits and Euro-currency. The sum of Euro- currency and Euro-deposit is called Euro-money.

Why has Euro-Money Market come Into Existence? The international operations in capital market conform to the general principles of the operation of domestic capital markets both perform basic intermediary functions. The difference comes from the need to undertake foreign exchange transactions in order to consummate the transfer of financial claims and that there is absence of any unified world legal framework for settlement of such claims. Thus the Eurocurrency markets have come into existence.

How is Euro-Money Created? A national currency becomes part of offshore currency market when it is transferred to a bank outside its own monetary system, i.e. transferred to a bank outside the nation in question. A US dollar held at Paris qualifies as a Euro-currency. One could conceivably create Eurocurrency and Euro deposits in the nation itself provided the banking law provides for Internartional Banking Facility (IBF). In this case the deposit is made in that segment of banking structure which is not regulated by the central bank of the country which has issued the currency. For example, a Euro-dollar

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can be created in America itself by simply depositing the dollar in that tier of the bank of America which is covered by the laws on international banking facility (IBF). The need to create Euro-money has given birth to Euro-bank.

Euro Bank: Euro-bank is a financial intermediary that bids for time deposits and makes loans in the offshore market. Usually, this will also mean that it deals in currencies other than those of the country in which it is located.

Offshore deposits can be created in two ways: 1. One can take the physical currency of a country out of the country and deposit it in a bank of another country, 2. A national currency deposit becomes part of the offshore currency market when it is; transferred to a bank outside the controlled national monetary system.

4.2. INTERNATIONAL BANKING Usual function of a bank is to mobilize resources and lend these to borrowers and charge for services through the spread of deposit and lending rates. Since international banking is an unregulated market involving greater risk, therefore to attract deposits, this market offers higher rate of deposits and provide loans at lower rates the market works on lower spreads as compared to domestic banking. This segment of banking is a whole sale segment of lending and deposit activity.

4.2.1 Reasons for the Growth of Euro-Money (Euro- Deposits) Market: The Euro-markets are unregulated financial intermediaries. These bring together borrowers and lenders from same country or different countries. They deal only in the currencies of individual countries and are thus a substitute for the domestic banking system. The rapid growth of these markets could be attributed to the following two reasons: 1. Depositors receive better terms than they can otherwise obtain at home (i.e. better interest rates on deposits than home interest rates).

2. Borrowers can borrow more, possibly at lower interest rate than they can at home (onshore).

The offshore banks functions with lower spreads. This is possible because: 1. Euro-banks are unregulated institutions therefore these are not required to maintain reserves against their deposit liabilities.

2. Euro-banks are not subject to interest rate ceilings, whether imposed by governments or cartel.

3. Euro-banks can take advantage of low tax location.

4. High degrees of competitiveness, and virtually unrestricted entry, force euro-banks to keep margins small and overhead costs low.

5. Euro-banks are less subject to pressures from the domestic government to allocate credit for socially valued sector but unprofitable in nature.

6. Euro-banks are subject to greater risk than domestic banks.

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Each Euro-currency market is linked through arbitrage to its domestic counterpart. Hence Eurocurrency rates are strongly influenced by domestic rates. Since there is no regulatory authority to set interest rates in Euro-markets, therefore in Euro-currency markets, the interest rates are determined by the forces of competition.

Since Euro Markets and the domestic money markets deal in the same currency and that there is considerable freedom for capital to move between the two markets in response to interest rate differentials, it is no coincidence that interest rate structures are closely linked. In the absence of specific obstacles, the funds may be used to arbitrage from the interest rate differentials existing in the two types of markets.

4.2.2. Euro – Deposits: The deposits denominated in currencies made outside the domestic banking system's operation are called Euro-deposits. These deposits are more risky because these are made beyond the control of the domestic banking authority. In other words, when a currency deposit is made in a bank outside the jurisdiction of the central bank which issued the currency is termed as Euro deposit.

Natures of Euro-Deposits Euro-currency, deposits are primarily conventional short term deposits such as 30 days or 90 days. Interest rates on these deposits are fixed for the term of the deposits. This characteristic of fixing deposits keeps the term of the deposit short because the interest rate in the Euromarkets fluctuate in response to demand and supply pressures. These deposits are--non-negotiable (unless specified negotiable). The deposits can also be made in composite currencies like ECU or SDR. A large part of liabilities of Euro-banks is in the form of CDs (certificate of deposits). The CDs are negotiable instruments that can be traded in the secondary market. These provide more liquidity to CDs than the term deposits. There is a penal clause on the CDs. After the introduction of International Banking Facility (IBF) in U.S. Euro-currency operations expanded under this facility, banks accept deposits denominated in foreign currency and these deposits are exempt from U.S. reserve requirement and insurance premium on deposits as long as the deposits are exclusively used for offshore financing.

4.2.3. Euro Loans: Usually Euro-dollar loans are direct bank to customer credit on the basis of formal lines of credit.

Since loans in this market are large in amount, therefore the market has developed the technique of loan syndication and forming of consortium banks. The loans in this market are sought by big borrowers such as governments and multinational firms. The loan syndication is a procedure that allows a bank to diversify some of sovereign risk that arises in international banking.

Loan Syndication There are three categories of banks in a loan syndicate. These are, lead banks, managing banks and participating banks. In large borrowings, there is separate group called co-

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managers. This group comprises of participating banks providing more than a specified amount in the pool of lending. Most of the loans are led by one or two banks which obtain mandate from the borrower to raise funds. After obtaining the mandate lead banks begin to assemble the management group who commits to provide the entire amount of the loan if required, i.e. they underwrite the total loan. Portion of loans are then marketed to the participating banks.

4.3. BASIC OPERATIONAL FEATURES OF INTERNATIONAL BANKING The main operational features of international banking are: 1. The basic feature of international banking operations is that the Euro-banks remain well hedged.

They receive deposits in various currencies, thus creating liabilities denominated in different currencies. These banks also make loans in different currencies creating assets in foreign currencies. These assets and liabilities are approximately balanced in terms of volume and maturities and therefore the profitability remain unaffected by the change in exchange rates.

Some times, it is difficult to match the maturities of assets and liabilities, in this case exchange risk is involved and therefore hedging is required. The hedging may be done in the future exchange by futures.

2. Euro-banks perform intermediation when they convert Euro-deposits into Euro-loans. The quanta of loans that can be given against the deposits depend on the reserve requirement. The credit multiplier is 1 / (Cash reserve requirement) or 1 /CRR. Since in the case of Euro-bank, the CRR can be as low as 2%. The credit creation in this case will be very large because the credit multiplier would be 1/0.02 = 50, i.e. the credit creation would be fifty times the deposits made in this segment of banking. In domestic oriented banking, the reserve requirements range from around 10%-30% of deposits. Some times, the Euro-bank may not even keep the reserves, because there is no regulation about it. In this case, the credit creation is infinite.

3. Deposits in the Euro-currency market are time deposits at fixed interest rates, usually of short maturity. Many of these deposits are on call, thus these can be withdrawn without notice. Most of the time deposits are made by other banks, various governments and their central banks as well as Multinational Corporation. Some times, the participation of even wealthy individual is not ruled out.

4. Deposits come in many forms, besides negotiable Euro-dollar certificates of deposits (Euro-dollar CDs), there are Euro-notes, similar to certificates. Floating rate notes (FRNs) and floating rate CDs have become popular as longer maturity deposits.

In contrast the Euro-loans are of long maturities at fixed or variable interest rates. Usually at variable interest rates. Therefore it is difficult to finance long term loans with short term deposits. To keep the flow of Euro deposits un-interrupted, the Euro-deposits have higher interest rates than the domestic deposits.

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4.3.1. Risks of Euro-Banks: Euro-banks face three types of risks: Exchange rate risk, interest rate risk and default risk.

Exchange Rate Risk The Euro-bank's have assets and liabilities denominated in foreign currencies. The compositions of these assets and liabilities differ from bank to bank. Since banks can not always match assets and liabilities in currency composition, therefore some of the assets or liabilities remain exposed.

The performances of these banks depend on the values of the exposed assets or liabilities.

Interest Rate Risk Euro-banks often face interest rate risk due to mismatch of maturity between assets and liabilities. As we have already indicated that deposits in Euro-banks are short term, while the lending is long term, therefore its spread between average interest earned on its assets and paid out on liabilities could be reduced during a period of rising interest rates. To hedge this risk, the banks may enter into an interest rate swap with another bank which has the mismatch of opposite type (average liability maturity exceeding average asset maturity).

Default Risk Like any domestic bank, Euro-banks face risk of default of payment. Euro-banks may not be able to monitor the foreign companies to which they lend. Recent debt crisis has shown that the lending

by Euro-banks to MNCs and governments is not safe. Euro-banks need to evaluate the credit worthiness of borrowers (may it be governments). These banks should also diversify their loan portfolio.

4.3.2. Default Risk and International Banking: In international banking the banks classify risks on three basis: (i) by country of exposure, (ii) by maturity of loan, and (iii) by the nature of loan.

By country of exposure we mean to which country the loan is being given or in which country the lending is being done. The countries defer in terms of political risk. So far as (the classification on the basis of extent of risk due to maturity of loan is concerned, it is usually believed that the short run commitments are less risky than the long term commitments. It is also believed that the financing of trade (import and export) add to productive capacity and we know that productive loans are less risky as compared to other forms of financing. Basic strategy to manage loan portfolio adopted by banks revolves around the geographical diversification. In diversification only one problem remains, that is how to determine the extent of exposure and the limit to which the loan can be provided to the client at a particular location. The banks are not able to precisely fix the limits of lending, although there are methods to assess the extent of exposure but it is difficult to assign limits. The exercise is usually done to ensure sufficient diversification of the asset portfolio so that expropriation, capital controls, or other forms of default does not have major adverse effects on the bank. The places having high risk provide higher interest rates, i.e. greater earnings are possible. But the banks have to be competitive, therefore the interest rate has to incorporate risk as well as it has to be competitive. Thus the risk assessment for a bank becomes necessary.

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To assess the credit-worthiness of the country following factors are examined to assess the extent of exposure.

1. Stability of government, 2. Quality of economic team deciding the economic policies, 3. Monetary and fiscal policies, 4. Exchange rate and trade policies (balance of payment adjustment policies), 5. Extent of cooperative attitude of the country with IMF, 6. Resource availability and efficiency of resource use, 7. Natural resource base, 8. Human resource base, 9. Export diversification by region and by commodity, 10. External debt position (amount, level of maturity and structure of debt, and 11. Foreign exchange reserve position.

Ultimate aim is to assess whether the country will be able to service the external debt. In the short run, the bank has to examine the country's access to IMF, World Bank, foreign official credit and the adequacy of foreign exchange reserves. If a country possesses the reserves worth four months of average imports, the reserves may be considered adequate. In the light of the above information a bank can decide: (a) an overall country exposure limit, (b) a limit for exposure over one year maturity and, (c) general areas of future lending. The classification is done by the nature of borrower and the type of activity such as: loans to government, loan to banks, etc. or loan to finance a project generating currency cash flows.

4.4. RISKINESS OF BANK'S FOREIGN CLAIMS AND PORTFOLIO THEORY Owners of the bank must know the rate of return on their investment, an employee of the bank whose salary depends on the performance of the bank must know the earnings of the bank and the insurance companies who insure deposits and other risks, must know the riskiness of bank claims, therefore the question of riskiness is important to be analyzed. We can apply portfolio theory for the assessment of riskiness of a bank's foreign claims. To apply the theory, we have to consider the value of portfolio-Probability lio of banks between time to to it, Sup pose V(to) is the value of portfolio at time t = to and V(tl) is the value of Prob. Distribution portfolio at time t = ti. The portfolio

jd1k

of

portfolio

a

value at time to + it is determined by cumulated cash flow over the interval to it. We can represent the value of V (t) in- the form of a distribution as shown in the Figure 11.1 because there is uncertainty in the environment. The riskiness of the portfolio + V (t) can be summarized by the variance of - V (t) the returns or terminal Value. Suppose Bank A's portfolio has greater variance and also the greater mean return than the bank B. The riskiness of the portfolio of bank A (greater variance) is covered by the greater average return (mean). In terms of portfolio theory, we say that the random returns VA stochastically dominate random returns V. Thus in this case, the higher riskiness as measured by higher variance of portfolio A is

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being compensated by higher mean returns as measured by the mean of the distribution. So far as the notion of riskiness is concerned there is no unique notion, One has to ask riskiness to whom: (1) to owner or to any one else whose career is intimately bound up with the earnings of only one bank, (2) to the equity holder in the portfolio of assets, (3) to regulatory agency which has the responsibility to assess the bankruptcy of banks.

The Risk to Owners: In this case, the summary measure of risk is the variance of the distribution of returns. Since the owners have to bear the risks referred above, therefore these risks are not comparable across banks.

What do we do if we find on comparison that bank A's terminal value 'V' has higher variance, but also the higher mean and on this basis one can conclude that if the bank A has a higher variance with greater mean returns than that of bank B, the V stochastically dominates VB and the risk averse investor would prefer returns V, over the return Vi Riskiness of Bank Equity Holding: If we consider an investor having invested in bank equity, how much an investor is exposed to risk can be estimated by applying portfolio theory. We know that his portfolio experiences risk from independently distributed returns. If his portfolio is highly diversified, then it can expect a return with certainty because gains in some assets are cancelled by losses in other assets. If we use capital asset pricing model as an approximation to the investment environment prevailing for the investor, the returns expected from the investment is a linear function of the correlation of bank's earnings with those of universe of assets, this may be expressed as: E(Ra) - ď ˘a = (E(Rm) - Rf)

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Ra = rate of return to an investor on the equity of banks, Rm = Market rate of return, Rf = Risk free rate of return, and a = Cov (Rb Rm)

is the measure of yield correlation between the market rate of return and the yield on bank's equity.

In this case a measures the riskiness of bank's equity relative to market risk.

Regulatory Agencies and the Riskiness of Banks In this case the regulatory agencies want to assess the bankruptcy likelihood of banks. Here we analyze and measure the riskiness for two purposes: (i) general characterizations of bankruptcy tail and (ii} the liability incurred by a regulatory agency if it must make up any

Ordering banks on the basis of

relative losses which result from bankruptcy. The second purpose is partially served if first is “Probability specified. The bankruptcy tail is that part of the distribution which is, left to the V (t) = 0. Thus the different portfolios imply tails of different shape. Some time it is easier to determine that one distribution is riskier than the other. In Figure 11.2, the tail B is consistently less riskier than tail A, because the probability of any magnitude of bankruptcy loss is smaller on tail B than on tail A at each point on the tail B. In this case, tails do not cross each other, but if the tails cross we must compare a distribution having low probability of large losses with one having higher probability of small losses.

- V (t) 0 + V (t) there is no universally acceptable ranking by riskiness in such a situation. But the capital market implicitly places a value on the bankruptcy tail. This capital market value is natural way to compare and rank bankruptcy risks.

The only difficulty is the generation of distribution of returns on portfolio shown in Figure 11.1. The distribution is independent of the notion of riskiness chosen to be analyzed. Once we adopt the notion of riskiness, this decision dictates which characteristic of the distribution we wish to operate on by the policy of diversification.

How do we generate the Distribution of Portfolio Returns?

To generate distribution of returns, we assume that the bank does not have equity participation.

The bank is only entitled to receive payment of its principal and interest if every thing else goes fine and in the case of default, it liquidates the project at market price. We also assume that the project pays all their returns on one future date. Let, Xi = total return on the project i measured, in terms of domestic currency, off- and D, = total payment of principal and interest due to the bank from the project If the return 'X' exceeds the payment 'D',,, the bank will be paid and if 'X', is less than 'D', then it will have to settle foil X,. In Figure 11.3, the thick line shows the probability distribution of bank's return on the loan. The bank bears risk only when X, < Di. To compute the bank's risk carrying from a project loan, we must first estimate a distribution of X, and then indicate the cut off point D'. For estimation of bank's risk the estimation of returns Xi from the project are very important. One has to analyse the risks involved in obtaining the return Xi. The risks are

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partitioned as per the source of their generation. The partitions are the broad categories such as mining,, textile production, chemicals, etc.. Then we may view the return X, to a regression model: Xi =  + 1i + 2i K2 + 3i K3 + ui Where K, = world economy factors; K2 = Industry factors; K3 = national economy factors and u = residual uncorrelated error. Here a = intercept term indicating a constant risk associated with the business; 1i,, 2i and 3i gives us the impact (responsiveness) of the factors on the return to the projects in category i.

The above model states that the randomness of X1 can be explained by the factors included in the regression equation. With the change in factors explaining X, Xi also changes. These factors are called delta (5) factors. Once are estimated, one can well forecast the return X, on the basis of the given change in Ki. Variance of Xi is the weighted average of the variance and co variances of delta factors.

4.5. ASSESSING RISKINESS OF LOANS TO GOVERNMENT (THE SOVEREIGN RISK) The notion of default means that the parties do not service their loans in time, i.e. the promised levels of payment are not met and in the extreme the project is worth less than the debt. The governments try to renegotiate the loan payment schedule much before its refusal to pay. Government refuses to pay because the economy is not generating enough foreign exchange to pay for the debt. We have to analyse what factors drive the economy to this situation. This situation arises when the government is unable to mobilise internal resources to purchase the foreign exchange or is unable to mobilise foreign loans. This situation arises due to world factors (X,) such trends in trade, incomes etc., national factors (X,, such as aggregate investment, income levels, exports, etc. and the industrial factors (X3). Now if Y, denotes the income or foreign exchange availability in country 'i', we can express the relationship between Y1 and the factors discussed above as: Yi =X i + yli X1i +' 2i + X2i + 3i X 3i + ui Where Xii is the world economy factors; X2, represent national economy factors and X31 are the proxy for industry factors. The responsiveness of Yi to these variables is given by yi, 7, and 73, and i, is the residual error term.

Once we identify a critical level below which the government cannot drive Yi we want to calculate the probability that the earnings can not be derived lower than the critical level. This level will indicate the probability of bankruptcy of a bank.

4.6. INTERNATIONAL BANKING: THE ORGANISATIONAL STRUCTURE Now we describe some important forms of banking organisation which would explain why and how the banks have become multinational. It is the changing and diverse organizational structure which also is responsible for banking to become multinational. The various forms of organizational structure

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through which the banks operate are: Correspondent Banking It is an informal linkage between banks in different countries. The banks maintain correspondent accounts with each other. Large banks have correspondent relationships with banks in almost every country in which they do not have office of their own. The purpose of maintaining foreign correspondent is to facilitate international payments and collections for customers. The term correspondent comes from communications that the banks used for settling customer accounts. Now-adays, these messages are sent through communication networks of such as SWIFT, CHIPS or CHAPS. Correspondent banking allows banks to help their customers doing business abroad, without having to maintain any personnel or office overseas.

The relationship is primarily for settling customer payments, but the services can be extended to provide limited credit for each other's customers and to setting up contacts between local business people and the clients of the correspondent banks.

Resident Representatives To provide their customers help on the spot in foreign countries, the banks open overseas business offices. The primary purpose of these offices is to provide information about local business practices and conditions, including the credit worthiness of potential customers and the bank's clients. The resident representative will keep in contact with local correspondent banks and would provide help needed by them.

Bank Agency An agency is like a full fledged bank except that it does not handle ordinary deposits. The agencies deal in the local money markets and in the foreign exchange markets, arrange loans, clear bank drafts and cheque and channel foreign funds into financial markets. Agencies are common in international banking. Agencies, quite often arrange long term loans for customers, but they deal primarily on behalf of the home office to keep it directly involved in the important foreign financial markets.

Foreign Branches Foreign branches operate like local banks, except that its directors and owners may be foreigners. Foreign branches are subject to local banking as well as domestic rules. They can benefit from loopholes of regulations. The books of foreign branches are incorporated with those of the parent bank. Although the foreign branch will also maintain separate books for revealing separate performance and for tax purposes. The existences of foreign branches mean very rapid cheque clearance for the customers.

Foreign Subsidiaries and Affiliate a foreign branch is a part of a parent organisation that is incorporated elsewhere. A foreign subsidiary is a locally incorporated bank owned either completely or partially by a foreign parent. Foreign subsidiaries do all types of banking and it may be very difficult to distinguish them from an ordinary local bank.

Foreign subsidiaries are controlled by foreign owners, even if the foreign ownership is partial.

Foreign affiliates are similar to subsidiaries in being locally incorporated and so on but these are joint ventures.

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Consortium Banks Consortium banks are the joint ventures of the larger commercial banks. They can involve half a dozen or more partners from numerous countries. They are primarily concerned with investment, and they arrange large loans and underwrite stocks and bonds. Consortium banks are not concerned with mobilizing deposits, these banks only lend to large corporations and perhaps the governments. They will take equity positions-part ownership of investments may it be loans. These banks are busy in arranging take-overs and mergers. There exist many consortium banks. One such bank is: International Commercial Bank PLC, the members of this bank are: Hong Kong and Shanghai Bank Co. (22%), Irwing Trust Co. (22%), First National Bank of Chicago(22%), Commerz Bank AG(12%), Credit Lyonnais(11%) and Branco de International SA(11%).

EXAMPLE 4. 1 An example of hypothesized Consortium Bank Suppose State Bank of India (SBI), Hong Kong, Shanghai Bank Co., Credit Lyonnais and Banco did Roma International SA decides to form a consortium bank with following equity participation: The bank is formed on the basis of MOU signed by each equity holder with the rules of the game well defined. The profit of the bank z. s shared as per the equity participation.

EDGE Act Corporations These banking corporations are particular to U.S. Euro-market. In 1981, U.S. congress passed this act which allowed banks, savings and loan associations, and mutual saving banks to establish IBFs as adjunct operations. IBFs constitute a large part of Euro-currency. Market in U.S. These facilities are not covered by domestic banking regulation including reserve requirement. In this facility, the aforesaid institutions can accept deposits from non-Americans with a minimum size of $100,000 and the withdrawals are also subject to similar limit. These organizations are barred from catering to the domestic customers. They can mobilise deposits from foreign customers and lend them.

Agreement Corporations These forms of corporations are also particular to U.S. and are different from Edge Act corporations. These forms of corporations are established with the concurrence of Federal Reserve, which allows the member of Federal Reserve System to enter into an agreement with an organisation to engage in international banking. Agreement corporations, unlike Edge Act Corporations, can be chartered by a state government and they can only engage in international banking not in general investment activities.

Indo-Anglo International Banking Corporation --------------------------------------------------------------------(Hypothesised)

(Consortium Bank)

--------------------------------------------------------------------State Bank of India (SBI)

30%

Hong Kong & Shanghai Bank Co.

40%

Credit Lyonnais

10%

Banco di Roma International SA

20%

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4.7. LOAN SYNDICATE (SYNDICATION) A loan syndicate is a group of banks which agree to lend a specific amount of loan. There are three categories of banks in a loan syndicate. These are: lead banks, managing banks, and participating banks. There is a separate group called co-managers. Most of the loans are led by one or two major banks who negotiate to obtain the mandate from the borrower to raise funds. After the preliminary stages of negotiation with a borrower, the lead bank begins to assemble the management group who commit to provide the entire amount of the loan, if necessary. Once the management group is formed, the placement memorandum is then prepared by the lead bank. Portions of the loan are then marketed to participating banks. The lead bank is normally expected to provide a share at least as large as any other bank. Once the lead bank has established the group of managing banks, it then commits the group to raise funds for the borrower on specified terms and conditions.

The chief responsibility of lead bank is the marketing of loan, although other members of the managing group assist in this respect. There are three main methods which are used to find participants: (i) the borrower may specify that a certain bank should be given the opportunity to participate because the borrower wishes to establish a relationship with that bank, (ii) lead bank itself invites participants to join the syndication. Each major bank maintains files on the syndicated lending activities of other banks. It can select the bank of its own choice out of this list.

Usually the syndicated loan is a term loan, where funds can be drawn down by the borrower within a specified time of the loan being signed. This is called the drawdown period. The repayments of the loan are subsequently made in accordance with an amortisation schedule. Sometimes amortisation of loans commences almost immediately following drawdown. Sometimes term loans have no amortisation over the life of the loan and all repayment is due on maturityâ&#x20AC;&#x201D;this type of loan is termed as a bullet loan.

Loan which require repayment according to an amortisation schedule and include a larger final payment of principal on maturity are termed as balloon payment loan. The period prior to the commencement of repayment is termed as the grace period. The extent of grace period is a major negotiating point between the borrowers and the lead bank.

Usually the syndicated loans are of the revolving credit type. In these loans, the borrower is given a line of credit which he may draw down and repay with greater flexibility than under a term loan.

Borrowers pay a fee on the undrawn amount of the credit line.

There are front end fees, and occasionally an agent's annual fee. Front end management fees are one off charges negotiated in advance and imposed when the loan agreement is signed. These fees are usually in the range of 0.5%-l% of the value of the loan. The fees may be higher if the borrower insists upon obtaining funds at a lower spread than warranted by market conditions and creditworthiness. The relationship between fee and spread is hard to quantify. Some studies suggest that the banks may offer lower spread if compensated by higher fees.

Front end fees consist of participation fees and management fees. Each of these typically amount

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to 0.25%-0.5% of the entire amount of the loan. Participation fees are divided between the underwriting banks and the lead bank. The lead bank usually takes a premium on the entire loan. The rest of the management fee is divided among the managing banks in proportion to the amount each agrees to underwrite prior to syndication.

The banks are concerned with after tax returns; therefore the borrower must adjust payments so that the banks receive the same net .repayment. The decision as to who will absorb the additional taxes imposed by the country in which the loan is booked is negotiated between the parties. A reserve requirement clause is also generally inserted, stipulating that an adjustment will be made if the cost of funds increases because reserve requirement are imposed or increased. The charges on syndicated loans can be calculated as: Annual payments = (LIBOR + spread) (TL) + Commitment fee (UDL) + Annual agent's fee (if any) + tax adjustment (if any) + reserve requirement adjustment (if any) Front-end fee = Lead bank premium (TL) + Participation fee + management fee + initial agent's fee (if any) Where TL = Total loan, UDL = undrawn loan.

With other things being equal, a longer maturity loan should carry a wider spread in order to leave the lenders indifferent to the trade-off between profits and risk. Furthermore, if spreads widen over time, lenders are locked into a long maturity loan at the old spread. If the spreads narrow, the borrower can refinance and therefore should not object to accepting higher spreads for longer maturities. Bankers attempt to analyse both the economic and political risk associated with the loan.

Quoting Spreads in Syndication: Spreads and maturities are heavily influenced by market conditions. In periods when market conditions are relatively easy, spreads decline and maturities become lengthier. Converse is true when market conditions are tight. The factors that need consideration for quoting spreads in a syndicated loan are: (1) the present level of interest rate, (ii) the bank's capital/asset ratios, (iii) the volatility of interest rates, (iv) liquidity considerations attributable to the amount of non-bank deposits entering the Euromarket, (v) relative loan demand pressures in domestic markets, and (vi) changes in the competitive structure of the syndicated credit market, (vii) the borrower's -risk.

The high level of nominal interest rate implies a narrower absolute spread. Interest is related to considerations of return on capital. Banks are concerned about the increase in their rate of return on capital. Assuming for the purpose of simplicity, that the banks has no over head or loan processing costs and that it purchases funds in the inter-bank market at LIBOR, its return on ,capital is derived as follows: ROC [RL â&#x20AC;&#x201D; (CSD) x DAR)] x ACR Where ROC return on capital, RL interest rate received on loan, CSD = Cost of servicing deposits, DAR deposit asset ratio, ACR = asset capital ratio.

In terms of bank's financial planning process, the above equation is often used to loan spreads on

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the basis of required rate of returns on capital. More factors, such as overhead costs and bad debt costs as proportions of loans advances can also be added to the equation.

The reasons for an inverse relationship between nominal interest rates and spreads is that if borrowers are sensitive to the total interest cost on syndicated loans (i.e.LIBOR plus spread), banks may be forced to lower spreads to compensate for higher LIBOR when faced with an expected fall in demand.

Another explanation for an inverse relationship between interest rates and spreads is that banks are expected to equate the marginal cost of all sources of funds. In periods of high nominal interest rates, the opportunity cost of reserve requirements is higher. Hence the absolute differential between Euromarket and domestic market interest, rates will widen because the former has no reserve requirements.

More funds will, shift into the Euro-markets and with an unchanged demand for funds, would reduce spreads.

One important aspect of syndicated loan is that the syndicated loans are floating rate loans.

These loans are the one linked to LIBOR (London Inter-bank Offer Rate), SIBOR (Singapore Inter-bank Offer Rate), HIBOR (Hong Kong Interbank Offer Rate), etc.

4.7.1. Loan Syndication Procedure in India: The process of syndication starts with the following steps in the sequence: 

To begin with the borrowing company starts with working out the investment proposal along with details of financing plans and obtains government approval for both. The financing plans are approved with a broad set of parameters so that some flexibility is left for the borrower.



The borrower then calls for quotations from leading foreign banks and usually also from the major domestic banks (such as SBI in India) for overseas component of financing plan. Based on the quotations, the borrower then gives 'mandate' to the bank which has quoted the best overall terms, supposes this bank is Hong Kong Bank.



Hong Kong Bank then prepares a document for examination by a set of banks to be associated as managing banks. This document is called the 'placement memorandum', which presents in details, the project for which the loan is being sought, the viability of the project, cash flows and other relevant information. The idea of this memorandum is to get a relatively large number of Euro-banks interested in the loan proposal. The loan is then marketed to a large number of participating banks. The task cannot be taken for granted as banks will probably not wish to commit their funds and time to a project which does not appear attractive enough.



Once the syndicate group is formed and the necessary commitments are obtained from the group members, the lead bank prepares the necessary legal documents and gets them signed by company officials.



Once the fourth step is completed the disbursement of the funds starts to the client in accordance with the mutually agreed conditions.

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EXAMPLE of syndicated loan by NALCO: The loan was to the tune of $680 million. Following banks formed the syndicate to provide the financing of the project: Lead bank: Banque National de Paris Co-Managers: State Bank of India Society General Bank of America Participating banks: There were 48 banks including -Bank of Tokyo, Barclays Asia, Citibank and Chase Manhattan.

The contribution was as follows: 1.

Banque National de Paris

$30 million

2.

State Bank of India

$30 million

3.

Society General

$30 million

4.

Bank of America

$30 million

Other participating banks, numbering 48 contributed $560 million

4.7.2. Advantages and Disadvantages of Loan Syndication: International lending by banks have some advantages and disadvantages for the banks. The advantages of the banks are: 1. International loans have been highly profitable for many large banks and have had a significant impact on the earnings of these banks such as for Citicorp, Bank of America and Manhattan.

2. Many banks have improved risk-return performance because they can diversify international loans by country and by type of customer.

3. Developing countries have traditionally attempted to preserve their high credit standing with international banks.

4. Several safeguards have reduced the risk of international lending. These include credit insurance programs in the lender's own countries, guarantees by parent companies on loans to affiliates and guarantees by host governments.

The disadvantages are: 1. Country risk analysis is extremely complex because it depends on many variables the behavior of which can not be correctly forecasted.

2. Off-Shore Financing I: Euro-Money Market 255 3. International bankers recently did not anticipate dramatic increases in country risk.

4. Some bankers have relaxed their credit standards to compensate for weak domestic demand and commercial demand for loans.

5. Critics question the ability of debtor countries to service their external debt because many loans are snort term variable loans.

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6. If borrowing countries are unable to meet their obligations on time, the banks will be forced to roll over their loans indefinitely 7. The ultimate purpose of some loans is to finance balance of payments deficits. This type of loan does not improve the debtor country's ability to generate foreign exchange earnings.

4.8. WHY THE BANKING HAS BECOME MULTINATIONAL Through the opening of representative offices, agencies and branches the banking has become among the most multinational of industries. For example, large banks like National Westminster, Barclays, Citicorp and Fuji Bank have operations in more countries than industrial giants like General Motors (GM) or IBM or Sony Banking has become multinational for the following reasons: For Collecting Market information Banks open up branches for collecting economic, political, social and other information regarding economies because these tend to affect the exchange rates. The banks which indulge in international banking activities need to collect these data for the reasons that the exchange rate affects the profitability of organizations to which the banks have lent.

To Obtain Information on Borrowers Euro-banks lend large amounts in various currencies; therefore it becomes necessary to obtain information about the borrowers before and after lending. To obtain information banks open offices at borrowerâ&#x20AC;&#x2122;s location. They try to evaluate financial stability of the borrowers and collect even the 'street talk' about the borrowers. To obtain reliable information this exercise is necessary.

To Serve the Client Profit maximizing banks do not open overseas offices merely to provide services for the clients. Usually, correspondents could do most of the work. However, it may be better for a bank to serve its domestic customers in their foreign operations than to allow its customers to develop strong ties with foreign banks or competing domestic banks that do have overseas offices.

The profitable services that are provided by overseas banking offices are: handling of collections and payments for domestic clients engaged in foreign trade can be lucrative and serve as reason for having an office overseas. Indeed, for many banks the fees from services provided to customers that are connected to international trade have become an increasingly important component of their earnings.

To Serve the Client One important service that a multinational bank provides is the custodial service. The custodial services are provided to clients who invest in securities overseas. Several large banks take possession of foreign securities overseas for safekeeping, collect dividends or offer up coupons, and handle stock splits, rights issues, and tax reclamation and so on. Banks also provide clients with reports on the status of their overseas investments; manage cash balance and so on. It is only possible when the banks have overseas offices.

To Provide Custodial Services To avoid domestic regulations and save taxes the banks may open offices overseas. This action creates Euro-currency markets. Banks, like corporations, open the offices in tax heavens to avoid reserve requirements and maximize after tax earnings.

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Standardization of Regulations of Banking Across Countries The greater globalizations of banks may be attributed to the changing banking regulations in the world.â&#x20AC;&#x2122; There are three important events which have accelerated the multinationalisation process. These are: (1) In the U.S. enactment of International Banking Act (IBA) placed U.S. banks and other foreign banks at a level playing field. The IBA required that foreign owned banks in U.S. to obtain deposit insurance and adhere to product and service restrictions enforced by the Bank Holding Company Act. In this way, IBA eliminated the comparative advantage of foreign banks. To provide advantage to foreign banks, in this act, foreign banks were allowed to accept deposits across state lines, (2) In Europe, single European banking act placed all European banks operating in Europe under the same set of rules. These rules provided for (a) free flow of capital throughout Europe, (b) banks can offer a vide variety of lending, leasing and securities activities in EEC, (c) the regulations regarding competition mergers and taxes will be similar throughout the EEC, (d) the banks established in any one of the EEC countries will have the right to expand into any or all of the other EEC members, and (3) uniform capital adequacy norms have been suggested for developing banking industry throughout the globe. This forced the banks of twelve industrialized countries to abide by same minimum capital constraints.

The changing banking environment in the world has led the banks to expand through out the world. A list of 20 top banks has been given in Appendix 11A. 4.9. SOME SETTLEMENT SYSTEMS IN THE WORLD The settlement systems in use in developed countries vary with each country because of varying customs and practices particular to a country. The system also incorporates different risk perspectives pertaining in countries in the settlement system. Some automated systems of settlement are given below: U.S. Settlement System Federal Reserve has its own settlement system called FEDWIRE (Federal Reserve Communication System) and CHIPS (Clearing House Inter-bank Payment System). Besides these, there are clearing systems which conduct clearance for paper, based settlement clearance in bills and cheques and the (Depository Trust Company (DTC)) which conducts the settlement of securities.

The transactions handled by FEDWIRE settlement system can be classified in two categories: 1. Transfers between Reserve Deposit Account (or settlement accounts) of all financial institutions in the U.S. with their affiliates.

2. Transfers of government securities through which treasury bills and Federal Reserve Agency conduct securities related settlements.

All transactions are conducted according to the Credit Transfer System. If a credit is advised through FEDWIRE, it can be immediately utilized. The credits through FEDWIRE are irrevocable. The credit instructions through FEDWIRE are legally final. -Suppose a paying bank defaults, the Federal Reserve Bank executes the payment as proxy to assure the finality of payment.

In the present American payment mechanism, a daylight overdraft (temporary overdraft during

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business hours) is allowed with the FEDWIRE, the Federal Reserve Bank guarantees finality of payment by assuming risk even if the paying bank is unable to cover the daylight overdraft.

Because of this daylight overdraft facility, the volume and the amount of transactions had increased enormously. This increased the risk perceptions about the settlement mechanism.

To mitigate this changing risk perceptions net debit cap was introduced which is an effective mean to control and regulate the daylight overdrafts.

Chips (Clearing House Inter bank System) It is a settlement system operating in New York Clearing Housing Association and was established as means of settling Euro-dollar transactions. Since Euro-markets have widened, it is presently a centralized settlement system processing more than 90% of dollar based international transactions.

CHIPS settlements are conducted in the following manner: (1) Payment instructions are sent out and received continuously during the day. Each member's net balance continues on changing, but at the cut-off time, every member fixes its own net balance including the portions on behalf of non-settling banks.

(2) The fixed net balance is then settled between the CHIPS accounts and the bank's account with the Federal Reserve Bank of New York through FEDWIRE. Settlement is done before the settlement is closed and as a result the CHIPS account balance becomes zero.

CHIPS transactions are different from FEDWIRE because the cancellation is not possible, i.e. to say that all payments are finalized only when net balance have been settled through FEDWIRE in the final settlement. Therefore, if for some reasons, the final settlement is not done; all transactions have to be recalculated up till the net balances excluding the bank concerned. However, this re-calculation risk is difficult to assess because at the last stage, many transactions are cancelled and net balances are to be calculated and the funds are required to be supplied to settle transactions. This would make other banks to default.

Settlement System in U.K. In U.K., CHAPS (Clearing House Automated System) operates to settle transactions by 14 major banks including bank of England. The system was established in 1984. The system is an effective means of settling transactions of London Financial Market. In this system, every year, the numbers of daily transfers tend to double. CHAPS's settlements are done by transfers between accounts held by settling banks with the Bank of England. These are immediately done after the cut off time (15.00 hrs). In this system, it is also possible for the settling banks to monitor their own accounts.

CHAPS's transactions are irrevocable and all are settled on the same day Utilization of the funds is guaranteed by the settling banks. This guarantee also encompasses the transactions of the branches and customers of the settling banks. The Bank of England functions as the back-up for all payments

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made on the basis of inter bank credit and is the basis of the whole settlement system.

The daylight overdrafts which are formally recognized in the US are also present in this system.

The bank of England is of the view that there is no problem with daylight overdrafts if net of these overdrafts become zero at cut-off time. In CHAPS, the daylight overdrafts are not posing any problems. If at all, the dimensions increase unmanageably, some sort of regulatory mechanism can be introduced.

The dimension of transaction in CHAPS is not as big as in FEDWIRE but it has functioned smoothly and in its long history under the supervision of Bank of England, the financial system has nurtured a sound tradition of mutual trust among financial institutions.

Settlement System in France The settlement system in France is called SAGITTAIRE. The system is operated by the Bank, of France. The settlements in this system are done by transferring net balances calculated at the cut-off time between SAGITTAIRE accounts at the Bank of France. The settlement time is 8 A.M. on the following day. There is no provision of daylight overdrafts. SAGYFIAIRE requires standard messages issued by SWIFT (Society for Worldwide Inter bank Financial Telecommunication S.C.). The system has following three characteristics: 1. SAGITTAIRE requires standard message issued by swift to be used in payment instruction.

2. The obligation of the party concerned to authenticate itself elevates the safety of the system.

3. By incorporating the domestic settlement system into the international network, ultimately the overseas fund transfers are also automated.

With the opening of SIT (Inter bank Teleclearing System), SAGITTAIRE is required to undertake following tasks: (a) Securities Settlement: Construction of a combined funds /securities settlement system by incorporating securities settlements which are currently being operated by SICOVAM, outside the jurisdiction of Bank of France, into the new SIT. (b) This is a move,

greater efficiency.

Settlement System in Germany In Germany, a set of financial institutions have their own settlement system. The commercial banks, saving banks, credit associations, etc. have their own settlement systems. The settlement between the businesses of different types is done by means of transfers between accounts held individually by each financial institution at the Bunds Bank. The settlements between the businesses of the same type are conducted through the group's settlement system. The Bunds Bank had been successful in making 60% of total business paperless. If this trend continues, about 70-80% of business will become paperless in near future. In this system: 1. The payment is irrevocable, 2. Daylight overdraft is basically forbidden.

There is an exception to (2), GIRO overdraft loan of a certain amount with a collateral is allowed.

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Since daylight overdrafts are not allowed, therefore the basic perception of the Bunds Bank is that the central bank should not be exposed to credit risk.

Settlement System in Switzerland The system of settlement prevailing in Switzerland is called Bankers Clearing. This system handles more than 90% of total inter bank transactions. Because of daylight overdrafts and the increase in the volume of transactions, Bankers Clearing felt short of capacity to handle the new volumes of transfers. Therefore, a new system SIC (Swiss Inter bank Clearing) was introduced in 1987. It can handle bigger volumes and also helps in managing the risk. Each participant makes settlements through newly opened SIC accounts, but in the event of insufficient funds, the payment instructions will be put on a mailing list called Queue File. This is done for reducing the credit risk. In this system also, daylight overdrafts are forbidden and the payments are irrevocable.

Perceiving the future shape of transactions SIC has embedded the following characteristics in itself: 1. It is a 24 hours settlement system, 2. It classifies the risks and introduces counter measure: There are three types of risks: (a) Credit risk: this risk arises due to non-payment by the paying bank, i.e. this is a credit related risk.

To counter the above risk following measures have been adopted: 1. Authorization of finality of payment to SIC (payments thus become irrevocable) 2. Net daylight overdrafts have been forbidden 3. Reservation of the right to cancel payment instructions in Queue File. (b) Operational risk: The risk resulting from problems with the operation of the system such as the computer shut down, some mechanical or software disturbances. To cope with this there is a back-up system. (c) Fraud risk: This risk is due to international misuse of the system by a participating bank. To counter this risk, following measures have been adopted: (1) Authentication is necessary, and (2) encryption is used to avoid frauds by participating banks.

Settlement System in Japan Japanese settlement system is yen based and is roughly grouped into the following three types: (a) Bill clearing system, (b) Domestic exchange settlement system-Zengin system, and (c) Yen Based settlement system for foreign exchange.

Yen settlements in Japan are done through these co-existing systems, each functioning as a central settlement system according to its own purpose. Settlements for net balances of each participating bank accompanied by the use of above yen settlement systems are done through transfers to accounts with Bank of Japan. Japan is now trying to move from cheque based transfer system to

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paperless settlement system. This is The Bank of Japan Financial Network System (Bank of Japan Network).

4.10. PROBLEMS OF MULTINATIONAL BANKING Multinational banking faces the following problems: (i) Banking operations become risky. The banks lend heavily and the fluctuation in exchange rate may put clients in repayment problems. The huge losses may force default by borrowers. (ii) The major causes of the risk of multinational banking is also a major cause of the development of multinational banking. In particular, the opening of overseas offices to avoid domestic regulations such as reserve requirements reporting of asset positions, anti payment for deposit insurance has at the same time made banks more vulnerable to deposit withdrawals. Furthermore, the acceptance of default and other risks from overseas lending has made banks domestic depositors subject to greater risks. (iii) Since banks provide jobs and prestige to an economy, consequently each country has an incentive to make its regulations just a little more liberal than other countries and thereby attract banks from other locations.

4.11. EURO-NOTE MARKET Euro-note market is the market for short to medium term debt instruments sourced in the Eurocurrency markets. This market has variety of products. The market has underwritten facilities and nonunderwritten facilities. The underwritten facilities are used for the sale of Euro-notes in variety of forms and non underwritten facilities are used for the sale and distribution of Euro-commercial papers (ECPs) and Euro-medium-term notes (EMTNs).

Euro-notes are short term negotiable promissory notes. They are underwritten by financial institutions. In US, there are three types of underwriting facilities for issuing euro-notes: 1. Revolving underwriting facilities (RUFs) 2. Standby note issuance facilities (SNIFs) 3. Note issuance facilities (NIFs) These facilities reflect a movement towards securitization of debt. The RUFs, NIFs and SNIFs, constitute medium term (Up to seven years) commitments by commercial banks or investment banks to underwrite and distribute the Euro-notes. In organizing Euro-note issues there are one to three arranger banks that organize a group of participating banks to take share of total commitments. The arranger bank would keep relatively small shares for themselves and earn fees for their services. The arranger banks and the participating group is ready to buy the borrowerâ&#x20AC;&#x2122;s notes in the event the notes could not be placed in the market at the guaranteed maximum interest expense.

The source of debt is substantially cheap. Moreover, these notes are underwritten by FIs therefore those could find easy secondary markets.

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4.12. COMPETITIVE ENVIRONMENT OF MULTINATIONAL The major competitors in the world banking industry are the banks from Europe, Japan and US. The institutional practices and banking regulations are different in these three types of banks; therefore each one has a particular competitive advantage. The important aspect of competitive edge in respect of each of these set of banks is discussed below.

European Banks The banks of this group are strongest contenders in the world. Their main strength lies in the strong capital base, strong balance sheets and dominant share of home markets expected to grow quickly but these banks are not accustomed to competition because local markets are protected from price cutting, as the banks collude to price their services. Since these banks dominate their domestic markets, therefore these will be able to subsidies overseas operations. But these banks do not adapt to situations therefore may face problems in competition with their US and Japanese counterparts. Strongest European banks are: Deutsche Bank AG, Dresdner Bank AG, and Union Bank of Switzerland, Credit Suisse, Swiss Bank Corporation, Barclays Commerz Bank AG. Japanese Bank Japanese banks are backed by strong customer base coupled with strong economy. These banks are rich in assets. These banks have poor quality assets, poor in capital and innovativeness. These banks are big size banks and are unable to translate the size into competitive advantage. Japanese deregulation would put many of these banks into disarray. Some strong Japanese Banks are: Fuji Bank, Sumitomo Bank, Sanwa Bank, Dai-Ichi-Kangyo.

US Banks American banks have weak capital base and huge write offs on their loans to LDCs, real estate developers and leverage buyouts. However, the American banks have been operating in a competitive environment both domestically and internationally, therefore have developed aptitude and competence to face competition. The banks have developed superior creative skills. These banks possess the skill to manage banking operations on electronic technology basis. The banks are innovative.

Their innovativeness and advances in technology gives them the edge in currency and securities trading.

Some important banks of US are: Citicorp, Bankers Trust, J.P. Morgan, etc..

Indian Banks Indian banking industry is old and had been functioning in traditional ways. Large parts of banking services are being provided by the nationalized banks. The industry is largely protected and regulated. The financial reforms started since 1991 are providing fillip to the banking services in India. In the Indian economy, 92 %

(approx) of banking business is handled by Indian banks. About 8%

of the total banking business is with foreign and private sector banks. The quality of assets of Indian commercial banks is not good. However, since the start of the financial reforms, Indian banks are becoming more competitive. Now the banks have to maintain capital adequacy norms. The banks like State Bank of India having huge size and skilled staff can become good global player. In India, the use of electronic media in banking industry has just started. Some of the important Indian banks arc: State Bank of India, Bank of Baroda, Punjab National Bank, Canara Bank, etc.

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4.13. EURO-BANKING AND THE CENTRAL BANKS The central banks often voice their concern about the offshore markets. The main concerns are: 1. While the central banks have a stronger control on credit creation but this control is lost when the banking business slips to offshore markets.

2. The central bank has control over the allocation of credit if there is no Euro-banking. With the Euro-banking in place, they have no control over allocation of credit in the offshore capital market.

Thus, as the banking business slips to offshore markets, the control on money supply declines.

3. As the Euro-markets are still viewed by the press and the public as mysterious and omnipotent, they make convenient scapegoats for failures of nerve in the handling of domestic monetary policy, 4. Suppose CRF is changed for controlling credit by impounding a larger portion of fresh deposits, to avoid this regulation the funds may be siphoned to offshore markets. Similarly, to avoid other regulations, the funds may be shifted from the domestic market to offshore markets.

5. There exists a strong arbitrage connection between the domestic and offshore markets because the interest rate differentials exist between these two markets. It will be possible only when the deposit rate of one market is greater than the lending rate of the other market.

The Structure of Interest Rates and Euro-Banking: The term structure of interest rates can be thought of as a graph of interest rates on securities of la particular risk class at a particular point in time, in which the interest rate is plotted on the vertical axis and time to maturity on the horizontal axis. Term structure theory analyses why the term structure has a particular shape at a particular time. Analysts sometimes refer to the term structure as being flat (same interest for all maturities, downward sloping (short term interest rates higher than long term rates) and upward sloping long term rates greater than short term rates. Figure 11.4 depicts the three shapes of term structure of interest rate curves. There are four theories with the help of which the term structure of interest rates can be explained: (i) Expectation theory, (ii) liquidity preference theory, (iii) preferred habitat theory, iv) inflation premium theory. (i) According to expectation theory, the expectations of future interest rate constitute the key determinates of the yield/maturity relationship. Each investor can buy either long-term securities and hold them till maturity or buy short-term securities and continually reinvest in short-term securities for holding period of long-term securities. In equilibrium, the expected return holding period will tend to be the same, whatever alternative or combination of alternative was chosen. As a result, the return on a long term bond will tend to equal the

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Unbiased average of current short-term rates and future short-term rates expected to prevail to maturity of the long-term bond. Expectation theory contends that the term structure of interest rate is entirely a function of investor's expectations about future interest rates. Most of empirical evidences underpin the importance of interest rate expectation. (ii) Hicks and others have argued that the long-term I rates, in fact, tend to differ from the average of expected short-term rates because market participants prefer to lend short unless offered a premium sufficient to offset the risk of lending long. Nicks argues that the liquidity premium tend to be greater, the, longer the maturity of the bond. His findings support the liquidity preference theory of the term structure of interest rates. The theory asserts that most investors wish to invest for short-term and the organizationsâ&#x20AC;&#x2122; aim to borrow long-term, so that the liquidity premium are positive and therefore the expected interest rates exceed the expected future interest rates. If liquidity preference theory is right, then the term structure should be upward-'sloping [Fig. 11.4(c)]. However, if future interest rates are expected to fall, the term structure could be downward sloping, but the liquidity preference theory would predict a less dramatic downward slope than expectations theory. (iii) The preferred habitat hypothesis of Modigliani and Sutch argues that bond markets are segmented by maturity, and that the maturity preferences of market participants are so strong that investors tend to borrow and lend only in a particular range of maturities. Therefore, in each different credit market, interest rates tend to be determined by supply and demand rather than by interest rate expectations. His explanation is sometimes called the market segmentation theory, or hedging pressure theory. (iv) The inflation theory argues that long-term interest rate reflects investor's expectations about future short-term interest rates plus a premium for risk. However, the advocates of the theory contend that the principal source of risk is the rate of inflation.. They argue that investors are interested in real rate of return and that the primary determinants in the term structure of interest rate is investor's expectations of inflation over different holding periods which is the critical factor translating nominal interest rates into real expected returns.

Whichever theory of term structure may hold for the Euro-market, in the absence of capital

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controls, arbitrage would ensure the virtual equality of internal and external rates at each maturity, and whatever holds for the domestic market would also hold for Euro-market.

If the capital controls are there, they affect all maturities equally. The internal term structure might not be identical to external one because of segmentation due to capital control, but since the Euro-rates should tend to be at the same position relative to internal rates for each maturity, a nearly identical term structure should hold.

4.14. QUESTIONS Section – A Very short Answer 1. What do you mean by ERM? 2. Define Euro-Money.

3. What is GDR? 4. What is ADR? 5. Define bond market.

6. What is EMU? 7. What do you mean by Correspondent Banking?

Section – B Short Answer 1. Explain European Exchange Rate Mechanism (or ERM) 2. Outline the history of the EMU 3. Outline the countries using the euro and EU Members outside the Euro-Zone 4. What is GDR? Explain the steps in issuing GDRs. 5. Explain the need forming GDRs. 6. Explain different form foreign equity investments.

7. Explain the features of ADR. 8. Explain the feature of bond market?

Section – C Long Answer 1. Briefly describe the variation of global market debt instrument.

2. What is commercial paper? What are its advantages?

3. Distinguish between euro & us cp programmes.

4. Explain the features of different types of euro bonds 5. Describe the mechanism of euro loan syndication.

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INTERNATIONAL FINANCE MANAGEMENT 6. Define certificate of deposit. Explain its types.

7. Discuss the role of World Bank.

8. Explain the objectives, structure and functioning If IMF. 9. What is ADB? How it renders developmental assistance?

4.15. SUGGESTED READINGS 1. Multinational enterprises and economic analysis - Caves. R 2. International financial management - Madura Jeff 3. International financial management â&#x20AC;&#x201C; A K Seth

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CHAPTER â&#x20AC;&#x201C; 5 MULTINATIONAL FINANCIAL MANAGEMENT

STRUCTURE 5.0. INTRODUCTION 5.1. MULTINATIONAL FINANCIAL MANAGEMENT 5.2. COMPLEXITIES AND ISSUE SIN MANAGING FINANCIAL FUNCTIONS IN AN INTERNATIONAL FIRM 5.3. FINANCE FUNCTION 5.4. FINANCE FUNCTION IN INTERNATIONAL FIRM. 5.5. QUESTIONS 5.6. SUGGESTED READINGS 5.0. INTRODUCTION Multinational corporations make two types of investment decisions: 1. portfolio investment decisions and (2) Foreign direct investment decisions. In this chapter we shall be considering portfolio investment decisions. The securities are bought and sold to form portfolio. The securities are of two types: fixed income securities such as fixed interest rate bonds and debentures or variable return securities such as variable interest rate bonds and securities. The bonds have fixed maturities where as equity does not have fixed maturity. Therefore these require deferent treatment.

5.1. MULTINATIONAL FINANCIAL MANAGEMENT Multinational financial management whenever an investment decision is required to be taken, the first step is to decide the type of security that is required to be included in the portfolio, the market from where the security would be purchased and the tax effects are also to be analyzed.

A multinational financial management aspect of portfolio investment is international diversification of portfolio. When portfolios are diversified to international investments, basic to this diversification is the international risk and return trade off in relation to domestic investment.

5.2. COMPLICITIES AND ISSUES IN MANAGING FINANCIAL FUNCTION A firm as a dynamic entity has to continuously adapt itself to changes in its operating environment as well as in its own goals and strategy. The decades of 19'80's and 1990's were characterized by unprecedented pace of environmental changes for most Indian firms. Political uncertainties at home and abroad, economic liberalization at home, greater exposure to international markets, marked increase in the volatility of critical economic and financial variables such as exchange rates and interest rates, increased competition, threats of hostile takeovers are among the factors that have forced many firms to

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thoroughly rethink their strategic posture.

The start of the 21st century was marked by an even greater acceleration of environmental changes and significant increase in uncertainties facing the firm. As we approach the WTO deadlines pertaining to removal of trade barriers, companies will have to face even greater competition at home and abroad. Capital account convertibility of the rupee is expected to be put in place any time. Ceilings on foreign portfolio inv6stment are being revised upwards and barriers to foreign direct investment in India are being steadily lowered. Indian banking sector is being opened up to significant increase in foreign stake. During 2004 and early 2005, the rupee has shown an upward trend against the US dollar putting a squeeze on margins of exporting industries. On the whole, the process of integration of India in the global economy is expected to accelerate and hence exposure of Indian companies to global financial markets is certainly going to increase significantly during years to come.

The responsibilities of today's finance managers can be understood by examining the principal challenges they are required to cope with. Five key categories of emerging challenges can be identified: To keep up-to-date with significant environmental changes and analyse their implications for the firm.

Among the variables to be monitored are exchange rates, interest rates and credit conditions at home and abroad, changes in industrial, tax and foreign trade policies, stock market trends, fiscal and monetary developments, emergence of new financial instruments and products, etc.

To understand and analyse the complex interrelationships between relevant environmental variables and corporate responsesâ&#x20AC;&#x201D;own and competitiveâ&#x20AC;&#x201D;to the changes in them. Numerous examples can be cited. What would be the impact of a stock market crash on credit conditions in the international financial markets? What opportunities will emerge if infrastructure sectors are opened up to private investment? What are the potential threats from liberalisation of foreign investment? How will a default by a major debtor country affect funding prospects in international capital markets? How will a takeover of a major competitor by an outsider affect competition within the industry? If a hitherto publicly owned financial institution is privatised how will its policies change and how will that change affect the firm?

To be able to adapt the finance function to significant changes in the firm's own strategic posture. A major change in the firm's product-market mix, opening up of a sector or an industry so far prohibited to the firm, increased pace of diversification, a significant change in operating results, and substantial reorientation in a major competitor's strategic stance are some of the factors that will call for a major financial restructuring, exploration of innovative funding strategies, changes in dividend policies, asset sales to overcome temporary cash shortages and a variety of other responses.

To take in stride past failures and mistakes to minimise their adverse impact. A wrong takeover decision, a large foreign loan in a currency that has since started appreciating much faster than expected, a floating rate financing obtained when the interest rates were low and have since been

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rising rapidly, a fix-price supply contract which becomes insufficiently remunerative under current conditions and a host of other errors of judgement which are inevitable in the face of the enormous uncertainties. Ways must be found to contain the damage.

To design and implement effective solutions to take advantage of the opportunities offered by the markets and advances in financial theory. Among the specific solutions we will discuss in detail later are uses of options, swaps and futures for effective risk management, securitisation of assets to increase liquidity, innovative funding techniques, etc. More generally, the increased complexity and pace of environmental changes calls for greater reliance on financial analysis, forecasting and planning, greater coordination between the treasury management and control functions and extensive use of computers and other advances in information technology.â&#x20AC;&#x201D;`

5.3. THE FINANCE FUNCTION The finance function in a firm can be conveniently divided into two sub-functions viz. accounting and control and treasury management. The two groups of tasks are by no means independent. Decisions taken by the treasurer have implications for the controller and vice versa with a continuous exchange of information between them. Figure 1.4 is a schematic presentation of the responsibilities of the treasurer and the controller.

The Finance Function: As is evident from Figure 1.4, tasks relating to accounting, reporting and internal control are the domain of the controller while financial analysis, planning, acquisition of funds and deployment of funds are the responsibilities of the treasurer. A related aspect is management of risk in consonance with the company's preferred risk-reward profile.

While both the control and treasury management aspects of the finance function are important and complementary in this book we have chosen to focus primarily on the latter. Accounting and taxation

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issues are dealt with rather briefly in two chapters towards the end of the book. A deeper treatment of these topics is best left to specialized works on the subject.

Acquisition and allocation of financial resources so as to minimize the cost and maximize the return, consistent with the level of financial risk acceptable to the firm is the core of treasury management.

Much management the book will be concerned with the problem of managing the portfolios of the firm's financial assets and liabilities both short run as well as long run to optimize the risk-return and risk-cost tradeoffs. In no financial companies, financial management can be confined to the short and long-term flows of funds arising out of operational requirements. The management may decide as a matter of policy not to take on positions in the financial markets unrelated to the main business of the firm purely to profit from fluctuations in financial prices. Alternatively, it may want the treasury to actively exploit market imperfections and the firm's superior forecasting ability to generate pure financial gains. The latter strategy naturally has greater risks associated with it. The complexity and challenge of international finance are due to the fact that a wide variety of instruments, products, funding options and investment vehicles are available for both reactive and pro-active management of corporate finance.

It must be pointed out at this stage that the finance manager is also concerned with operating decisions such as choice of markets, sourcing of inputs, etc. This is more so in the multinational context than in a purely domestic context. Decisions which would normally be left to the marketing and purchase departments, have significant implications for the company's exposure to changes in exchange rates and interest rates in a multinational context. The finance manager would be expected to make substantive contributions to these decisions.

In the final analysis, the finance function like any other in the company is expected to assist the top management in the formulation of strategic goals and then support the corporate effort to attain these goals. In the process, it must not lose sight of the operational requirements of day-to-day management, continuous monitoring, information flow and control.

5.4. FINANCE FUNCTION IN INTERNATIONAL FIRM In the last chapter, it was said that the finance manager must help in formulating the firm's objectives and then design and implement financial strategies -to help achieve them. It is important to agree on the definition of the firm's objectives before!4 framework can be set up for financial decisions.

In micro-economic and organisational theories of the firm there has been a longstanding controversy as to what is the appropriate description of the objectives of a firm. Among the issues that have been vigorously debated are, single versus multiple objectives, managers' versus shareholders' objectives, optimizing versus satisfying, firm as a single monolithic decision making entity versus firm as a coalition of groups with possibly conflicting objectives and so on. Related to these issues is the question of descriptive realism versus predictive power of a theory of the firm.1 We will steer clear of these controversies and specify a firm's objectives in terms of a definition

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which has been accepted in the modem theory of finance viz. the objective of the management of a firm is to maximize the current value of the shareholders' wealth i.e. the current market value of the firm's outstanding equity shares.

Let us examine this a little more closely. In particular, we want to be sure about two things: (i) the current value maximization objective does not ignore the multi-period character of financial (and other) decisions and (ii) it incorporates uncertainty in some way.

Shareholders' wealth is the discounted value of after-tax cash flows paid out by the firm. Since after-tax cash flows available for payout can be shown to be the same as the stream of dividends (over the infinite future), the current value of shareholders' wealth is given by

Here So is the current value of the shareholders' wealth, DT is the dividend paid at the end of period t and k, is the rate of discount used by the shareholders to discount income streams which are considered to be equivalent (in terms of risk) to the firm's dividend stream.

The reader might wonder as to why capital gains do not appear in the valuation equation. After all, a shareholder invests in a share both for the dividend income and hopes of capital gains. The answer is, capital gains are taken care of in the above formula. To see this consider an example. Suppose a firm pays a dividend DI of Rs 15 at the end of the current year and thereafter, dividends will grow at the rate of 10% per annum. Suppose the investor's discount rate is 15%. The present value of this stream is given by'`

(In the above formula, g denotes the annual growth rate of dividends which in the present example is 10% or 0.10).Suppose the investor buys this share for Rs 300 today and holds it for 3 years. Its value at the end of the third year is

The dividend D4' at the end of fourth year is

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The value of the share at the end of the third year is the discounted value of all the dividend payments from that time on. Thus the investor who holds the share for three years and then sells it receives three dividend payments and the sales proceeds at the end of the third year. The present value of these payments is

For the example at hand this works out to be 3

3

= 151(1.15) + 15(1.1)1(1.15) + 15(1.21)/ (1.15) + 399.30/ (1.15) = 13.0435 + 12.4764 + 11.9337 + 262.5419 = 299.9945 This equals the value obtained for so earlier viz. 300 except for rounding off errors.

Thus the concept of wealth maximization incorporates a multi-period horizon with any combination of dividends and capital gains. The next question is how is it affected by uncertainty.

Uncertainty makes equity shares risky assets. Since future after tax cash flows are uncertain so are dividend payments and capital gains. The modern theory of finance as represented by the famous Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) rests on the following three propositions: 1. Investors are "risk-averse" i.e. they demand compensation for investing in risky assets. More specifically, if one asset (say a share of company A) is perceived to be riskier than another (say a share of company B) they would demand a higher expected return from asset A. Risk is to be understood as some measure of variability of cash flows. Suppose A and B have identical expected (in some sense "average") dividend streams but A's cash flows are perceived to be liable to greater fluctuations than B's, then asset A will be priced lower than B. In terms of our valuation equation, investors would use a higher rate of discount to discount cash flows from A than from B. 2. A risky asset has two types of risks associated with it. One is the unsystematic asset-specific risk and the other is systematic risk. In the context of share valuation, firm-specific risks are the unsystematic risks whereas risks arising out of movements of general economic and industry variables are systematic risks.

Thus, a firm in say textile industry will perform badly when the entire economy is passing through a severe recession; so will most firms in most industries. On the other hand this firm may sometimes

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perform badly even when the economy is booming because of some adverse circumstances peculiar to the firmâ&#x20AC;&#x201D;say a long drawn-out strike. The former is systematic risk while the latter is unsystematic. The total variability in the firm's cash flows can be broken down into two components, one attributable to factors peculiar to the firm while the other is due to the general economic and market conditions.

3. Risk-averse investors will not worry about firm-specific, unsystematic risks since these risks are diversifiable. Investors will invest in-~a number of companies covering a broad range of industries and also in real assets such as houses and stocks of commodities. My stocks in a textile firm may perform badly because of factors peculiar to that firm but at the same time my stock in an IT firm may be doing extremely well. My portfolio as a whole would not be very sensitive to such firm-specific factors. Hence no additional compensation will be demanded for these risks. Thus the only risk that matters is the systematic risk arisino, out of the fact that the firm's fortunes may be linked to the. General economic conditions.

The Capital Asset Pricing Model thus arrives at the famous result known as the Security Market Line which says that the expected return on a risky asset consists of the risk-free return plus a risk premium which depends only on the covariability of the firm's cash flows with general economic and market conditions:3

RI denotes the rate of return on the risky asset i, R is the rate of return on the "market portfolio", RJ is the rate of return on a risk-free asset (such as a treasury bill) and 6i,,, and (T2 ", are, respectively, the covariance between the returns on asset i and the market portfolio and the variance of the return on market portfolio. E (.) is the expectations operator. The ratio [AI /(62) ] is called the "Beta" of asset i.

Investors would use the expected value of RI as the rate of discount to find the present value of the income stream associated with asset i. Thus the wealth maximization hypothesis allows for uncertainty through its impact on the rate of discount k, iii (2.1) and (2.2).

Risk Management and Wealth Maximization: A large part of this book will be devoted to techniques for managing financial risks; in particular those arise more prominently in the context of international finance. The above discussion of the impact of risk on the value of the firm gives rise to a very important and interesting question: what should be the interesting attitude of the firm's management regarding firm-specific risks? It appears that since these risks are diversifiable, they are not "priced" by the investors i.e. they do not affect the expected rate of return demanded by the investorsâ&#x20AC;&#x201D;the discount rate k, Why then should the firm spend resources to insure against these risks? Even if certain risks are systematic in the sense that they affect almost all firms adversely, it is not clear that hedging such risks necessarily adds to shareholder value. As Fite and

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Pleiderer (1995) have argued such risks can be hedged only at a cost since the party to whom the risk is transferred will demand compensation for bearing the risk. Thus for instance, while it is true that increase in energy costs will have an adverse impact on almost all firms, in an efficient market, the compensation that has to be paid for bearing this risk would just equal the increase in the value of the firm resulting from eliminating this risk; on balance the firm's shareholders will neither gain nor lose.

Risks arising out of fluctuations in exchange rates, interest rates and commodity prices are pervasive that is they affect most of the firms; however, they affect different firms in different ways and are therefore firm-specific or idiosyncratic. For instance, a strengthening of the dollar against the rupee will improve the prospects for exporting firms while the fortunes of those firms which have a heavy import content in their production will be affected adversely. The theory underlying the CAPM tells us that hedging such risks is irrelevant as it adds no shareholder value.` Finally, even, if the irrelevance argument is not found to be convincing, the well-known Modigliani Miller analysis of a firm's optimal capital structure offers another argument against hedging. In a world of no taxes, no transactions costs and no information asymmetries they demonstrated that a firm's financing policy does not matter as long as it does not affect its investment policy. If some shareholders are unhappy with the particular debt-equity structure adopted by the firm, they can achieve whatever leverage they desire by trading on their own' account. The same argument can be extended to hedging risks such as exchange rate risks. A firm which exports to the United States and has dollar receivables can hedge these with forward sales of dollars against rupees; while its shareholders can achieve the same result on their own (by taking similar but smaller positions in the dollar-rupee forward market), hedging by the firm will add no shareholder values If capital markets are perfect, individual investors, in particular a firm's share- holders can replicate financial strategy adopted by the firm. In such a world, active risk management policy' cannot add value.

In practice, we find that firms do expend considerable amount of resourcesâ&#x20AC;&#x201D;managerial time and moneyâ&#x20AC;&#x201D;in an attempt to hedge firm-specific risks. For instance, they avoid highly risky investment projects, purchase insurance against product liability suits, and enter into forward contracts in foreign exchange, and specific commodities (which may be critical inputs) and so forth. Is there a rationale for these actions?

In addition to the "irrelevance of unsystematic risks" or "shareholders can do it themselves" arguments against hedging it has also been argued that since financial markets are efficient, it makes little difference in the long run whether and what kind of risk management posture a firm adopts. This means that with efficient markets it would not matter in the long run whether a firm follows an active hedging policy, a purely passive strategy of hedging all risks at all times or a policy of no hedging at all.

Note however that the hypothesis of efficiency of financial markets is far from firmly established.

If active risk management by a firm adds shareholder value it must be Because it alters the firm's cash flows in a way which is beneficial to the shareholders even after

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meeting the cost of hedging and (ii) the firm can achieve this at a lower cost than what the shareholders would have to incur if they did it on their own. This is possible in the presence of some capital market imperfections which are assumed away by the Modigliani-Miller theorem.

With reference to the valuation equation, hedging can increase shareholder wealth both by influencing future cash flows and by reducing the discount rate at which these cash flows are discounted.

In general, it is true that, the former effect is stronger though there can be circumstances under which hedging can reduce the expected return investors demand from a particular firin. 6 One of the most cogent arguments for hedging by the firm has been presented by Froot et al (1994).7 They not only provide a rationale for hedging as such but also put forward an explanation as to why selective or discretionary hedging rather than hundred percent hedging might be an optimal policy under certain conditions. The main thrust of their argument can be summarized as follows: 1. Firms enhance shareholder wealth—create "corporate value"—by making good investments.

"Investments" here means not only physical plant and equipment but also R&D, product development, market investments such as advertising and promotion and so forth.

2. The firm's ability to take advantages of all the available good investment opportunities depends crucially on the availability of internally generated cash. While in a world of no taxes, no bankruptcy costs and perfect capital markets, the financing of investments may be irrelevant,8 in practice, firms typically prefer to finance projects with internal funds as much as possible.

External finance—debt and new equity in that order—are less preferred alternatives. When a firm finds itself short of internal funds, it cuts back on its investment expenditures.9 3. Careful hedging can minimize toe probability of the firm finding itself short of internal cash at a time when the environment presents good investment opportunities.

This inter linkage of investment and financing decisions also helps explain why it may not be necessary to hedge all environmental exposures or at least not hundred per cent. For an oil producer, further investments in exploration and development become attractive when oil prices are ruling high; but this is precisely when internal cash generation is also high. Hence the firm may not have to hedge against oil price fluctuations. On the other hand a multinational pharmaceuticals firm would find that its cash flows are very sensitive to exchange rates while emergence of profitable investment opportunities in R&D, new product development and so forth is largely independent of movements in exchange rates. Hedging against exchange rate fluctuations would minimize the probability of its having to sacrifice these opportunities on account of shortage of internally generated cash. The investment-financing interlink age predicts that firms with more growth opportunities are more likely to be hedgers than those with more stable businesses.

Shapiro and Titman (1985) point out that unsystematic risk like exchange rate risks, if left unmanaged, increase the probability of the firm getting into financial distress. There are both direct and

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indirect costs of financial distress. Direct costs refer to the costs incurred during bankruptcy, liquidation or reorganization process. Even if exchange rate and interest rate exposure does not lead to bankruptcy, there are indirect costs of financial distress due to loss of credibility in the eyes of the firm's customers, suppliers and workers. This can lead to an adverse impact on the firm's revenue or an increase in its operating costs. If its bankers, suppliers, customers and employees think that the firm is in a liquidity crunch, they may react in a manner that can sometimes threaten the very survival of the firm but will most probably affect its future operating cash flows.10 Shapiro and Titman offer five reasons why this could happen. We will take a brief look at them. 

Financial distress and the possibility of bankruptcy can affect managerial incentives. Managers are more likely to choose high-risk investments that benefit shareholders at the expense of the firm's creditors. They are likely to cut corners on product quality and the safety of workers. Finally, there will be an incentive to get out of the business which they would otherwise have continued.



The suspicion that the firm may be slackening on quality and the fear (in the case of firms which sell consumer durables, capital equipment, etc.) that if the firm goes out of business, after-sales service and spares will be difficult to-,,obtain, may scare away customers and thus affect sales volumes adversely.



A firm which is perceived to be struggling for survival will find its operating costs going up.

Suppliers will tighten credit term's (they may even demand advance payments), will be reluctant to undertake long term commitments to supply highly specialized components and subassemblies (because these require' investment in fixed assets on their part which are not readily transferable to other uses). The firm may find it difficult to attract and retain good personnel'' thus raising its labour costs and/or reducing productivity.



When day-to-day survival is in doubt, the firm is likely to become less careful about its creditworthiness. Creditors, realizing this are likely to stiffen their terms. Trade credit, bank advances and term loans will become more expensive or even totally unavailable.



The firm will have to incur higher costs just to maintain the organisation. Employees, suppliers, creditors and other Stakeholders will demand compensation for bearing added risks involved in dealing with a firm perceived to be in financial distress.

In essence what this argument says is that while financial markets may be efficient, and hedging

or no hedging may not make a difference in the "long run", the firm may not have the luxury of a long run; serious damage may have been done before the dice turns in its favour. The assertion that in the long run things would even out is little comfort to a treasurer who is faced with the prospect of a huge cash loss in huge next quarter on account of an unfavourable exchange rate movement.

Another argument in favour of hedging has to do with the nature of tax schedules faced by the firm. In many countries tax schedules exhibit "convexity" i.e. the marginal tax rate rises as taxable income

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rises. A consequence of this is that the tax paid when taxable profits are high is more than tax saved when an equal loss occurs. Thus suppose due to exchange rate uncertainty, a firm's taxable income could be either +1000 or â&#x20AC;&#x201C;200 with equal probability. Taxable income upto 500 is taxed at a rate of 40% while income in excess of 500 is taxed at a rate of 50%. Its expected tax liability would be 0.5(0) + 0.5 [0.4 x 500 + 0.5 x 500] = 225 Suppose with hedging of currency exposure, it can lock in taxable income of [0.5(-200) + 0.5(l 000)] or hedging 400. Its tax liability would be (0.4 x 400) or 160, a tax saving of 65. Another point to note is that even when marginal tax rates are constant, tax laws generally allow losses to be set off against taxable income in the future. With positive interest rates, this reduces the present value of such tax savings. Also, when a firm makes losses and has no taxable income, it cannot take advantage of tax write-offs for depreciation, interest and incentives such as investment tax credits. Thus, reducing the variability of pre-tax income enables the firm to save on taxes in a number of ways. Graham and Smith (1999) have estimated that for a typical US firm, 5% reduction in the variability of before tax income results in a saving of 3% in taxes.

While this appears to provide an important reason for hedging currency and other macroeconomic risks, surveys of managers motivations do not bring it out as an important factor.

Agency-theoretic explanations for hedging focus on the conflict between stockholders and bondholders. There is the well-known problem of "under-investment" described by Myers and Majluf (1984). If stockholders think that a large part of the cashflows from a new project will accrue to bondholders, they will not undertake some positive

NPV projects if they have to issue risky debt.

Hedging can reduce or eliminate the probability of default and induce firms to undertake more investment.

Once again, this rationale for hedging predicts that firms with greater growth opportunities (and hence more room for discretionary investment decisions) are more likely to be hedgers.

Many other explanations have been advanced to account for the observed fact that firms do expend considerable resources managing their exposures to macro-economic risk factors like exchange rates, interest rates and commodity prices.

The argument that shareholders can hedge their own risks by diversifying their portfolios as well as using hedging instruments like forward contracts assumes that shareholders have the same access to hedging instruments as the firm. Also, some risks can be hedged internally without recourse to any hedging products. Such possibilities will be better known to the management of the firm rather than its shareholders. There- is also the problem of information. To do it themselves, shareholders would need information on the timing and amount of currency and other exposures faced by the firms in their portfolios; gathering such information would prove to be a costly activity for most shareholders whereas for firms there is no additional cost involved.

It has also been pointed out that criteria used for appraising managerial performance may encourage hedging. In a multi-division firm, if each unit is judged on the basis of its own cash flows or

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profits, unit managers may engage in hedging to reduce the unit-level risk even when the firm as a whole may have a natural hedge. Thus, if one division is a net exporter to the US while another is a net importer, the firm as a whole may not have to hedge against rupee-dollar fluctuations but individual divisions may still engage in active hedging of exchange-rate exposure.

To sum up, there are good reasons why firms should and do pay attention to financial and operating risks which are specific to their own operations along with risks arising out of changes in the general economic conditions. 14 However, one point must be noted. In the case of a multinational firm whose shareholders are scattered around the world, it is not clear exactly how hedging serves shareholder interests. Suppose an American firm has German and Japanese shareholders. If the firm follows the policy of stabilizing its cash flows measured in US dollars it may very well be destabilizing the values of the portfolios of its foreign shareholders measured in their respective currencies. On the other hand, the presence of capital market imperfections is likely to be much more pervasive across national boundaries than within a country. This would induce greater concern about macro-economic exposures on the part of multinationals compared to single-country firms.

Main (1996) has provided some empirical evidence on the relationship between a firm's financial characteristics and hedging decisions. Surprisingly enough, he finds little or no relationship between hedging and growth opportunities, hedging and tax progressivity, and hedging and costs of financial distress. He does find a significant relation between hedging and firm size indicating that perhaps there are significant economies of scale in hedging activity.

5.5. QUESTION Section - A Very short type answers 1 what is multinational financial management?

2. What is acquisition fund?

3. Give the meaning of cash management.

4. What is risk management?

5. What do you mean by investment financing?

Section â&#x20AC;&#x201C; B Short type answer questions 1. What is the finance function?

2. What is the budget planning control?

3. Mention about the management information system.

4. Define the account receivable and importance.

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INTERNATIONAL FINANCE MANAGEMENT Section – C Long type answer questions 1. Explain the complexities in managing financial functions.

2. Explain the tax planning and management.

3. What are the finance functions in international firm?

4. Explain risk management and wealth maximization.

5.6. SUGGESTED READINGS 1. Multinational enterprises and economic analysis - Caves. R 2. International financial management - Madura Jeff 3. International financial management – A K Seth

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CHAPTER- 6 MULTINATIONAL WORKING CAPITAL MANAGEMENT STRUCTURE

6.0. INTRODUCTION 6.1. WORKING CAPITAL CYCLE 6.2. SHORT-TERM FINANCING OPTIONS 6.3. INVESTING SURPLUS FUNDS 6.4. WORKING CAPITAL MANAGEMENT 6.5. GLOSSARY 6.6. QUESTIONS 6.7. SUGGESTED READINGS 6.0. INTRODUCTION The Working capital management is an integral part of the total financial management of an enterprise that has a greater impact on Profitability, Liquidity and Overall performance of the enterprise irrespective of its nature. In fact, working capital is a circulatory money investment that takes place right from the input stage to output. Management of working capital is complicated on account of two important reasons, namely, fluctuating nature of its amount, and a need to maintain a proper balance between current assets and non-current assets in order to maximize profits.

The importance of working capital in an industry cannot be over stressed, as it is one of the important causes of success or failure of an industry. Whatever be the size of the business, working capital is its life-blood. Working capital constitutes the funds needed to carry on day to day operations of a business, such as purchase of raw materials, payment of wages and other expenses. For running a business an adequate amount of working capital is essential. A firm with shortage of working capital will be technically insolvent. The liquidity of a business is also one of the key factors determining its propensity to success or failure. In, India, paucity of working capital has become a chronic disease in the industrial sector. This calls for a systematic and integrated approach towards utilizing a companyâ&#x20AC;&#x2122;s assets with maximum efficiency.

Managing working capital is a matter of balance. A department must have sufficient cash on hand to meet its immediate needs while ensuring that idle cash is invested to the organizationâ&#x20AC;&#x2122;s best possible advantage. To avoid tipping the scale, it is necessary to have clear and accurate reports on each of the components of working capital and an awareness of the potential impact of outside influences. Working capital is the money used to make goods and attract sales. The less Working capital used to attract sales, the higher is likely to be the return on investment. Working Capital management is about the commercial

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and financial aspects of inventory, credit, purchasing, marketing, and royalty and investment policy. The higher the profit margin, the lower is likely to be the level of Working capital tied up in creating and selling titles. Working capital management in international context involves managing cash balances, account receivable, inventory, and current liabilities when faced with political, foreign exchange, tax, and liquidity constraints. It also encompasses the need to borrow short-term funds to finance current assets from both in-house banks and external local and international commercial banks. The overall goal is to reduce funds tied up in working capital. This should enhance return on assets and equity. It also should improve efficiency ratios and other evaluation of performance parameters.

Management of short-term assets and liabilities is an important part of the finance managerâ&#x20AC;&#x2122;s job.

Funds flow continually in and out of a corporation as goods are sold, receivables are collected, short-term borrowings are availed of, payables are settled and short-term investments are made. The essence of short-term financial management can be stated as: i) Minimize the working capital needs consistent with other policies for example, granting credit to boost sales, maintain inventories to provide a desired level of customer service etc. ii) Raise short-term funds at the minimum possible cost and deploy short-term cash surpluses at the maximum possible rate of return consistent with the firmâ&#x20AC;&#x2122;s risk preferences and liquidity needs.

In international context, the added dimensions are the multiplicity of currencies and a much wider array of markets and instruments for raising and deploying funds.

6.1. WORKING CAPITAL CYCLE Cash flows in a cycle into, around and out of a business. It is the business's lifeblood and every manager's primary task is to help keep it flowing and to use the cash flow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out of cash and expire. The faster a business expands the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash will help improve profits and reduce risks. Bear in mind that the cost of providing credit customers and holding stocks can represent a substantial proportion of a firm's total profits. There are two elements in the business cycle that absorb cash - inventory (stocks and work-in-progress) and receivables (debtors owing you money). The main sources of cash are payables (your creditors) and equity and loans.

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Each component of working capital (namely inventory, receivables and payables) has two dimensions: Time and money. When it comes to managing working capital - TIME IS MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. Consequently, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment.

Similarly, if you can negotiate, improved terms with suppliers e.g. get longer credit or an increased credit limit; you effectively create free finance to help find future sales. In the next sections an attempt has been made to explain the short-term objectives of working capital management.

6.2. SHORT-TERM FINANCING OBJECTIVES: 1. Minimize expected cost.

By ignoring risk, this objective reduces information requirements, allows borrowing options to be evaluated on an individual basis without considering the correlation between loan cash flows and operating cash flows, and lends itself readily to breakeven analysis. One problem with this approach is that if risk affects the companyâ&#x20AC;&#x2122;s operating cash flows, the validity of using expected cost alone is questionable. If forward contracts are available, however, there is a theoretically justifiable reason for ignoring risk; namely, loan costs should be evaluated on a covered basis. In that case, minimizing expected cost is the same as minimizing actual cost.

2. Minimize risk without regard to cost.

A firm that followed this advice to its logical conclusion would dispose of all its assets and invest

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the proceeds in government securities. In other words, this objective is impractical and contrary to shareholder interests.

3. Trade off expected cost and systemic risk.

The advantage of this objective is that, like the first objective, it allows a company to evaluate different loans without considering the relationship between loan cash flows and operating cash flows from operations. Moreover, it is consistent with shareholder preferences as described by the capital asset pricing model. In practical terms, however, there is probably little difference between expected borrowing costs adjusted for systematic risk and expected borrowing costs without that adjustment. This lack of difference is because the correlation between currency fluctuations and a well-diversified portfolio of risky assets is likely to be quite small.

4. Trade off expected cost and total risk: Basically, it relies on the existence of potentially substantial costs of financial distress. On a more practical level, management generally prefers greater stability of cash flows (regardless of investor preferences). Management will typically self-insure against most losses, but might decide to use the financial markets to hedge against the risk of large losses. To implement this approach, it is necessary to take into account the covariances between operating and financing cash flows. This approach (trading off expected cost and total risk) is valid only where forward contracts are unavailable. Otherwise, selecting the lowest-cost borrowing option, calculated on a covered after-tax basis, is the only justifiable objective.

In the following sections an attempt has been made to explain the various short-term financing and investment options available to MNCs.

Short-term Financing Options: International money markets particularly in well-developed financial centres like London, New York, and Tokyo offer a variety of instruments to raise short-term financing as well as place short-term funds. The principal dimensions of the borrowing investment decisions are the instrument, currency, location of the financial centre, and any tax related issues. Between them they decide the cost of return on funds, extent of currency exposure, the ease with which funds can be moved from one location and currency to another, and thus the overall efficiency of the cash management function. Firms typically prefer to finance the temporary component of current assets with short-term funds. The financing options that may be available to an MNC: a) The inter company loan b) The local currency loan, and c) Euro Notes and Euro commercial paper a) Inter company financing: A frequent means of affiliate financing is to have either the parent company or sister affiliate provide an inter company loan. At times, however, these loans may be limited in amount or duration by

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official exchange controls. Normally, the lender’s government will want the interest rate on an inter company loan to be set as high as possible for both tax and balance-of-payments purposes, while the borrower’s government will demand a low interest rate for similar reasons. The relevant parameters in establishing the cost of such a loan include the lender’s opportunity cost of funds, the interest rate set, tax rates and regulations, the currency of denomination of the loan, and expected exchange rate movements over the term of the loan. b) Local Currency Financing: Like most domestic firms, affiliates of multinational corporations generally attempt to finance their working capital requirements locally, for both convenience and exposure management purposes. Since all industrial nations and most less developed countries (LDCs) have well-developed commercial banking systems, firms desiring local financing generally turn there first. The major forms of bank financing include overdrafts, discounting, and term loans. Nonbank sources of funds include commercial paper and factoring.

Loans from commercial banks are the dominant form of short-term interest-bearing financing used around the world. These loans are described as Self-liquidating because they are usually used to finance temporary increases in accounts receivable and inventory. These increases in working capital are soon converted into cash, which is used to repay the loan.

Short-term bank credits are typically unsecured. The borrower signs a note evidencing its obligation to repay the loan when it is due, along with accrued interest. Most note are payable in 90 days; the loan must, therefore, be repaid or renewed every 90 days. The need to periodically roll over bank loans gives a bank substantial control over the use of its funds, reducing the need to impose severe restrictions on the firm. To further ensure that short-term credits are not being used for permanent financing, a bank will usually interest a cleanup clause requiring the company to completely out of debt to the bank for a period of at least 30 days during the year. Bank credit provides a highly flexible form of financing because it is readily expandable and, therefore, serves as a financial reserve. Whenever the firm needs extra short-term funds that can’t be met by trade credit, it is likely to turn first to bank credit.

Unsecured bank loans may be extended under a line of credit, under a revolving-credit arrangement.

c) Euro notes and Euro-Commercial Paper: A recent innovation in nonbank short-term credits that bears a strong resemblance to commercial paper is the so-called Euro note. Euro notes are short-term notes usually denominated in dollars and issued by corporations and governments. The prefix “EURO” indicates that the notes are issued outside the country in whose currency they are denominated. The interest rates are adjusted each time the notes are rolled over. Euro notes are often called Euro-commercial paper (Euro-CP, for short). Typically, though, the name Euro-CP is reserved for those Euro notes that are not underwritten.

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6.3. INVESTING SURPLUS FUNDS In a multinational corporation with production and selling subsidiaries spread around the world, cash inflows and outflows occur in diverse currencies. Apart from cost and return considerations, several other factors influence the choice of currencies and locations for holding cash balances. The bid-ask spreads in exchange rate quotations represent transaction costs of converting currencies into one another. Other costs such as telephone calls, telexes and other paperwork may also contribute substantially to the transaction costs. Minimizing transaction costs would require that funds be kept in the currency in which they are received if there is the possibility that they might be needed latter in the same currency. Availability of investment vehicles and their liquidity is yet another important factor. Withholding taxes may influence the choice. If balances are held in interest bearing assets in a country which has a withholding tax on non-resident interest income, and the tax rate exceeds the parentâ&#x20AC;&#x2122;s home country tax rate, the parent cannot get full credit for the foreign tax paid and such a location may therefore become unattractive for holding funds. Once the treasurer has identified the cashflows and determined how many surplus funds are available, in which currencies and for what duration, he or she must choose appropriate investment vehicles so as to maximize the interest income. Again, at the same time, the treasurer must look towards minimizing currency and credit risks and ensuring sufficient liquidity to meet any unforeseen cash requirements. The major investment vehicles available for short-term placement of funds are: (i) Short - term bank deposits, (ii) Fixed-term money market deposits such as CDs, and (iii) Financial and commercial paper.

The main considerations in choosing and investment vehicle can be summarized as follows: Yield: Total return on the investment including interest income and any capital gain or loss. Very often, security and liquidity considerations may take precedence over yield.

Marketability: Since liquidity is an important consideration, the ease with which the investment can be unwound is important. Instruments like CDs have well developed secondary markets while CPs and trade related paper have limited liquidity.

Exchange Rate Risk: If funds eventually required in currency A are invested in currency B, there is an exchange rate risk. If covered, there is no advantage to switching currencies.

Price Risk: If a fixed-term investment such as a CD or a T-bill has to be liquidated before maturity, there is the risk of capital loss if interest rates have moved up in the meanwhile.

Transactions Costs: Brokerage commissions and other transactions costs can significantly lower the realized yield particularly on short-term investments. Money-market investments are often available in fixed minimum sizes and maturities, which may not match the size of the available surplus and the duration for which it is available.

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Current Asset Management: Objectives: After studying this lesson you should be able 

To understand the differences between domestic and international working capital management



To know the international cash management practices adopted by multi national corporation



To know the procedures involved in accounts receivable management



To observe the inventory management techniques adopted by international business firms

Introduction: The management of working capital in the multinational corporation is similar to its domestic counterpart. Both are concerned with selecting that combination of current asset-cash, marketable, accounts receivable, and inventory-that will maximize the value of the firm. The essential differences between domestic and international working-capital management include the impact of currency fluctuations, potential exchange controls, and multiple tax jurisdictions on these decisions, in addition on the wider range of short-term financing and investment options available. Multinational firms can shift liquid assets among various affiliates. The following sections focus on management practices of international companies’ cash, accounts receivable, and inventory management.

Cash Management: International money managers attempt to attain on a worldwide basis the traditional domestic objectives of cash management: (1) bringing the company’s cash resources within control as quickly and efficiently as possible and (2) achieving the optimum conservation and utilization of these funds.

Accomplishing the first goal requires establishing accurate, timely forecasting and reporting systems, improving cash collections and disbursements, and decreasing the cost of moving funds among affiliates.

The second objective is achieved by minimizing the required level of cash balances, making money available when and where it is needed, and increasing the risk-adjusted return on those funds that can be invested. Restrictions and typical currency controls imposed by governments inhibit cash movements across national boundaries. These restrictions are different from one country to other. Managers require lot of foresight, planning, and anticipation. Other complicating factors in international money management include multiple tax jurisdictions, multiple currencies, and relative absence of internationally integrated interchange facilities for moving cash quickly from one place to other. However, by adopting advanced cash management techniques MNCs are able to take advantage of various opportunities available in different countries. By considering all corporate funds as belonging to a central reservoir or ‘pool’ and managing it as such, overall returns can be increased while simultaneously reducing the required level of cash and marketable securities worldwide.

Centralized Cash Management: Advantages When compared to a system of autonomous operating units, a fully centralized international cash management program offers a number of advantages, such as;

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1. The corporation is able to operate with a smaller amount of cash; pools of excess liquidity are absorbed and eliminated; each operation will maintain transactions balances only and not hold speculative or precautionary ones.

2. By reducing total assets, profitability is enhanced and financing costs reduced.

3. The headquarters staff, with its purview of all corporate activity, can recognize problems and opportunities that an individual unit might not perceive.

4. All decisions can be made using the overall corporate benefit as the criterion.

5. by increasing the volume of foreign exchange and other transaction done through headquarters, banks provide better foreign exchange quotes and better service.

6. Great expertise in cash and portfolio management exists if one group is responsible for these activities.

7. Less will be lost in the event of an expropriation or currency controls restricting the transfer of funds because the corporation’s total assets at risk in a foreign country can be reduced.

The foregoing benefits have long been understood by many experienced multinational firms.

Today the combination of volatile currency and interest rate fluctuations, questions of capital availability, increasingly complex organization and operating arrangements, and a growing emphasis on profitability virtually mandates a highly centralized international cash management system. There is also a trend to place much greater responsibility in corporate headquarters. Centralization does not necessarily imply control by corporate headquarters of all facets of cash management. Instead, a concentration of decision making at a sufficiently high level within the corporation is required so that all pertinent information is readily available and can be used to optimize the firm’s position.

Netting: In a typical multinational family of companies, there are a large number of intra corporate transactions between subsidiaries and between subsidiaries and the parent. If all the resulting cash flows are executed on a bilateral, pair wise basis, a large number of currency conversions would be involved with substantial transaction costs. With a centralised system, netting is possible whereby the cash management centre (CMC) nets out receivables against payables, and only the net cash flows are settled among different units of the corporate family.

Payments among affiliates go back and forth, whereas only a netted amount need be transferred.

For example, the German subsidiary of an MNC sells goods worth $1million to its Italian affiliate that in turn sells goods worth $2 million to the German unit. The combined flows total $3 million. On the net basis, however, the German unit need remit only $1 million to the Italian unit. This is called bilateral netting. It is valuable, though only if subsidiaries sell back and forth to each other.

But a large percentage of multinational transactions are internal – leading to a relatively large volume of inter affiliate payments – the payoff from multilateral netting can be large, relative to he costs of

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such a system.

The netting center will use a matrix of payables and receivables to determine the net payer or creditor position of each affiliate at the date of clearing. Assume that there is a U.S. parent corporation with subsidiaries in UK, Belgium, and Australia. Each of the amounts due to and from the affiliated companies is converted into a common currency (the U.S. dollar in this example) and entered onto the matrix. Without netting, the total payments in the system would equal $44 million. Multilateral netting will pare these transfers to $12 million, a net reduction of 73% (Exhibit 1).

Cash Pooling: The CMC act not only as a netting center but also the repository of all surplus funds. Under this system, all units are asked to transfer their surplus cash to the CMC, which transfers them among the units as needed and undertakes investment of surplus funds and short-term borrowing on behalf of the entire corporate family. The CMC can in fact function as a finance company which accepts loans from individual surplus units, makes loans to deficit units and also undertakes market borrowing and investment. By denominating the intra-corporate loans in the unitsâ&#x20AC;&#x2122; currencies, the responsibility for exposure management is entirely transferred to the finance company and the operating subsidiaries can

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concentrate on their main business, viz. production and selling of goods and services. Cash pooling will also reduce overall cash needs since cash requirements of individual units will not be synchronous.

Rein voicing Centre: The concept of CMC can be combined with that of a rein voicing centre. Under this system, notionally, all subsidiaries sell their output to the reinvoicing centre, which is located in a low tax country.

The sales are invoiced in the selling companyâ&#x20AC;&#x2122;s currency. The reinvoicing centre takes title to the goods and in turn sells to third party customers, as well as other members of the corporate family which may be production and/or sales subsidiaries. The actual deliveries are made from the selling units to the buying units. For intra-corporate sales, the buying units are invoiced in their respective currencies. Thus the entire currency exposure is transferred to the reinvoicing centre which can use matching and pairing to minimize recourse to forward markets or other hedging devices. Also, the reinvoicing centre can access foreign exchange markets more efficiently than individual subsidiaries. Leading and lagging can be used to transfer funds from cash-surplus units to cash-deficit units. CMCs, finance companies, and reinvoicing centres are generally located in major money market centres where active markets in foreign exchange and a variety of money market instruments are available. Also, the presence of an efficient banking system can facilitate speedy settlement of receivables and payables.

Some important issues have to be sorted out before setting up a centralised cash management system with netting and cash pooling. If the CMC uses a single currency as the common denominator to compute net positions, this will lead to transactions exposure for individual subsidiaries. Hence the choice of the common currency must be made in the light of local currencies of the individual divisions, existence of sufficiently active forward markets and other hedging products between these currencies and the common currency and so forth. The second issue is related to rules governing settlement of debts within the system. If an individual subsidiary has a net debtor position, how much time should it be given to settle, how much interest should it be charged on overdoes, how should it prevent a subsidiary from arbitraging between its local money market and the CMC (e.g. if a subsidiary can earn a much higher rate in the local money market than what it has to pay on overdoes to the centre, it will have incentive to delay payments) are among the considerations which must be thoroughly analyzed.

Despite these advantages, complete centralization of cash management and funds holding will generally not be possible. Some funds have to be held locally in each subsidiary to meet unforeseen payments since banking systems in many developing countries do not permit rapid transfers of funds.

Also, some local problems in dealing with customers, suppliers and so on, have to be handled on the spot for which purpose local banks have to be used and local banking relationships are essential. Each corporation much evolves its own optimal degree of centralization depending upon the nature of its global operations, locations of its subsidiaries and so forth. Further, conflicts of interest can arise if a subsidiary is not wholly owned but a joint venture with a minority local stake. What is optimal with regard to cash and

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exposure management from an overall corporate perspective need not be necessarily so from the point of view of local shareholders.

Collection and Disbursement of Funds: Accelerating collections both within a foreign country and across borders is a key element of international cash management. Considering either national or international collections, accelerating the receipt of funds usually involves the following: i) Defining and analyzing the different available payment channels, ii) Selecting the most efficient method (which can vary by country and customer), iii) Giving specific instructions regarding procedures to the firm’s customers and banks.

Management of disbursements is a delicate balancing act: holding onto funds versus staying on good terms with suppliers. It requires a detailed knowledge of individual country and supplier policies, as well as the different payment instruments and banking services available around the world. A constant review on disbursements and auditing of payment instruments help international firms achieve better cash management. The following questions may help international firms to find suitable methodology.

1. What payment instrument are you using to pay suppliers, employees, and government entities (e.g. checks, drafts, wire transfers, direct deposits)?

2. What are the total disbursements made through each of these instruments annually?

3. What is the mail and clearing float for these instruments in each country?

4. What techniques, such as remote disbursement, are being used to prolong the payment cycle?

5. How long does it take suppliers to process the various instruments and present them for payment?

6. What are the bank charges and internal processing cost for each instrument?

7. Are banking services such as controlled disbursement and zero-balance account used where available?

Management of the Short-term Investment Portfolio: A major task of international cash management is to determine the levels and currency denominations of the multinational group’s investment in cash balances and money market instruments.

Firms with seasonal or cyclical cash flows have special problems, such as spacing investment maturities to coincide with projected needs. To manage, this investment properly requires (a) a forecast of future cash needs based on the company’s current budget and past experience and (b) an estimate of a minimum cash position for the coming period. Common-sense guidelines for globally managing the marketable securities portfolio are as follows.

1. Diversify the instruments in the portfolio to maximize the yield for a given level of risk. Don’t invest only in government securities. Eurodollar and other instruments may be nearly as safe.

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2. Review the portfolio daily to decide which securities should be liquidated and what new investment should be made.

3. In revising the portfolio, make sure that incremental interest earned more than compensates for such added costs clerical work, the income lost between investments, fixed charges such as the foreign exchange spread, and commission on the sale and purchase of securities.

4. If rapid conversion to cash is an important consideration, then carefully evaluate the security’s marketability (liquidity). Ready markets exist for some securities, but not for others.

5. Tailor the maturity of the investment to the firm’s projected cash needs. Or a secondary market with high liquidity should exist.

6. Carefully consider opportunities for covered or uncovered interest arbitrage Cash Transmission: An important but easy to overlook aspect of cash management is minimising the unnecessary costs in the process of collecting cash from debtors and making payments to creditors. These costs arise from the so called “float”. A debtor issues a cheque or a draft in favour of the firm, 6.4. WORKING CAPITAL MANAGEMENT Working capital management in international context requires managing cash balances, accounts receivable, inventory, and current liabilities when faced with political, foreign exchange, tax, and liquidity constraints. It also encompasses the need to borrow short-term funds to finance current assets from both in-house banks and external local and international commercial banks. The overall goal is to reduce funds tied up in working capital. This should enhance return on assets and equity. It also should improve efficiency ratios and other evaluation of performance parameters. When a foreign affiliate operates in a hyperinflation country, cash working capital problems abound. Parents of such affiliates must, at a minimum, be aware their affiliate may be recapitalized. If they cannot raise sales prices faster than the rate of inflation, they must be prepared to invest follow-up capital, year after year until the inflation rate diminishes. MNCs can finance working capital needs through in-house banks, international banks, and local banks where subsidiaries are located.

International banks finance MNCs and service these accounts through representative offices, correspondent-banking relationships, branch banks, banking subsidiaries, and affiliates.

6.5. GLOSSARY Commercial Paper: Is unsecured debt issued by a limited number of the nation’s largest and strongest companies.

Factoring: Selling receivables to a finance company, which then responsible for collection.

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Line of Credit: A line of credit is an informal, revocable borrowing limit offered by banks.

Operating Cycle: The operating cycle is the time from the acquisition of inventory until cash is collected from product sales.

Revolving Credit Agreement: A revolving credit agreement is an irrevocable borrowing limit requiring a commitment fee on the unused amount.

Working Capital Management: The assets and liabilities required to operate a business on a day-to-day basis. The assets include cash, receivables, and inventories, while the liabilities are generally payables and accruals.

6.6. QUESTIONS Section – A Very short answer question 1. Define working capital management.

2. What is Local currency financing?

3. What is Inter Company Financing?

4. What is Transactions Costs?

5. Give the meaning of Cash Management Section – B Short answer question 1. What are the main objectives of international working capital management?

2. What are the various short-term investments?

3. What are the Short-term Financing Objectives?

4. Give the short note on Euro notes and Euro-Commercial Paper.

5. What is the current assets management? What are its objectives?

Section – C Long answer question 1. How international working capital management is different from working capital management of domestic firms?

2. What are the various short-term investment and financing objectives available for MNCs? 3. Explain the Centralized Cash Management and advantages.

6.7. SUGGESTED READINGS 1. Alan C Shapiro, Multinational Financial Management (2002), Prentice-Hall of India, New Delhi.

2. Prakash G Apte, Global Business Finance, Tata McGraw-Hill Publishing Company Limited, New Delhi.

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3. David K. Eiteman, Arthur I. Stonehill, Michael H Moffett, Multinational Business Finance, Addison Wesley Longman (Singapore) Pte. Ltd, New Delhi.

4. Prakash G Apte, International Financial Management, Tata McGraw-Hill Publishing Company Limited, New Delhi.

5. Ephraim Clark, International Financial Management, Thompson Asia Pte. Ltd, Singapore.

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CHAPTER â&#x20AC;&#x201C; 07 FOREIGN EXCHANGE STRUCTURE 7.0. INTRODUCTION 7.1. FOREIGN EXCHANGE 7.2. EXCHANGE RATES 7.3. FOREIGN EXCHANGE MARKET 7.4. THEORIES AND RATE OF EXCHANGE 7.5. BALANCE OF PAYMENTS 7.6. DEFINITIONS OF FOREIGN EXCHANGE RISK 7.7. FINANCIAL ACCOUNTING AND FOREIGN EXCHANGE 7.8. QUESTIONS 7.9. SUGGESTED READINGS 7.0. INTRODUCTION Most countries have their own currencies, and when people in different countries do business with each other, an exchange of currencies must take place. For example, suppose you're vacationing in London and you walk into a pub and order a pint of ale. No bar attender in Britain is going to let you pay you in dollars you're going to have to get a hold of some British pounds sterling. More generally, you're going to have to get a hold of some foreign exchange.

7.1. FOREIGN EXCHANGE All currencies other than the domestic currency (in our case, all currencies other than the dollar).

The foreign exchange market refers to any and all places where different currencies are traded for one another.

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.

7.2. EXCHANGE RATE The rate which refers to the demand for the supply of a currency is the external value of it. It measures the number of units of one currency which exchange, in the foreign exchange market for one unit of another. E.g.; suppose ÂŁ1 exchange for $2 that is ÂŁ1= $2 just as a commodity is sold and purchase in the market for some price.

Importance of exchange Rates: 1. Exchange rates establish relationships between the different currencies or monetary units of the world.

2. Exchange rates have been instrumental in developing international trade. These have considerably increased the tempo of international investments.

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3. They provide a direct link between domestic prices of commodities and productive factors and their prices in the rest of the world.

4. With the prices at home and abroad at a given level, a low rate of exchange will hamper imports and stimulate exports, and thereby tend to bring about a balance of payment surplus.

Floating Rate of Exchange: Floating rate which is allowed to fluctuate freely according to supply and demand forces. Such float is Free Float if no intervention takes place by the central bank of the country. In the real world some degree of intervention exists which leads to a managed float, such managed floats are either single or joint. Dollar, Sterling and Yen were floating with varying degree of intervention within a band of 2.25% on either and they are singly floats. The European common market countries (Germany, France, Belgium, Netherlands, Luxemburg, Ireland, Demark and Sweden) are under a joint float within a narrow bank called â&#x20AC;&#x153;Snake in the Tunnelâ&#x20AC;?. The new IMF policy is to keep relatively stable exchange rates within a wider band of fluctuations. Indian rupee is kept relatively stable with the help of a basket of Currencies up to July 1991. When the rupee was devalued and LERMs was adopted later. (Limited Exchange Rate Management System).

Fixed vs. Flexible exchange rate: Exchange rate stability has always been the objective of monetary policy of almost all countries.

Except during the period of the Great Depression and World War II, the exchange rates have been almost stable. During post-war II period, the IMF had brought a new phase of exchange rate stability. Most governments have maintained adjustable fixed exchange rate till 1973. But the IMF system failed to provide an adequate solution to three major problems causing exchange instability, viz., (i) providing sufficient reserves to mitigate the short-term fluctuations in the balance of payments while maintaining the fixed exchange rates system; (ii) problems of long-term adjustments in the balance of payments; and (iii) crisis generated by speculative transactions. As a result, the currencies of many countries, especially the reserve currencies were subject to frequent devaluation in the early 1970s. This raised doubts about the continuation of the Brettan Wood System, and also the viability of the fixed exchange rate system. The breakdown of Brettan Wood System generated a debate on whether fixed or flexible exchange rate. Let us briefly describe the main arguments in favour of fixed and flexible exchange rates.

Arguments for Fixed Exchange Rate: The first argument in favour of fixed exchange rate is that it provides stability in the foreign exchange markets and certainty about the future course of exchange rate and it eliminates risk caused by uncertainty. The stability of exchange rate encourages international trade. On the contrary, flexible exchange rate system causes uncertainty and might also often lead to violent fluctuations in the international trade. As a result the foreign trade oriented economies become subject to severe economic

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fluctuations, if import-elasticity is less than export elasticity.

Secondly, fixed exchange rate system creates conditions for smooth flow of international capital simply because it ensures continuity in a certain return on the foreign investment, while in case of flexible exchange rate; capital flows are constrained because of uncertainty about expected rate of return.

Thirdly, fixed rate eliminates the possibility of speculations, where by it removes the dangers of speculative activities in the foreign exchange market. On the contrary, flexible exchange rates encourage speculation. As mentioned earlier in this chapter, there is controversy about the destabilizing effect of speculation. But, if speculators buy a currency when it is strong and sell it when it is weak, speculation will be destabilizing.

Fourthly, the fixed exchange rate system reduces the possibility of competitive depreciation of currencies, as it happened during the 1930s. The possibility has been further strengthened by the IMF rule for the member nations. Also, deviation from the fixed rates is easily adjustable.

Finally, a case is also made in favour of fixed exchange rate of the basis of existence of currency area.

The flexible exchange rate is said to be unsuitable between the nations which constitute currency area, since it leads to chaotic situation and hence hampers trade between them.

Advantages of Basked Currencies: With the existing system of exchange controls in India, a free floating rupee was out of question in the eighties. The rupee is not strong enough to with stand the speculative onslaughts. Our trade would have suffered. Alternatives left to the monitory authorities in India were therefore to link it with $ or L a combination of some major currencies like the SDR. Since both $ and L were having their own problems, the choice has fallen on a basket of currencies but unlike the 16 major currencies in the case of SDR, at that time only 5 major currencies having good trade connections with India in 1975 were chosen in its basket. The SDR valuation would have been unrealistic for India as some of the currencies represented in SDR have no relations with Indiaâ&#x20AC;&#x2122;s trade. The basis of SDR valuation was itself changed to a bag of 5 currencies in 1981. It was felt that it would be advantageous for India to link the rupee to a mix of currencies properly weighted as this would give greater stability and more certainty so that Indiaâ&#x20AC;&#x2122;s trade and investment abroad would not suffer. The import bill and debt servicing burder are heavy for India and it would be necessary to have relative stability in the exchange rate. The fact that moderate depreciation took place in effect as against $ DM etc. would have probably helped our export trade in particular.

Present Exchange Rate System: With the initiation of economic and financial reforms in July 1991, for reaching changes were introduced in the Foreign exchange policy and exchange rate management. FERA was diluted and banks have been allowed greater freedom of lending and their deposits and lending rate have also been freed to a large extent. Foreign exchange release is mostly left to the banks, for many purposes, subject to an upper limit for each purpose. Rupee was made partially convertible first in 1992 followed by full convertibility on trade account in 1993 and thereafter full convertibility on current account inclusive of

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invisible account in 1994. The era of decontrol on Foreign exchange has started with these reforms. We have now a system of exchange rate management adopted by the RBI since 1994 and the FERA was replaced by FEMA in the year 2000.

Exchange Rates in India: The table below gives TT rates of various currencies in terms of rupees. TT means telegraphic transfer which is next best means and quickest method of transferring fund from one currency to another currency. It is next to physical delivery of currency on spot. The rates for TT buying and selling for major currencies in the world are given in terms of rupees for each of the foreign currency units. The margin between buying and selling rate is the profit to the whole seller.

7.3. FOREIGN EXCHANGE MARKETS Foreign Exchange Market is the framework of individuals, Firms, Banks and Brokers who buy and sell foreign currencies. The foreign exchange market for any one country. Example, the France franc, consists of all the locations uch as Paris, London, New York, Zurich, and Frankfurt and so on. The most important foreign exchange market are found in; London, New York, Tokyo, Frankfurt , Amsterdam, Paris , Zurich, Toronto ,Brussels, Milan , Singapore and Hang Kong.

The players of Foreign Exchange Market: The main participants in the market are Companies and individuals, Commercial banks, central banks and Brokers. Companies and individuals need foreign currency for business or travel purposes.

Commercial banks are the source from which companies and individuals obtain their foreign currency.

There are also foreign exchange brokers who bring buyers and sellers and banks together and receives commissions on the deals arranged. The other main players obtaining in the market in the central bank, the main part of whose foreign exchange activities involves the buying and selling of the home currency or foreign currencies with a view to ensuring that the foreign exchange rate moves in line which established targets set for it by the government. There are numerous foreign exchange market centers around the world but dealers in different locations can communicate with one another via the telephone, telex and computers.

Foreign Exchange Instruments: Spot transaction: A spot foreign exchange transaction is the exchange of one currency for another, at the spot (or todayâ&#x20AC;&#x2122;s) exchange rate. Although the exchange rate is agreed at the time of the transaction, market convention dictates that the exchange of funds (settlement) will occur two business days later (the spot date).

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Forward transaction: A forward transaction is identical to a spot transaction, except that the settlement date (and the exchange of currencies) is more than two business days ahead.17 The forward transaction allows each party to lock in a known forward exchange rate today, with the outright exchange of currency amounts occurring at a future date.

Foreign exchange swap transaction: A foreign exchange swap (FX swap) is an agreement to exchange two currencies at the Current spot date and to reverse the transaction at a specified future date. In fact, an FX swap is equivalent to a spot transaction and an offsetting forward transaction rolled into one. Entering into an FX swap is equivalent to borrowing in one currency and lending in another, allowing management of cross-currency cash flows. The FX swap market can be a more efficient way of borrowing and lending currency amounts than using the relevant currency money markets directly. FX swaps carry no currency exposure because the exchange rate on the spot date and at the future settlement date is fixed at the time of the transaction.

Globally, FX swaps continue to be the most heavily traded FX instrument. A significant reason for this is due to market players’ preference to repeatedly transact short term FX swaps rather than transacting one longer maturity swap.

Currency options: A currency option gives the holder the right, but not the obligation, to buy or sell one currency against another at a specified exchange rate, over a specified period. Most Currency options are ‘overthe-counter’, meaning they are written by financial institutions to meet the exact needs of the option buyer.

FXTrends: Currency Exchange Trends: This table displays the change (trend) in currency exchange rates for the top most traded currencies.

Tuesday, Oct 10, 2006 Change Compared to:

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Generally, in our country we make payments for our purchases in coins or notes. When the amount is big we pay through a cheque on some local bank. If we want to remit money to distant places we may issue a cheque or send a bank draft. But, if we have to make payments to a foreigner say, in New York, we shall have to call our banker to change our rupees into dollars, and remit them to New York. This change of rupees into dollars (or any other currency) and vice versa is called Foreign Exchange.

Methods of Foreign Payments: 1. Gold / Silver 2. Bank Drafts: International payments may be made by means of cheque and Bank drafts.

3. Foreign Bills of Exchange: “A bill of exchange is an unconditional order in writing, addressed by one person to another, requesting the person to whom it is addressed to pay a certain sum on demand or on a specified future date “(Inland Bill –Due for the payment is calculated from the date of which it was drawn; Foreign bills –date on which the bill was accepted.) b. Sight Bill which is honored on presentation. c. Short Bill which is payable within 10 days. d. Long Bill which matures with 90 days.

4. Telegraphic Transfers: A sum can be transferred from a bank in one country to a bank in another part of world by cable or telex. It is the quickest method of transmitting the funds.

5. Documentary (or reimbursement) credit:-Transfer bills .i.e. Bill of lading, Letters of Credit.

Foreign Exchange Market: The foreign exchange market is an informal arrangement of the larger commercial banks and a number of FOREX brokers. The banks and brokers are linked together by telephone, Telex and satellite communication network called the SWIFT (Society For World Wide International Financial

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Telecommunications). This counter based communication system, based in the Brussels, Belgium links banks and brokers in just about every financial centers.

The banks and brokers are in almost constant contact with activity in some financial center or the 24 Hrs. a day. Because of the speed of the communications, significant event have vertically instantaneous impacts every where in the world despite the huge distances separating market participants.

This is what makes the foreign exchange market just as efficient as a conventional stock or commodity market housed under a singly roof.

The efficiency of the Spot foreign exchange market is revealed in the extremely narrow spreads between buying and selling prices. These spreads can be smaller than a 10th of the percent of the value of currency exchanged and are therefore about 50th or less of the spread faced on bank notes by international travelers.

Clearing House: A clearing house is an institution at which banks keep funds which can be moved from one bank’s account to another’s to settle inter bank transactions. When foreign exchange is trading against the US Dollar, the clearing house that is used is called CHIPS an acronym for the Clearing House Inter bank Payments Systems (CHIPS). CHIPS is located in new York and as we shall explain below, transfer funds between member bank currencies and also trade directly with each other without involving the dollar – For example Deutschemark, for British pounds or Italian Lire for Swiss Francs. In these situations a European clearing house will be used. However because a substantial volume of transactions is settled in dollars, we describe here how CHIPS works, although we can note that settlement between banks is similar in other financial centers.

Determination of exchange rates / equilibrium rate of foreign exchange: The foreign exchange rate is determined in the free foreign exchange markets by the forces of ‘demand for and supply for foreign money’. To make the demand and supply functions to foreign exchange, like the conventional market demand and supply functions, we define the rate of exchange as the price of one unit of the foreign currency expressed in terms of the Units of the home currency.

The Demand for Foreign Exchange: Generally, the demand for foreign currency arises from the traders who have to make payments for imported goods. If a person wants to invest his capital in foreign countries, he requires the currency of that country. The functional relationship between the quantity of foreign exchange demanded and the rate of foreign exchange is expressed in the demand schedule for foreign exchange {which shows the different rates of foreign exchange}. It is understood from the demand schedule that the relationship,

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between the quantities of the foreign exchange demanded that the rate of foreign exchange is inverse in such a way that a fall in the rates of exchange is followed and inverse in the quantity of the foreign exchange demanded. The main reason for this relationship is that, a higher rate of foreign exchange by rendering imports more expensive reduces the demand for them and consequently, also reduces the amount demanded of foreign exchange which is required to pay for imports. On the other hand, a lower rate of exchange by making the imports cheaper causes the demand for them to rise and consequently increases the demand for foreign exchange needed to pay for higher imports.

Let us assume, that the rate of foreign exchange {price of US dollar expressed in terms of Indian rupees} is R1 and amount of foreign exchanges (US dollar) demanded is Q1. When the rate of foreign exchange falls from R1 to R2, i.e., the rupee price of the US dollar falls, the amount of foreign exchange demanded increases from Q1 to Q2. This happens because, consequent upon the US dollar becoming cheaper in terms of Indian rupees, the dollar price of the American goods remaining unchanged, the prices expressed in terms of Indian currency fall and consequently the demand for the American export foods in India increases, unless the extreme assumption is made that such demand is perfectly price inelastic. The amount demanded of the foreign exchange will decrease when the rate of foreign exchange rise i.e., when the foreign currency becomes costlier in terms of domestic currency.

The demand curve for the foreign exchange is shown in where the rate of foreign exchange and the quantity of foreign exchange demanded have been shown on the Y axis and X axis respectively.

According to the demand curve DD, which is negatively sloping from left to right, it can be seen that the foreign exchange rate elasticity of demand for foreign exchange is less than infinity and greater than zero.

The demand for foreign exchange arising from the imports of commodities and services, has the same foreign exchange rate elasticity, as is the elasticity of demand for imported goods and services with

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respect to their prices expressed in the local currency.

2. The supply of foreign exchange: The need for and supply of foreign currency arises from the exporters who have exported goods and services to foreign countries. The supply schedule or curve of foreign exchange shows the different quantities of foreign exchange, which would be available at different rate of foreign exchange, in the foreign exchange market. The sources of supply of foreign exchange depend largely upon the decisions of foreigners. The total quantity of the different goods and services, which a country can export and, therefore, the quantity of foreign currencies which it can acquire depends upon how many the residents of the foreign currencies are willing to import from a particular country.

3. The Equilibrium Rate of Foreign Exchange: After deriving the demand and supply curves relating to foreign exchange, the equilibrium rate of foreign exchange in the foreign exchange market is determined through the point of intersection between the supply and demand curves of foreign exchange as shown in the following figure. The rate of exchange refers to the rate at which the currency of one country can be converted into the currency of another country. Thus, it indicates the exchange ratio between the currencies of two countries.

The demand for the supply of a foreign exchange, and how these affect the rate of exchange, in this figure the demand for and supply of foreign exchange have been measured along the axis OX, and the rate of exchange along that of OY. Where as DD curve indicates the demand for a foreign currency. SS curve indicates its supply.

Both intersect at P demand and supply being equally represented by OL, the rate of exchange is OR. Demand and supply for foreign currency When supply of foreign exchange rises to OM, its demand remaining constant, the rate of exchange declines to OR and when the demand for foreign exchange rises to OM, its supply remaining constant, the rate goes up to OR. Thus, we conclude that if the demand for a foreign currency increases, its rate of exchange must go up, and if its supply exceeds its demand, the rate must decline.

Functions of The Foreign Exchange Market: The foreign exchange market performs mainly three functions

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1. Transferring the purchasing power 2. Provision of credit for foreign trade and 3. Furnishing facilities for hedging for foreign exchange risks

1. Transferring the purchasing power: The most important function is the transfer of purchasing power from one country to another and from one national currency to another. The purchasing power is transferred through the use of credit instruments. The main credit instrument is used for the transferring the purchasing power is the telegraphic transfer (TT) of the cabled order by one bank (in country A) to its correspondent abroad (in country B) to pay B funds out of its deposit account to its designated account or order. The telegraphic transfer is simply a sort of cheque, which is wired or radioed rather than sent by post. Purchasing power may also be transferred through bank drafts. There is also the commercial bill of exchange or acceptance, through which even today a considerable amount of payments in international trade is made.

A bill of exchange is an order, written by the exporters of goods directing the importer to pay the exporter or the party bank, discount house, or other financial institutions with which the exporter has discounted the bill.

2. Provision of credit for foreign trade: The foreign exchange market also provides credit for foreign trade. Like all the traders, international trade also requires credit. It takes time to move the goods from seller to purchaser and during this period, the transaction must be financed. When the exporter does not need credit for the manufacture of export goods, credit is necessary for the transit of goods. When the special credit facilities of the foreign exchange market are used, the foreign exchange department of a bank or the bill market is used; the foreign exchange department of the bank or the bill market of one country or the other extends the credit facilities to finance the foreign trade. 3. Furnishing facilities for hedging foreign exchange risks

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The foreign exchange market by providing facilities of buying and selling at spot or forward exchange, enables the exporters and importers to hedge their exchange risks arising from change in the foreign exchange rate. The forward market in exchange also enables those banks, which are unlikely to run any considerable exchange position to cover their commitments.

Factors influencing fluctuations in the rate of Exchange: The equilibrium rate of exchange is the normal rate below and above which the market rate of exchange fluctuates. There are a number of influences, which may cause fluctuations in the rate of exchange, either acting singly or in collaboration with others. Fluctuations may due to the combination of the following factors:

I. Market Influences: Market conditions are those influences or factors that affect the demand for and supply of foreign currencies in the short period. They include i). Trade operation These operations include exports and imports i.e., the flow of goods from one country to other. If the exports of a country exceed its imports, it means that the demand for the currency of this country will rise because foreign merchants will buy this currency to settle their debts. Thus, exports increase in the demand for a currency will change the rate and it will make the rate more favourable to the creditor nation. Just the reverse will take place when the imports of the country exceed its exports.

ii). Stock exchange transaction These include investment and speculation in international securities, payment of interest and dividend on loan and investments, and repayment of loans raised by one country to another. They affect the demand for and supply of a currency and hence its rate of exchange.

iii). Banking operations These include the investment of funds made by the bankers of one country in other countries, issue of circular notes, letters of credit, arbitrage peration i.e., buying and selling of foreign currencies with a view of making profit. If drafts are being sold by a bank in India to foreign centre, the demand for that foreign currency will increase and its rate of exchange will go up. The buying of bills of exchange by bankers is of very great importance as it affords them a consignment means of utilizing their surplus funds. Bank rate is a very strong weapon which also influences the rate of exchange. If the bank rate in India has been raised, it will certainly attract funds from other centers. Consequently, the demand currency will rise and the value will go up. Just the reverse will happen when the bank rate falls in India.

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iv). Government financial operations Under this category, are included repatriation payments and loans given by one Government to another during the period of war. Such payments and transfers affect the demand for and supply of foreign exchange.

v). Speculative influence Serious fluctuations are also caused in the rate of exchange by the sale and purchase of foreign currencies by speculators. The speculative activity depends upon the certain factors like rumors of war, inflation, natural calamities, budgetary position etc.

II. CURRENCY INFLUENCE These refer to long period influence, which affect the rate of exchange because they modify the purchasing power of currencies. The depreciation and debasement of a currency affect its rate of exchange. If the currency has been inflated (over issue of currency has taken place) in the country funds will begin to move out i.e., flight of capital will take place; and its rate of exchange in relation to other currencies will tend to be unfavourable. Deflation will undoubtedly raise its rate of exchange.

III. Political Conditions: Satisfactory political conditions constitute another important factor that attracts foreign capital towards a country. A country which enjoys a political stability creates condition favourable for the investment of foreign capital. When the funds are invested into a country, demand for a currency of that country increases as a result of which the rate of that currency becomes more favourable.

7.4. THEORIES OF RATE OF EXCHANGE Every country has a currency different from others. There is no common medium of exchange. It is this feature that distinguishes international trade from domestic. Suppose the imports and exports of a country are equal, the demand for foreign currency and its supply conversely, the supply of home currency and the demand for it will be equal. The exchange will be at par. If the supply of foreign money is greater than the demand it will fall below par and the home currency will appreciate. On the other hand, when the home currency is in great supply, there will be more demand for the foreign currency. This will appreciate in value and rise above par.

Economists have propounded the following four theories in connection with determination of rate of exchange: 1. Mint par theory 2. Purchasing power parity theory 3. Balance of payments or equilibrium theory and

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4. Foreign exchange theory Mint par theory: Mint par indicates the parity of mints or coins. It means that the rate of exchange depends upon the quality of the contents of currencies. It is the exact equivalent of the standard coins of one country expressed in terms of standard coins of another country having the same metallic standards the equivalent being determined by a comparison of the quantity and fineness of the metal contained in standard coins as fixed by law. A nationâ&#x20AC;&#x2122;s currency is said to be fully on the gold standard if the Government: 1. Buys and sells gold in unlimited quantity at an official fixed price.

2. Permits unrestricted gold movements into and out of the country.

In short, an individual who holds domestic currency knows in advance how much gold he can obtain in exchange for it and how much foreign currency this gold will buy when exported to another country. Under these circumstances, the foreign exchange rate between two gold standard countriesâ&#x20AC;&#x2122; currencies will fluctuate within the narrow limits around the fixed mint par. But mint par is meant that the exchange rate is determined on the weight-to-weight bases of the metallic contents of the two currency units, allowance being given to the purity of the metallic content. The mint parity theory of foreign exchange rate is applicable only when the countries are on the same metallic standards. This, thee can be no fixed mint par between gold and silver standard country.

Purchasing power parity theory: This theory was developed after the break down of the gold standard post World War I. The equilibrium rate of foreign exchange between two inconvertible currencies in determined by the ratio between their purchasing powers. Before the first World War, all the major countries of Europe were on the gold standard. The rate of exchange used to be governed by gold points. But after the I World War, all the countries abandoned the gold standard and adopted inconvertible paper currency standards in its place. The rate of foreign exchange tends to be stabilized at a point at which there is equality between the respective purchasing powers of the 2 countries. For eg; say America and England where the goods purchased for 500 $ in America is equal to 100 pounds in England. In such a situation, the purchasing power of 500 US $ is equal to that of 100 English pounds which is another way of saying that US $500 = 100, or US $5=1 pound. If and when the rate of foreign exchange deviates from this nor, economic forces of equilibrium will come into operation and will bring the exchange rate to this norm. The price level in countries remain unchanged but when foreign exchange rate moves to 1=$5.5, it means that the purchasing power of the pound sterling in terms of the American dollars has risen. People owing Pounds will convert them into dollars at this rate of exchange, purchase goods in America for 5$ which in England cost 1 pound sterling and earn half dollar more. This tendency on the part of British people so to convert their pound sterling into dollars will increase, the demand for dollar in England, while the supply of dollar

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in England will decrease because British exports to America will fall consequently the sterling price of dollar will increase until it reaches the purchasing power par, i.e. 1=US $5. On the other hand, of the prices in England rose by 100 percent those on America remaining unaltered, the dollar value of the English currency will be halved and consequently one sterling would be equal to 2.5 $. This is because 2 unite of English currency will purchase the same amount of commodities in England, as did one unit before. If on the other hand, the prices doubled in both the countries, there would be no exchange in the purchasing power parity rate of foreign exchange, this, in brief is the purchasing power parity theory of foreign exchange rate determination.

The change in the purchasing power of currency will be reflected in the exchange rate.

Equilibrium Exchange Rate (ER) =Er X Pd / Pf Where; ER = Equilibrium Exchange Rate Er = Exchange Rate in the Reference period Pd = Domestic Price Index Pf = Foreign currencies price index.

Balance of payments theory: According to this approach, foreign exchange rate is determined by independent factors no related to international price levels, and the quantity of money has asserted by the purchasing power parity theory. According to this theory, an adverse balance of payment, lead to the fall or depreciation of the rate of foreign exchange while a favourable balance of payments, by strengthening the foreign exchange, causes an appreciation of the rate of foreign exchange.

When the balance of payments is adverse, it indicates a situation in which a demand for foreign exchange exceeds its supply at a given rate of exchange consequently, its price in terms of domestic currency must rise i.e., the external value of the domestic currency must depreciate. Conversely, if the balance of payment is favourable it means that there is a greater demand for domestic currency in the foreign exchange market that can be met by the available supply at any given rate of foreign exchange.

Consequently, the price of domestic currency in terms of foreign currency rises i.e., the rate of exchange moves in favour of home currency, a unit of home currency begins to command larger units of the foreign currency than before.

Balance of Payment theory, also known as the Demand and Supply theory. And the general equilibrium theory of exchange rate holds that the foreign exchange rate, under free market conditions is determined by the conditions of demand and supply in the foreign exchange market. According to this theory, the price of a commodity that is , exchange rate is determined just like the price of any commodity is determined by the free play of the force of demand and supply. â&#x20AC;&#x153;When the Balance of Payment is equilibrium, the demand and supply for the currency are equal. But when there is a deficit in the balance of payments, supply of the currency exceeds its demand and causes a fall in the external value of the

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currency. When there is a surplus, demand exceeds supply and causes a rise in the external value of the currency.”

Dealings on the foreign exchange market spot and forward exchange: The term Spot exchange refers to the class of foreign exchange transaction which requires the immediate delivery or exchange currency on the spot. In practice, the settlement takes place with in two days in most markets. The forward transaction is an agreement between two parties, requiring the delivery at the some specified future dates of a specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the ‘Forward Exchange Rate” and the market for forward transaction are known as “Forward Market”.

Forward Exchange Rate: - The rate quoted in terms of price of one country to another.

The forward exchange rate may be at Par, Discount, and Premium.

At Par: - If the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the contract, the forward exchange rate is said to be at Par. At Premium: - The forward rate of currency, say the dollar is said to be at premium with respect to the spot rate when one dollar buys more units of another currency, say rupee in the forward than in the spot market.

At Discount: - The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward.

Futures: While a future contract is similar to a forward contract, there are several difficulties between them.

While a forward contract is tailor –made for the client by his international bank, a future contract has standardized features. The contract size and maturity dates are standardized futures can be traded only on an organized exchange and they are traded competitively. Margins are not required in respect of a forward contract but margins are required of all participants in the future market.

Options: An option is a contract or financial instrument that gives holders the right, but not the obligation, to sell or buy a given quantity of an asset a specified price at a specified future date. An option to buy the underlying assets is known as a call option, and an option to sell the underlying assets is known as a put option. Buying or selling the underlying assets via. The option is known as exercising the option.

The stated price paid (or received) is known as the exercise or strike price .The buyer of an option is known as the long and the seller of an option known as the writer of the option, or the short. The price for the option is known as premium.

With reference to their exercise characteristics, there are two types of options, American and European. A European option can be exercised only at the maturity or expiration date of the contract,

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whereas an American option can be exercised at any time during the contract.

7.5. BALANCE OF PAYMENTS International trade and other international transactions result in a flow of funds between countries.

All transactions relating to the flow of goods, services and funds across national boundaries are recorded in the balance of payments of the countries concerned.

Balance of Payments – Meaning and Definition: Balance of payments (BoPs) is systematic statement that systematically summarizes, for a specified period of time, the monetary transactions of an economy with the rest of the world. Put in simple words, the balance of payments of a country is a systematic record of all transactions between the ‘residents’ of a country and the rest of the world. The balance of payments includes both visible and invisible transactions. It presents a classified record of: i. All receipts on account of goods exported, services rendered and capital received by ‘residents’ and ii. Payments made by then on account of goods imported and services received from the capital transferred to ‘non-residents’ or ‘foreigners’.

Thus the transactions include the exports and imports (by individuals, firms and government agencies) of goods and services, income flows, capital flows and gifts and similar one-sided transfer of payments. A rule of thumb that aids in understanding the BOP is to “follow the cash flow”. Balance of payments for a country is the sum of the Current Account, the Capital Account, and the change in Official Reserves.

Concepts Used in Balance of Payments: Before going into in detail discussion of balance of payments reader has to be familiar with the following concepts: a. Economic Transactions: Economic transactions for the most part between residents and nonresidents, consist of those involving goods, services, and income; those involving financial claims on, and liabilities to the rest of the world; and those (such as gifts), classified as transfers.

A transaction itself is defined as an economic flow that reflects the creation, transformation, exchange, transfer, or extinction of economic value and involves changes in ownership of goods and / or financial assets, the provision of services, or the provision of labor and capital. b. Double Entry System: Double entry system is the basic accounting concept applied in constructing a balance of payments statement. That is every transaction is recorded based on accounting principle. One of these entries is a credit and the other entry is debit. In principle, the sum of all credit entries is identical to the sum of all debit entries, and the net balance of all entries in the statement is zero. Exports decreases in foreign financial assets (or increases in foreign financial liabilities) are recorded as credits,

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while imports increases in foreign financial assets (or decreases in foreign financial liabilities) are recorded as debits. In other words, with regard to assets, whether real or financial, decreases in holdings are recorded as credits, while increases in holdings are recorded as debits. On the other hand, increases in liabilities are recorded as credits, while decreases in liabilities are recorded as debits.

c. Concept of Residence: Concept of residence is very important attribute of an institutional unit in the balance of payments because the identification of transactions between residents and non-residents underpins the system. The concept of residence is based on sectoral transactorâ&#x20AC;&#x2122;s center of economic interest. An institutional unit has a center of economic interest and is a resident unit of a country when from some location, dwelling, place of production, or other premises within the economic territory of country, the unit engages and intends to continue engaging, either indefinitely or over a finite period usually a year, in economic activities and transactions on a significant scale. The one-year period is suggested only as a guideline and not as an inflexible rule.

d. Time of Recording: The IMF Balance of Payments Statistics contains over 100,000 quarterly and annual time series data. When the data are available, the annual entries generally begin in 1967 and quarterly entries begin in 1970. The period for which data are available varies from country to country, but most countriesâ&#x20AC;&#x2122; data extend from the mid-1970s to the present. Data in international investment positions available for selected countries from 1981 onwards.

In balance of payments the principle of accrual accounting governs the time of recording of transactions. Therefore, transactions are recorded when economic value is created, transformed, exchanged, transferred, or extinguished. Claims and liabilities arise when there is a change in ownership.

Put in simple words, balance of payments is usually prepared for a year but may be divided into quarters as well.

BOPs and Accounting Principles: Three main elements of actual process of measuring international economic activity are: 1. Identifying what is/is not an international economic transaction, 2. Understanding how the flow of goods, services, assets, money create debits and credits 3. Understanding the bookkeeping procedures for BOP accounting Each transaction is recorded in accordance with the principles of double entry book keeping, meaning that the amount involved is entered on each of the two sides of the balance-of-payments accounts. For every transaction there must be two entries, one is credit, and the other one is debit.

Consequently, the sums of the two sides of the complete balance-of-payments accounts should always be the same, and in this sense the balance of payments always balances. In practice, the figures rarely balance to the point where they cancel each other out. This is the result of errors or missions in the

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compilation of statements. A separate balancing item is used to offset the credit or debit.

However, there is no book-keeping requirement that the sums of the two sides of a selected number of balance-of-payments accounts should be the same, and it happens that the (im) balances shown by certain combinations of accounts are of considerable interest to analysts and government officials. It is these balances that are often referred to as “surpluses” or “deficits” in the balance of payments.

The following some simple rules of thumb help to the reader to understand the application of accounting principles for BoPs. 1. Any individual or corporate transaction that leads to increase in demand for foreign currency (exchange) is to be recorded as debit, because if is cash outflow, while a transaction which results in increase the supply of foreign currency (exchange) is to be recorded as a credit entry.

2. All transactions, which result an immediate or prospective payment from the rest of the world (ROW) to the country should be recorded as credit entry. On the other hand, the transactions, which result in an actual or prospective payment from the country to the ROW should be recorded as debits.

Balance Of Payments Credit and Debit

Thus balance of payments credits denote a reduction in foreign assets or an increase in foreign liabilities, while debits denote an increase in foreign assets or a reduction of foreign liabilities. The same is summarized in Table- 3.

Valuation of Goods and Services Just knowing the accounting principles in balance of payments is not enough for arriving actual balance of payments of different countries, it is necessary to know the basis for valuing the goods and services and their recording time in accounts.

Use of common valuation base for valuation of goods and services is very important for meaningful comparison of balance of payments data between countries that are exporting and importing.

At the same time comparison of balance of payment of data among member countries of IMF is also

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possible only when the goods and services are valued on the basis on common price. The IMF recommends the use of “Market prices” as base, because this being the price paid by or accepted to pay “willing buyer” to a “willing seller”, where the seller and buyer are independent parties and buying and selling transactions are governed only by commercial considerations. Following the principle may not be possible in all the transactions. In other words, there are some cases or transactions, which are necessary to use some other base for valuing goods and services. There are two choices of valuation basis available generally for export and import of goods and services, they are: one F.O.B (free on board) and the other C.I.F (cost insurance fright). IMF recommends the F.O.B for valuation of goods and services, because the C.I.F base includes value of transportation and insurance in the value of the goods.

In India’s balance of payments statistics, exports are valued on F.O.B basis, while imports are valued at C.I.F basis (see Table 2.7). Another problem of valuation arises when foreign currency is translated into domestic currency. It would be meaningful when the translation takes place on the basis of exchange rate prevailing at the time of translation But in practice, transactions that occurred in a particular month are translated on the basis of average exchange rate for the month.

Valuation Time of Exports and Imports of Goods and Services: Since the balance of payment statistics are prepared on quarterly basis and they translated into domestic currency on monthly average foreign exchange rate base, the timing of recording time is very important. Here timing means recording one transaction in two different countries records should be the th

same time. For example India’s exported software to US for Rs.500 crores on 28 October 22, 2006, then the transaction should be recorded by giving the date 28

th

October, 2006, in both (India and US)

countries’ records, and not 28th October, 2006 in India’s records and 1st or some other date in the US records. Put in simple words, the two side of transaction should be recorded in the same time period. But there are various principles have been evolved for deciding the time. For example, exports are recorded when they are cleared by customs, and imports are recorded when the payment is made.

Components of the Balance of Payments: Balance of payments statistics must be arranged within a coherent structure to facilitate their utilization and adaptation for multiple purposes (policy formation, analytical studies, projections, bilateral comparisons of particular components or total transactions, regional and global aggregations, etc.). The IMF requires member countries (all 197 member countries) to provide information on their BOP statistics in accordance with the provisions of Article 8 Paragraph 5 of the IMF Agreement. The basic principles are given in the Balance of Payments Manual, fifth edition (BPM5) issued by the IMF in the year 1993. The BPM5 establishes the standard international rules for the compilation of BOP statistics and provides guidelines on the reporting format to the IMF, which was decided on the objectives of large number of

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users after comprehensive discussions and feedbacks of member countries. The balance of payment is a collection of accounts conventionally grouped into three main categories. In other words, within the balance of payments there are three separate categories under which different transactions are categorized. They are: 1. The Current Account: It records a nation's total exports of goods, services and transfers, and its total imports of them 2. The Capital Account: It records all public and private investment and lending activities.

3. The Official Reserve Account: It measures the changes in holdings of gold and foreign currencies (reserve assets) by official monetary institutions.

The difference in above 1 and 2 is termed as ‘basic balance’. The RBI refers to it as overall balance. The IMF introduced the notion of overall balance in, which all transactions other than those involving reserve assets were to be “above the line”. However, depending on the context and purpose for which the balance is used, several concepts of balance have developed. They are trade balance (BOT), balance of invisibles (BOIs), current account balance, balance on current account and long-term capital.

The following discussion provides detailed discussion of all the three components of balance of payments.

A. The Current Account: As we have read in the above that current account records all flows of goods, services, and transfers. The structure of current account in India’s balance of payments is depicted in Table – 2.2.

Components of Current Account: The current account is subdivided into two components (1) balance of trade (BoT), and (2) balance of invisibles (BOIs).

1. Balance of Trade (BoT) Balance of payments refers the difference between merchandise exports and merchandise imports of a country. BOT is also known as "general merchandise", which covers transactions of movable goods with changes of ownership between residents and nonresidents. So, balance of trade deals with the export and import of merchandise, except ships, airline stores, and so on.

Purchased by non-resident transport operators in the given country and similar goods purchased overseas by that country’s operators, purchases of foreign travelers, purchases by domestic missions.

The data of exports and imports are obtained from trade statistics and reports on payments/receipts submitted by individuals and enterprises.

The valuation for exports should be in the form of F.O.B (free on board) basis and imports are valued on the basis of C.I.F (cost, insurance and fright). Exports are credit entries. The data for these

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items are obtained from the various forms of exporters, which would be filled by exporter and submitted to designate authorities. While imports are debit entries. The excess of exports over imports denotes favorable (surplus) balance of trade, while the excess of imports over exports denotes adverse (deficit) balance of trade. The balance of the current account tells us if a country has a deficit or a surplus. If there is a deficit, does that mean the economy is weak? Does a surplus automatically mean that the economy is strong? Not necessarily. But to understand the significance of this part of the BOP, we should start by looking at the components of the current account: goods, services, and income and current transfers.

A. Goods - These are movable and physical in nature and in order for a transaction to be recorded under "goods", a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out).

B. Services â&#x20AC;&#x201C; Service trade is export / import of services; common services are financial services provided by banks to foreign investors, construction services and tourism services. These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is recorded like an import (a debit), and if money is received it is recorded like an export (credit).

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C. Current Transfers - Financial settlements associated with change in ownership of real resources or financial items. Any transfer between countries, which is one-way, workers' remittances, donations, a gift or a grant, official assistance and pensions are termed a current transfer. Current transfers are unilateral transfers with nothing received in return. Due to their nature, current transfers are not considered real resources that affect economic production.

D. Income - Predominately current income associated with investments, which were made in previous periods. Additionally the wages & salaries paid to non-resident workers. In other words, income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.

2. Balance of Invisibles (BoI) These transactions result from an intangible action such as transportation, business services, tourism, and royalties on patents or trade marks held abroad, insurance, banking, and unilateral services.

All the cash receipts received by the resident from non-resident are credited under invisibles. The receipts include income received for the services provided by residents to non-residents, income (interest, dividend) MBA- H4030 International Business Finance earned by residents on their foreign financial investments, income earned by the residents by way of giving permission to use patents, and copyrights that are owned by them and offset entries to the cash and gifts received in-kind by residents from nonresidents. On the other hand debits of invisible items consist of same items when the resident pays to the non-resident. Put in simple debit items consists of the same with the roles of residents and nonresidents reversed.

The sum of the net balance between the credit and debit entries under the both heads Merchandise, and invisibles is Current Account Balance (CAB). Symbolically: CAB = BOT +BOI It is surplus when the credits are higher than the debits, and it is deficit when the credits are less than debits.

Use of Current Account: Theoretically, the balance should be zero, but in the real world this is improbable. The current account may have a deficit or a surplus balance, that indicates about the state of the economy, both on its own and in comparison to other world markets.

A countryâ&#x20AC;&#x2122;s current accounts credit balance (surplus) indicates that the country (economy) is a net creditor to the rest of the countries with which it has dealt. It also shows that how much a country is saving as opposed to investing. It indicates that the country is providing an abundance of resources to other economies, and is owed money in return. By providing these resources abroad, a country with a current account balance surplus gives receiving economies the chance to increase their productivity while

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running a deficit. This is referred to as financing a deficit.

On the other hand a country’s current account debit (deficit) balance reflects an economy that is a net debtor to the rest of the world. It is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements. For example, let us say an economy decides that it needs to invest for the future (to receive investment income in the long run), so instead of saving, it sends the money abroad into an investment project. This would be marked as a debit in the financial account of the balance of payments at that period of time, but when future returns are made, they would be entered as investment income (a credit) in the current account under the income section.

A current account deficit is usually accompanied by depletion in foreign exchange assets because those reserves would be used for investment abroad. The deficit could also signify increased foreign investment in the local market, in which case the local economy is liable to pay the foreign economy investment income in the future. It is important to understand from where a deficit or a surplus is stemming because sometimes looking at the current account, as a whole could be misleading.

B. The Capital Account: Capital account records public and private investment, and lending activities. It is the net change in foreign ownership of domestic assets. If foreign ownership of domestic assets has increased more quickly than domestic ownership of foreign assets in a given year, then the domestic country has a capital account surplus. On the other hand, if domestic ownership of foreign assets has increased more quickly than foreign ownership of domestic assets in a given year, then the domestic country has a capital account deficit. It is known as “financial account”. IMF manual lists out a large number of items under the capital account. But India, and many other countries, has merged the accounting classification to fit into its own institutional structure and analytical needs. Until the end of the 1980s, key sectors listed out under the capital account were: (i) private capital, (ii) banking capital, and (iii) official capital.

Private capital was sub-divided into (i) long-term and (ii) short-term, with loans of original maturity of one year or less constituting the relevant dividing line. Long-term private capital, as published in the regular BOP data, covered foreign investments (both direct and portfolio), long-term loans, foreign currency deposits (FCNR and NRE) and an estimated portion of the unclassified receipts allocated to capital account. Banking capital essentially covered movements in the external financial assets and liabilities of commercial and cooperative banks authorized to deal in foreign exchange. Official capital transactions, other than those with the IMF and movements in RBI’s holdings of foreign currency assets and monetary gold (SDRs are held by the government), were classified into (i) loans, (ii) amortization, and (iii) miscellaneous receipts and payments. The structure of capital account in India’s balance of payments is shown in Table 2.3.

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Components of Capital Account: From 1990-91 onwards, the classification adopted is as follows: i. Foreign Investment – Foreign investment is bifurcated into Foreign Direct Investment (FDI) and portfolio investment. Direct investment is the act of purchasing an asset and at the same time acquiring control on it. The FDI in India could be in the form of inflow of investment (credit) and outflow in the form of disinvestments (debit) or abroad in the reverse manner. Portfolio investment is the acquisition of an asset, without control over it. Portfolio investment comes in the form of Foreign Institutional Investors (FIIs), offshore funds and Global Depository Receipts (GDRs) and American Depository Receipts (ADRs).

Acquisition of shares (acquisition of shares of Indian companies by nonresidents under section 5 of FEMA, 1999) has been included as part of foreign direct investment since January 1996. ii. Loans – Loans are further classified into external assistance, medium and long-term commercial borrowings and short-term borrowings, with loans of original maturity of one-year or less constituting the relevant dividing line. The principal repayment of the defense debt to the General Currency Area (GCA) is shown under the debit to loans (external commercial borrowing to India) for the general currency area since 1990-91. iii. Banking Capital – Banking capital comprises external assets and liabilities of commercial and government banks authorized to deal in foreign exchange, and movement in balance of foreign central banks and international institutions like, World Bank, IDA, ADB and IFC maintained with RBI. Nonresident (NRI) deposits are an important component of banking capital. iv. Rupee Debt Service – Rupee debt service contains interest payment on, and principal re-payment of debt for the erstwhile rupee payments area (RPA). This is done based on the recommendation of highlevel committee on balance of payments. v. Other Capital – Other capital is a residual item and broadly includes delayed exports receipts, funds raised and held abroad by Indian corporate, India’s subscriptions to international institutions and quota payments to IMF. Delayed export receipts essentially arises from the MBA- H4030 International Business Finance leads and lags between the physical shipment of goods recorded by the customs and receipt of funds through banking channel. It also includes rupee value of gold acquisition by the RBI (monetization of gold). vi. Movement in Reserves – Movement in reserves comprises changes in the foreign currency assets held by the RBI and SDR balances held by the government of India. These are recorded after excluding changes on account of valuation. Valuation changes arise because foreign currency assets are expressed in terms US dollar and they include the effect of appreciation/depreciation of non-US

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currencies (such as Euro, Sterling, Yen and others) held in reserves. Furthermore, this item does not include reserve position with IMF.

The above discussion details that capital account transactions of financial assets and liabilities between residents and nonresidents, and comprises the sub-components: direct investment, portfolio investment, financial derivatives, and other investment.

As per the earlier classification, institutional character of the Indian creditor/debtor formed the dividing line for capital account transaction, whereas now it is the functional nature of the capital transaction that dominates the classification.

C. Errors and Omissions Account As you have read in BOP and accounting principles that there are number and variety of transactions that occur in a period for which the balance of accounts is prepared and all these

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transactions are recorded as per double entry accounting system. In principle, therefore, the net sum of all credit and debit entries should equal. In practice, however, this does not happen since errors and omissions occur in compiling the individual components of the balance of payments. The net effect of these errors and omissions (including differences in coverage, timing and valuation), are entered as unrecorded transactions. So, errors and omissions account is used to account for statistical errors and / or untraceable monies within a country. In practice, therefore, the unrecorded transactions, which pertain to the current, capital transfer and financial accounts, serve to ensure that the overall balance of payments actually balances. Table - 2.4 details of the errors and omissions, overall balance and monetary movement.

D. Overall Balance Overall balance is equal to the sum of total current account, capital account, errors & omissions.

E. Monetary Movements The last element of the balance of payments is the official reserves account. A countryâ&#x20AC;&#x2122;s official reserve consists of gold and foreign exchange (reserve assets) by official monetary institutions, special drawing rights (SDRs) issued by the International Monetary Fund (IMF), and allocated from time to time to member countries. It can be used for settling international payments between monetary authorities of the member countries, but within certain limitations. An allocation is a credit, where as retirement is a debit.

Table-4 Errors and Omissions, Overall Balance, and Monetary Movement

The foreign exchange reserves are held in the form of gold, foreign bank notes, demand deposits with foreign banks and other claims on foreign countries, which can readily be converted into foreign bank

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demand deposits. A change in official reserve account measures a country’s surplus or deficit on its current account and capital account transactions by netting reserve liabilities from reserve assets.

Balance Payments Identity: It is the sum of the Current Account plus the Capital Account plus Change in Official Reserve Account (see Table-2.5). Table 2.6 provides India’s components of balance of payments from 1950 to 2006. BOPs = Current Account + Capital Account + Change in Official Reserve Account.

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India’s Balance of Payments on Current Account: Before analyzing India’s balance of payments position over different plan period and there is a need to have knowledge on analyzing the Current Account. Exports imply demand for a local product while imports point to a need for supplies to meet local production requirements. As export is a credit to a local economy while an import is a debit, an import means that the local economy is liable to pay a foreign economy. Therefore a deficit between exports and imports otherwise known as a balance of trade deficit (more imports than exports) - could mean that the country is importing more in order to increase its productivity and eventually churn out more exports. This in turn could ultimately finance and alleviate the deficit.

A deficit could also stem from a rise in investments from abroad and increased obligations by the local economy to pay investment income (a debit under income in the current account). Investments from abroad usually have a positive effect on the local economy because, if used wisely, they provide for increased market value and production for that economy in the future. This can allow the local economy eventually to increase exports and, again, reverse its deficit.

So, a deficit is not necessarily a bad thing for an economy, especially for an economy in the developing stages or under reform: an economy sometimes has to spend money to make money. To run a deficit intentionally, however, an economy must be prepared to finance this deficit through a combination of means that will help reduce external liabilities and increase credits from abroad.

For example, a current account deficit that is financed by short-term portfolio investment or borrowing is likely more risky. This is because a sudden failure in an emerging capital market or an unexpected suspension of foreign government assistance, perhaps due to political tensions, will result in an immediate cessation of credit in the current account.

As we have read in the above that the current account shows whether a country has favorable balance or deficit balance of payments in any given year.

For example, the surplus or deficit of the current account are reflected in the capital account, through the changes of in the foreign exchange reserves of country, which are an index of the current strength or weakness of a country’s international payments position, are also included in the capital account.

The following discussion details India’s balance of payments on current account, over five year planning periods (see Table – 2.7):

The First Plan Period: India had been experiencing persistent trade deficit, but she had a surplus in net invisibles, accordingly India’s adverse balance of payments during the First plan was only Rs. 42 crores. However, the overall picture of India’s balance of payments position was quite satisfactory.

The Second Plan Period: The prime feature of the Second Plan period was the highest (Rs.2, 339 crores) trade deficit in

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the balance of payment. Net invisibles in this period was Recorded at Rs.614 crores, and covering a part of trade deficit. Balance of payments in this period recorded unfavorable, at Rs.1, 725 crores. The unfavorable balance of payment in the Second Plan was due to heavy imports of capital goods to develop heavy and basic industries, the failure of agricultural production to raise to meet the growing demand for food and raw materials from a rapidly growing population and expanding industry, the inability of the economy to increase exports, and the necessity of making minimum ‘maintenance imports’ for a developing economy. This led to foreign exchange reserves sharply declined and the country was left with no choice to think of ways and means to restrict imports and exports.

The Third Plan and Annual Plans: Third plan period resembles the features of the Second plan with Rs.1, 951 crores unfavorable balance of payments. But the reasons for this state of affaire were different from the Second Plan.

Unfavorable balance of payments in this period was primarily because of expanding imports under the impact of defense and development and to overcome domestic shortages (for example imports of food grains) and sluggish exports and failed to match imports. Loans from foreign countries, PL480 and PL665 funds, and loans from the World Bank and withdrawals from IMF financed the current account deficit. In spite of all these there was some depletion of foreign exchange reserves of the country.

The higher unfavorable balance of payment that started in the beginning of the Second Plan continued through out the Plan and also continued persistently during the Third and Annual Plans. During this period, huge amount was used to pay interest on the loans contracted earlier. This has reduced the invisibles balance. Consequently, balance of payment deficit was negligible.

The Fourth Plan Period: In this Plan period India’s current account balance was recorded favorable at Rs.100 cores, it was due to the objectives of the Plan. The objectives of the Plan are self-reliance – i.e., import substitution of certain critical commodities (that are key importance for the Indian economy), export promotion, so as to try to match raising import bill. Government had succeeded in finding substitutes for imports and succeeded in export promotion. The trade deficit in this period has come down from Rs. – 2,067 crores in Annual Plans to Rs. – 1,564 cores by the end of Fourth Plan period. The net current account balance was favorable for the first time in India.

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The Fifth Plan Period: In the Fifth Plan period India’s trade deficit had increased from Rs. – 3,179 crores to Rs. – 3,374 crores by the end of Fifth Plan period. It was due persistent increase in imports and inadequate increases in exports due to relative decline in export prices were made the revival of deficit trade balance. Sharp increase in invisible is another outstanding feature of Fifth Plan period. The prime factors responsible for this increase are stringent measures taken against smuggling and illegal payment of transactions, relative stability in the external value of rupee at a time when major international currencies were experiencing sizable fluctuations, increase in earnings from tourists, the growth earnings from technical, consultancy and contracting services, and increase in the number of Indian nationals going abroad for employment and larger remittances nest by them to India. Net invisibles were more than the trade balance deficit, thus

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India’s current account balance was favorable at Rs. 3,082 crores, which was comfortable for the first time in planning period started.

The Six-Plan Period: There has been a sea change in India’s current account balance since 1979-80, as against favorable balance experienced by the economy the whole of the Fifth Plan; India started experiencing unfavorably balance of payments from 1979-1980 onwards. In other words, trade deficit widen from 197879 onwards. In this period the trade deficit was recorded at Rs.3, 374 crores, it was due to terrific growth of imports and very low growth rate of exports. This trade deficit was completely eaten the net invisibles and left current account deficit. For meeting this deficit India had taken external assistance, withdrawals of SDR, and borrowing from IMF under the extended facility arrangement. Apart from these, India used a part of its accumulated foreign exchange reserves to meet its balance of payments.

The Seventh Plan Period: During this period the total trade deficit increased to Rs. 54,204 crores. The net invisibles recorded a positive balance at Rs.16, 157 crores. After adjusting the positive balance of net invisibles, the current account balance was registered at Rs. – 41, 047 crores, which was the cause for serious concern, it was due to the larger imports. The increase in imports was due to import liberalization, promotion of industrial development, and the relative steep depreciation of the rupee vis-avis other currencies. The ultimate solution has to be found in controlling imports to the unavoidable minimum and promoting exports to the maximum. Professor Sukhmoy Chakravarty in his work “Development Planning – the Indian Experience (1987)”, questioning the policy of liberal imports wrote: “In my judgment, India’s balance of payments is likely to come under pressure unless we carry out a policy of import substitution in certain crucial sectors. These sectors include energy, edible oil and nitrogenous fertilizers. In all these sectors, except fertilizers, India is getting increasingly dependent on imports resulting in a volatile balance of payments situation”.

In the year 1990-91 net invisible recorded a negative balance of Rs.433 crores, which was the first time during last 40 years. It was largely the consequence of a net outflow of investment income of the order of Rs.6, 732 crores in 1990-91 as against Rs.4, 875 crores in 1989-90- as increase by 38 per cent.

Thus, the cushion available through positive net invisibles to partly neutralize the trade deficit was removed.

The Eighth Plan Period: During 1992-03 to 1996-97 the trade deficit had continuously increased except 1992-03, and is was three fold increase from the year 1990-91. The total trade deficit for the Plan period was recorded at Rs.1, 49,004 crores. Net invisibles also increased from a positive balance Rs. 4,259 in the year 1991-92

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to a positive balance of Rs.86, 090 crores by the end of the Plan period. It was good support for India.

Despite this, the current account balance was recorded a negative balance in all the years and the total deficit was recorded at Rs. 62,914 crores.

The Ninth Plan Period: In this planning period the highest trade deficit was recorded in the year 1999-2000 with Rs.77, 359 crores. Net invisibles had increased continuously in all the years of the plan except 2001-02, and the total net invisibles recorded at Rs. 2,52,995 crores. However, Indiaâ&#x20AC;&#x2122;s current account balance was registered negatively at Rs. 53,175 crores. On an overall the current account deficit was high in the year 1997-98 but the deficit had comedown to Rs.16, 426 crores, it was due to heavy receipts on account of invisibles amounting to Rs.71, 381 crores, not only wiped of trade deficit, they also created a surplus balance in current account with Rs.16, 426 crores.

The Tenth Plan Period: During the first two (2002-03, and 2003-04) years of the Tenth Plan, the current account balance was recorded a positive balance of Rs. 30,660 crores and Rs.63, 983 crores respectively. It was due to heavy surplus on invisibles. Indiaâ&#x20AC;&#x2122;s current account balance over the 2001-02 to 2003-04 year showed a favorable balance of payments. However, in the year 2004-05, there was a huge trade deficit (provisional) of Rs.1, 64,542 crores on account of unexpected increase in imports, although there huge jump in our exports. Net invisibles shown as positive balance of Rs.1, 39,756 crores, but it is just enough to cove 85 per cent of trade deficit. Consequently, a current account deficit of Rs.24, 786 crores was recorded, which is an unhealthy development. It may further worsen if India follows reckless policy of import liberalization.

Committee on Balance of Payments: Dr. C. Rangarajan, former Governor, Reserve Bank of India who headed the high level Committee on balance of payments submitted its report on June 4, 1993. The Committee made the following findings and recommendations for correcting balance of payments: 1. The Committee stressed the fact that a realistic exchange rate and a gradual relaxation of restrictions on current account transactions have to go hand in hand.

2. In the medium-term care has to be taken to ensure that there is no capital flight through liberalized windows of transactions under invisibles. At the same time there is no escape from a very close control overall capital transactions so that future liabilities are kept under control.

3. The Committed suggested that Current account deficit of 1.6 per cent of GDP should be treated as ceiling rather than as target.

4. The Committee had given number of recommendations regarding to foreign borrowings, foreign investment, and external debt management.

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The following are the very important recommendations among them: a) Government must exercise caution against extending concessions of facilities to foreign investors, which are more favorable than what are offered to domestic investors and also against enhancing external debt to supplement equity. b) A deliberate policy of prioritizing the use to which external debt is to be put should be pursued and no approval should be accorded for any commercial loan with a maturity of less than five years for the present. c) Efforts should be made to replace debt flows with equity flows. However, foreign direct investment would contain both debt and equity, and the system of approvals is applicable to all external debt. The approval of debt linked to equity should be limited to the ratio of 1:2. d) On the question of encouraging foreign investment, the Committee recommended that a national law should be seriously considered to codify the existing policy and practices relating to dividend repatriation, disinvestments, non-discrimination subject to conditions, employment of foreign nationals, non-expropriation and sanction as also servicing of external and commercial borrowing.

e) Recourse to external debt for balance of payments support would have to be discouraged unless it is on concessional terms or with very long maturity.

5. The Committee recommended that no sovereign guarantee should be extended to private sector since it will give rise to issues of adequate control over management, performance, and discrimination between domestic and foreign companies.

6. The minimum foreign exchange reserves target should be fixed in such a way that the reserves are generally in a position to accommodate imports of three months. The Committee was timely warning to manage our external debt and thus salvage our economy.

7.6. FOREIGN EXCHANGE RISK Foreign exchange risk concerns risks created by changes in foreign currency levels. An asset, liability or profit or cash flow stream, whether certain or not, is said to be exposed to exchange risk when a currency movement would change, for better or worse, its parent, or home, currency value. Exposure arises because currency movements may alter home currency values.

Forms of currency risks 1. Transaction exposure 2. Translation exposure.

3. Economic exposure.

1. Transaction exposure It arises because a payable or receivable is denominated in a foreign currency. The transaction

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exposure arises because the cost or proceeds (in home currency) of settlement of a future payment or receipt denominated in a currency other than the home currency may vary due to changes in exchange rate. Clearly transaction exposure is a cash flow exposure. It may be associated with trading flows (trade Drs and Crs) dividend flows or capital flows.

2. Translation exposure Translation exposure (sometimes also called accounting exposure) arises on the consolidation of foreign currency denominated assets, liabilities and profits in the process of preparing accounts. There are four basic translation methods:

a) The current/non-current method: This approach uses the traditional accounting distinction between current and long term items and translates the former at the closing rate and the latter at the historical rate. b) The all-current (closing rate) method: This method merely translates all foreign currency denominated items at the closing rate of exchange. Accounting exposure is given simple by net assets or shareholderâ&#x20AC;&#x2122;s funds (sometimes called equity). This method has become increasingly popular over time and is now the major world wide method of translating foreign subsidiaryâ&#x20AC;&#x2122;s balances sheet. c) The monitory/non-monitory methods: The monitory items are assets, liabilities or capital the amounts of which are fixed by contract in terms of the number of currency units regardless of changes in the value of money. d) The temporal method: The temporal method of translation uses the closing rate method for all items stated or replaced cost, realized values. Market value or expected future value, and uses the historical cost rate for all items stated at historical cost.

3. Economic Exposure Economic exposure arises because the present value of a stream of the expected future operating cash flow demonstrate in the home currency or in a foreign currency may very due to changed exchanged rates. Transaction and exposure are both cash flow exposure. Transaction exposure is a comparatively straight forward concept but transaction and economic exposure are more complex.

Economic exposure involves us in a analysis the effects of changing exchange rates on the following items.

1. Export sales, when margins and cash flow should change because devaluation should make exports more comparative 2. Domestic sales, when margins and cash flow should alter substantially in the import competitive sector 3. Pure domestic sales, where margins and cash flow should change in response to deflationary

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measures which frequently accompany devaluations 4. Cost of imported inputs which should rise in response to the devaluations.

5. Cost of domestic inputs, which may vary with exchange rate changes

7.7. FOREIGN EXCHANGE AND FINANCIAL ACCOUNTING The accounting professions in the USA, Britain and in many other advanced countries now have most identical rules for accounting for foreign currencies in publishing accounts. Generally speaking, translation of foreign currency items uses the current rate method.

Transaction gains, whether realized or not, are accounted for through the profit and loss account.

But there is a major exception and this relates to a foreign currency denominated borrowing where a transaction profit or loss whether realized or not, arises from taking on a foreign currency borrowing in a situation in which the borrowing can be designated as a hedge for a net investment denominated in foreign currency, then the gain or loss on the borrowing, if it is less than the net investment hedged, would be accounted for by in reserves rather than through the income statement. If this kind of transaction gain respectively on the net investment hedged, then the excess gain or loss is to be reported in the profit and loss account.

Non- transaction gain and losses due to be dealt with by reserve accounting direct to the balance sheet rather than through the profit and loss account.

According to US accounting rules, translations of foreign currency denominated profit and loss account are to be made at the average exchange rate during the accounting period.

7.8. QUESTIONS Section - A Very short answer questions 1. What is foreign exchange?

2. What is BOP? 3. Give the meaning of exchange rate.

4. What do you mean by foreign exchange market?

5. Define the foreign exchange risk.

Section â&#x20AC;&#x201C; B Short answer questions 1. What are the components of BOPs? 2. Discuss the valuation basis for goods and services?

3. What are the components of current account?

4. Explain the use of studying current account balance.

5. What is the significance of BOP data?

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Section – C Long answer questions 1. Discuss the environment of international financial management.

2. What is BOP? Briefly discuss the components of BOPs. 3. BOPs transactions are recorded based on accounting principles. Discuss.

4. What is current account? Discuss in detail the components of current account.

5. What is capital account? What are its components? Discuss.

6. Discuss the structure of overall balance of payments 7. Discuss the India’s balance of payment position over the planning periods.

8. List out the recommendations given by Dr.Rangarajan Committee for correcting BOP. 9. What is current account deficit? How is it managed? Discuss 10. List out the ways used by India in managing current account deficit.

7.9. SUGGESTED READINGS 1. Apte, P.G, “International Financial Management”, Tata McGraw Hill Company, New Delhi.

2. Buckley, Adrian, “Multinational Finance”, Prentice Hall of India, New Delhi.

3. Eitman, D.K, and A.I Stenehilf, “Multinational Business Cash Finance”, Addison Wesley, New York.

4. Henning, C.N, W. Piggott and W.H Scott, “International Financial Management”, McGraw Hill Intel Edition.

5. Levi, Maurice D, “International Financial Management”, McGraw Hill Intel Edition.

6. Five-Year Plans, Planning Commission.

7. Reserve Bank of India, “Balance of Payments Compilation Manual”, RBI, Bombay.

8. Handbook of Statistics on Indian Economy (2004-05), RBI. 9. India’s Balance of Payments, RBI. 10. Economic Survey, Ministry of Finance, Govt. of India 11. Report of the Committee Trade Policies, Government of India

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CHAPTER – 8 HEDGING STRUCTURE 8.0. INTRODUCTION 8.1. PRINCIPALS OF EXPOSURE MANAGEMENT 8.2. INTERNAL TECHNIQUES OF EXPOSURE MANAGEMENT 8.3. EXTERNAL TECHNIQUES OF EXPOSURE MANAGEMENT 8.4. QUESTIONS 8.5. SUGGESTED READINGS

8.0. INTRODUCTION Transaction gains, whether realized or not, are accounted for through the profit and loss account.

But there is a major exception and this relates to a foreign currency denominated borrowing where a transaction profit or loss whether realized or not, arises from taking on a foreign currency borrowing in a situation in which the borrowing can be designated as a hedge for a net investment denominated in foreign currency, then the gain or loss on the borrowing, if it is less than the net investment hedged, would be accounted for by in reserves rather than through the income statement. If this kind of transaction gain respectively on the net investment hedged, then the excess gain or loss is to be reported in the profit and loss account.

Non- transaction gain and losses due to be dealt with by reserve accounting direct to the balance sheet rather than through the profit and loss account.

According to US accounting rules, translations of foreign currency denominated profit and loss account are to be made at the average exchange rate during the accounting period.

The British standard allows the use of either the current rate or the average rate for this purpose.

It is fair to say that opinion in Britain is moving towards the average exchange rate method.

8.1. PRINCIPLES OF EXPOSURE MANAGEMENT Hedging exposures, sometimes called risk management or exposure management, is widely resorted to, by finance directors, corporate treasurers and portfolio managers. The practice of covering exposure is designed to reduce the volatility of the firms’ profits and/or cash generation and it presumably fallows that this will reduce the volatility of the values of the firm.

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THE GOAL OF RISK MANAGEMENT According to the theories of exchange rate movements show that the four way equivalence of foreign exchange exposure and how will reduce the risks on the different forms of risks i.e. Transaction, Translation and Economic exposures. According to PPP Movements in exchange rate offset price level changes. If PPP were to hold immutably and with no time lag, there world, so the argument goes, because no such thing as exposure rate risk and consequently no need to hedge. If the annual rate of inflation in Britain is 10% higher than that in US, the pound will depreciate against the USD by an appropriate % rate. As a result, then is no relative price risk.

According to Capital Asset Pricing Model (CAPM), well diversified international investor should not be willing to pay a premium for corporate hedging activities which they, themselves, can readily replicate by adjusting their own portfolios. Hedging to reduce overall variability of cash flow and profits may be important to managers, compensated accordingly to short-term results, but it is irrelevant to diversified shareholders. The ups and downs of individual investments are compensated by holding a well diversified portfolio.

CAPM suggests that what matters in share pricing is systematic risk. If exchange risk and interest risk are considered to be unsystematic. Then the effect can be diversified anyway by holding a balanced portfolio. On the other hand, if they are systematic and if forward and interest rate instruments are priced according to CAPM, then all that the firm does by entering into hedging contracts is to move along the Security Market Line (SML).

Creditors may be concerned with total variability of cash flows where default is possible, gains and losses that the firm experiences due to random currency fluctuations may influence valuation through the effect on debt capacity. Where total variability is important, hedging in the foreign exchange market may add to the firmâ&#x20AC;&#x2122;s debt capacity.

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Modigliani and Miller (MM) can also array against hedging. MM argue in respect of gearing, that the investor can manufacture home-made leverage which achieves the same result as corporate gearing.

The same kind of argument apprise in respect of individual hedging vs. Corporate hedging. In other words, home made hedging, world made corporate hedging irrelevant. But there are counter arguments here too. Hedging market are wholesale markets and corporate hedging may, therefore, be cheaper.

Furthermore, some hedging techniques are only available to the company â&#x20AC;&#x201C; leading and lagging and Transfer pricing to name but two. Hedging requires information about current and future exposures and contingent exposures too and it is doubtful whether investors have anything like.

The Arguments for Corporate Hedging: If risk management is to be logically justified in financial terms, there has to be a positive answer to the question. Will exposure management increase the value of the firm? The fact that the firm is confronted with interest rates, exchange rates and / or commodity price risk is only a necessary condition for the firm to manage that risk. The sufficient conditions is that exposure management increases the value of the firm.

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Hedging Reduces the Probability Of Financial Distress: Where VFD is the value of the firm above which financial distress is encountered, it can be seen that hedging reduces the probability of financial distress from point ‘p’ to point ‘q’. Hedging and the tax system interrelate to impact upon the level of net cash flows of the firm. How does this work? If company is facing an effective tax schedule which is convex, than a reduction in the volatility of profit through hedging can reduce corporate tax payable. What is meant by a convex tax schedule? If the firm follows average effective tax rate raises the profit. (If the tax schedule is convex, hedging can lead to a reduction in the firm’s expected taxes. The more convex the tax schedule and the more volatile the firm’s pre-tax profits, the greater are the tax benefits that accrue to the company. Corporate tax schedule in Britain and the USA currently give the firm only minimal)

Information for Exposure Management: Management of foreign exchange exposure is an integral part of the treasury function in the multinational company. Rational decision taking presupposes that relevant information pertinent to the decision is available. The generalization is no less true of treasury management than it is of any other aspect of business. To make logical decisions of foreign exchange exposure, relevant information is required. What kind of information? Transaction exposure, translation exposure and Economic exposure, Macro economic exposure. Macro economic exposure is concerned with how a firm’s cash flows, profits and hence value change as a result of developments in the economic environment which includes, exchange rate, interest rate, inflation rate, wage level, commodity price levels and other shocks to the system. The analysis of macro economic exposure is very much the leading edge of hedging techniques.

We have classified foreign exchange exposure under their headings; transaction, translation and economic exposure. This contrasts with pure translation exposure where difference arises due to accounting conventions in the process of consolidating the financial accounts of companies within a group.

8.2. INTERNAL TECHNIQUES OF EXPOSURE MANAGEMENT Internal techniques embrace Netting, Matching, Leading and Lagging, pricing policies and Assets and Liability management. External techniques include forward contracts, borrowings short term, discounting, factorizing, government exchange risk guarantees and currency options.

Internal Hedging Strategies: Hedging device is a firm may be able to reduce or eliminate currency exposure by means of internal strategies or invoicing arrangements like risk sharing between the firms and its foreign customers.

We take a look at some of the commonly used or recommended methods.

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Invoicing: The firm may be able to shift the entire exchange risk to the other party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency.

Empirically, in a study of the financial structure of foreign trade Grassman (1973) discovered the following regulations:1. Trade between developed countries in manufactured products is generally invoiced in the exporter’s currency.

2. Trade in primary products and capital assets are generally invoiced in a major vehicle currency such as the USD. 3. Trade between developed and less developed countries tends to be invoiced on the developed countries currency.

4. If a country has a higher and more volatile inflation rate then its trading partners, there is a tendency not to use that countries currency in trade invoicing.

Another hedging tool in this context is the use of “Currency Cocktails” for invoicing. Thus for instance, a British importer of chemicals from Switzerland can negotiate with the supplier that the invoice by partly in CHF and party in GBP

Netting and Offsetting: A firm with receivables and payables in diverse currency can net out its exposure in each currency by matching receivables with payables. Thus a firm with exports to and imports from say Germany need not cover each transaction separately. It can use a receivable to settle all or part of a payable, and take a hedge only for the net DEM payable or receivable.

Netting also assumes importance in the context of cash management in a multinational corporation with a number of subsidiaries and extensive intracompany transactions. Eg: American parent co. with subsidiary in UK and France. Suppose that the UK subsidiary has to make a dividend payment to the parent of GDP 2,50,000 in three months time, the parent has three months payable of EUR 5,00,000 to the French subsidiary, and French subsidiary has 3 months payable of GBP 3,00,000 to a British supplier (who is not a part of the Multinational). A netting system might work as follows.

The forecasts of spot rates these matters here are:GBP/ USD: 1.50 EUR/ USD: 0.9000 implying GBP/EUR: 1.667. The UK subsidiary is asked to pay GBP 2, 50,000 to the French subsidiary’s UK supplier. Thus the French firm has to hedge only the residual payable of GBP 50,000. GBP 2, 50,000 converted into EUR at the forecast exchange rate amount to EUR 4, 16,675. The Parent may obtain a hedge for the residual amount of EUR 83,325.

Netting involves associated companies which trade with each other. The technique is simple.

Group companies merely settle inter-affiliate indebtedness for the net amount owing. Gross intra-group

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trade receivables and payables are netted out. The simplest scheme is known as bilateral netting.

Multi-lateral netting: It is more complicated but in principle is no different from bilateral netting.

Multi-lateral netting involves more than two associated companies. Inter-group debt virtually always involves the services of the group treasury.

Netting reduces banking cost and increases central control of inter company settlements. The reduced number and amount of payments yields savings in terms of buy/sell spreads in the spot and forward markets and reduced bank charges.

Matching: Netting is a term applied to potential flows with in a group of companies whereas matching can be

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applied to both intra-group and third-party balancing. Matching is a mechanism whereby a company matches its foreign currency inflows with its foreign currency outflows in respect of amount and approximate timing. The pre-requisite for a matching operation is two-way cash flow in the same foreign currency within a group of companies. This gives rise to a potential for natural matching.

Leading and Lagging: Another internal way of managing transaction exposure is to shift the timing of exposures by leading or lagging payables and receivables. The general rule is lead, that is, advance payables and lag, that is, postpone receivables in â&#x20AC;&#x2DC;Strongâ&#x20AC;&#x2122; currency and conversely, lead receivable and lag payables in weak currencies.

An American firm has a 180 day payable of AUD 1,00,000 to an Australian supplier. The market rates are:USD/ AUD SPOT: 1.3475, 180 day forward: 1.3347 Euro US $ 180 day interest rate 10% p.a Euro AUD 180 day interest rate 8% p.a The Australian authorities have imposed a restriction on Australian firms which prevents them from borrowing in the Euro AUD market. The American firm wants to evaluate the following four alterative hedging stratigies:-

a) Buy AUD 1, 00,000 180 day forward (forward) b) Borrow US$, convert Spot to AUD, invest in a Euro AUD deposit, settle the payable with the deposit proceeds (Money market cover) c) Borrow AUD in the Euro market; settle the payable, buy AUD 180 day forward to pay off the loan (lead with a forward).

Let us determine US $ outflow 180 day have under each strategy:1. Forward Cover:- US $ outflow = 1,00,000 / 1.3347 = 74923.204 2. Money market cover:- The firm must invest AUD

(1,00,000/ 1.04) ie,

AUD 9,61,538.46 to get AUD 1,00,000 on maturity. To obtain ie, must borrow and sell spot US (961538.46 / 1.3475) = US 7,13,572.

3. Lead: The American firm can possibly extract a discount at 9.5% p.a. from the Australian firm since this is the latter opportunity cost of short term funds. Thus leading would require cash payment of AUD ( 1,00,000 / 1.0475) = AUD 9,54,653.94

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4.Lead with a forward:- The firm must borrow AUD 9,54,653.94 at 8% p.a requiring repayment of AUD 9,92,840.10 which must be bought forward requiring an outflow of US $ 7,43,867.61. This is equivalent to the lead strategy. You can convince yourself that if the American firmâ&#x20AC;&#x2122;s borrowing cost were higher than the Euro US $ rate, the lead with forward strategy would have been better than a simple lead.

In effect, leading and lagging involve trading off interest rate differentials against expected currency appreciation or depreciation.

Risk Sharing: Another non-market based hedging possibility is to work out a currency risk sharing agreement between the two parties. For instance, the exporter and importer.

Let us work an illustrative example:An Indian company has exported a shipment of garments to an American buyer on 90 days credit terms. The current USD/ INR Spot is 46.25 and 90 days forward is 47.00. The payment terms are designed as follows:a) The National amount of the invoice is USD 1,00,000. If at settlement, the Spot USD/ INR rate, ST, is greater than or equal to 46.00 but less than or equal to 48.00, the national invoice amount of USD 1,00,000 would be translated into rupees at a rate of Rs. 47 per dollar, i.e. Rs. 47,00,000 buyer cost will vary between USD 97916.67 ( = 47,00,000 / 48) & USD 102173.91 ( = 47,00,000 / 46). b) If the spot rate at settlement is less then 46.00, the conversion rate would be

[(47.00- 0.5)

(46.00 - ST)]. The buyer cost would be USD (4500000 / 42) = USD 107142.86.

8.3. EXTERNAL TECHNIQUES OF EXPOSURE MANAGEMENT External techniques of exposure management resort to contractual relationships outside of a group of companies in order to reduce the risk of foreign exchange losses. External techniques include forward exchange contracts, Short-term borrowings, financial future contracts, currency options, discounting bills receivable factoring receivables, currency overdrafts, currency SWAPâ&#x20AC;&#x2122;s and government exchange risk guaranties.

Forward markets: A forward foreign exchange contract is an agreement between two parties to exchange one currency for another at some future date. The rate at which the exchange is to be made, the delivery date, and the amounts involved are fixed at the time of the agreement. This may be used to cover receivables and payables, but also enables a company or high net worth individual to speculate on foreign currency movements.

Forward markets are available for periods beyond 5 years for such currencies as USD, Sterling, DEM, Francs, Yen, Canadian dollars and so on. 10 year forwards are quoted by a few banks for many of the above. The forward market may be used to cover a receipt and payment denominated in a foreign currency when the date of receipt for payment is known. But it can be readily adopted to allow for situations when the exact payment date is not known.

Forward options:

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Britain exporter may decide to cover despite an uncertain payment date via a forward option.

Forward market has the maturity period for making payment but forward option has no date of maturity.

Swap deals: Another method of dealing with unspecified settlement date is by a swap deal. This method is virtually always cheaper than covering by way of forward options. A swap involves the simultaneous buying and selling of currency for different maturities. Swap deals used for forward cover are of two basic types: Forward/ Forward and Spot / Forward. In either case, the exporter begins by covering the foreign currency transaction forward to an arbitrarily selected but fixed date, just as in an ordinary fixed date forward contract. Then if the precise settlement date is subsequently agreed before the initial forward contract matures. The original settlement date may be extended to the exact date by a forward/ forward swap.

Short term borrowings: Short-term fixed rate borrowings or deposits is another technique for covering foreign-currency denominated receivables and payables respectively. Assume credit available to/by three to six months, it can be arranged an overdraft, discounting of bills, commercial papers is a corporate short-term, unsecured promissory note issued or a discount to yield business.

The commercial papers maturity generally does not exceed 270 days. Currency overdrafts and currency hold accounts simply use floating rate borrowing and depositing respectively, to achieve the same ends as under shortterm borrowings or depositing with a fixed rate. The difference is clearly one of interest rate exposure. Floating rate borrowings or depositing clearly gives risk to an interest rate exposure, fixed rate finance does not.

Exchange risk guarantees: As part of a series of encouragement to exporters, government agencies in many countries offer their business insurance against export credit risk and certain export financing schemes. Many of these agencies offer exchange risk insurance to their exporters as well as the usual export credit guarantees.

The exporter pays a small premium and in return the government agency absorbs all exchange risk, thereby taking profits and absorbing losses. To value and to check with such bodies are ECGD in the UK, HERMES in Germany, COFACE in France, Netherlands Credit Insurance Company in Holland, EXIM bank in the USA, ECGC in India and so on.

8.4. QUESTIONS Section â&#x20AC;&#x201C; A Very short answer questions 1. What do you mean by exposure management?

2. What is risk management?

3. Give the short note on netting.

4. What is leading?

5. What is lagging?

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INTERNATIONAL FINANCE MANAGEMENT 6. What is SWIFT? Section – B Short answer type questions 1. Describe internal and external exposure management.

2. What is meant by exchange rate risk guarantee? Describe Briefly 3. Describe leading and lagging Section – C Long answer type questions 1. Explain the external techniques of exposure management.

2. Explain the internal techniques of exposure management.

3. What is a forward option? Discuss.

8.5. SUGGESTED READINGS 1. Multinational enterprises and economic analysis - Caves. R 2. International financial management - Madura Jeff 3. International financial management – A K Seth

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CHAPTER – 09 DERIVATIVES STRUCTURE

9.0. INTRODUCTION 9.1. DERIVATIONS – SWAPS – FINANCIAL FUTURES AND FOREIGN EXCHANGE 9.2. CURRENCY OPTIONS 9.3. INTEREST RATE RISK 9.4. FINANCIAL ENGINEERING 9.5. QUESTIONS 9.6. SUGGESTED READINGS

9.0. INTRODUCTION A derivative is a financial product the value of which is derived from the value of underlying asset.

Derivatives are widely used in developed financial markets to speculate on currencies and financial assets. These are also used to hedge portfolio risk or used for hedging exposures by corporate finance manager.

9.1. DERIVATIONS – SWAPS – FINANCIAL FUTURES AND FOREIGN

EXCHANGE

1. Future contracts, 2. Option contracts, 3. Swaps, and 4. Some engineered products based on the combination of futures, options, equity and bonds The engineered products are beyond the scope of this book, therefore these will not be discussed in details. A small discussion will be done along with a few examples of these products. However, we shall be discussing first three derivatives in somewhat details so that the students are able to use these instruments for hedging and speculative purpose.

9.2. CURRENCY OPTION CONTRACTS Philadelphia Stock Exchange has been dealing with in standardized foreign currency option contracts since 1982. It is dealing in (buy and sell) options of seven currencies against the U.S. Dollar ($).

These currencies are: (1) Sterling (BP), (2) Deutsche marks (DM), (3) Canadian dollars (Can $), (4) Swiss

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francs (SF), (5) Japanese yen (JY), (6) Australian dollars (A$) and (7) French franc (FF). These options are traded on three, six and nine months, cycle. Other major trading centres are: Chicago International Money Market, Montreal Stock Exchange, Amesterdam Stock Exchange and London Stock Exchange.

The Montreal Stock Exchange offers options on C$ on U.S. $, JY, DM and SF, etc. Amsterdam deals in currency options on dollar against BP, DM, Dutch Guilder (DG) and the ECU. London Stock Exchange deals in dollar pound options. London Stock Exchange follows entirely the same rules, contract sizes and other characteristics such as quotation, methods, etc. as those of Philadelphia exchange. LIFFE (London International Financial Future Exchange) also introduced dollar-pound options in mid 1985, but its contract size and other characteristic differ from the London and Philadelphia Stock Exchange. Table 9.4 indicates the standardized sizes of options at Philadelphia Stock Exchange.

All option exchanges are regulated through regulatory bodies. These option exchanges are regulated in the same manner as the stock exchanges. In U.S., the Securities and Exchange Commission regulates the option exchanges. The commission per transaction in U.S. $30 to $60 per transaction and is much lower per contract when the transaction involves more than one option contract.

Now, in U.S., the banks and brokerage firms have begun to offer option contracts on some currencies. These options are tailored to the needs of the customer. Since these options are not standardized, all terms must be specified in the contract. The minimum contract size offered by financial institutions is $5 million. Since these contracts are done with particular institutions, therefore there is no credit guarantees required. Financial institutions may ask for collaterals from any individuals.

Functioning of Option Markets and Some Related Concepts: Currency options are similar to options on ordinary stocks. The buyer of the option can not loose more than the cost of the option and is not subject to any margin calls. Philadelphia stock exchange is an organized market for options on BP, DM, SF, US $, JY, FF and Can $. The options are traded on three month, six month and nine month cycles. Currency options provide the right, but not the obligation to buy or sell a specific currency at a specific price at any time prior to a specified date. This means that the user of the option obtains an insurance against adverse movement in exchange rate but retains the opportunity to benefit from a favourable movement in exchange rate. At the same time, the maximum risk to the buyer of an option is the actual cost of the option. Currency options are not substitute for forward market, but as a new, distinct and advantageous to those seeking either protection or profit from changes in exchange rates.

There are two types of options: (a) American and (b) European. (a) An option which can be exercised on any business day within the option period

is called

American Option and (b) An option which can be exercised only on the expiry date is of European kind.

In options the right and obligations for performing a contract are separated and sold therefore an

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option may be a Call Option or a Pitt Option. A Call Option is an option to purchase a stated number of units of underlying foreign currency at a specified price per unit during a specific period of time where as a Pitt Option gives the right to sell the underlying foreign currency at the specified price per unit during a specified period of time. The other terms used in respect of options are: Option Buyer The party who obtains the right by paying a premium is called the option buyer.

There is no obligation with the buyer.

Option Seller The party who owns obligation to perform if the option is exercised. He will have to sell currency if call option is exercised and he will have to buy it, if put option is exercised.

Exercise Price or Strike Price of on Option The price at which the option holder has the right to purchase or sell the underlying currency. So far as the quotations of options in U.S. are concerned, except for French Francs and Yen, the exercise prices are stated in cents.

Suppose a DM 35 Call Option, would be an option to buy DM at $0.35 per mark. In the case of Japanese Yen option the exercise prices are stated in hundredth of a cent. So JY 54 call option gives the right to the option holder to buy yen at $0.0054 per yen. Expiration Months of an Option The expiration months for option are: March, June, September and December. At any given time, the trading is available in nearest three of these months. Expiration Date of an Option The last date on which an option may be exercised. For foreign currency options, this is the Saturday before the third Wednesday of the expiration month. Option Premium It is the price of an option, i.e. the sum of money that the buyer of an option pays when an option is purchased, or the sum that the writer of an option receives when an option is written.

Intrinsic Value of on Option The intrinsic value of an option is the extent to which an option is profitable to exercise. In the case of a call option, if the spot price of the underlying currency is above the option exercise price, then the excess of this price over the exercise price is the intrinsic value of the option. The option with the intrinsic value are said to be in the money. If spot DM 35 option has the price $0.35, and DM 32 call would have an intrinsic value of $0.03 [= ($0.35 - 0.32)].

Time Value of on Option The time value of an American option at any time prior to expiration must be at least equal to its intrinsic value. In general, it will be greater. This is because, there is a possibility that the spot price will move further in favour of the option holder. The difference between the value of the option and its intrinsic value is the time value of option. For European option, this argument does not hold because the option is to be exercised on the day of maturation, therefore these option will have less value before expiration date than their intrinsic value which is known at the time of exercise.

Notice of Exercise Notice of exercise is required to be given by an option holder to an option writer that the option is being exercised. The option holder may exercise his option and the option writer may be assigned a notice of exercise at any time prior to expiration of the option.

Opening Transaction a purchase or sale transaction which establishes an options position is the opening transaction.

Closing Transaction a transaction which liquidates the existing option position, option holder may

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liquidate their position, transaction by an offsetting sale. An option writer may liquidate his position by an offsetting purchase.

Option at the Money an option whose exercise price is the same as the spot price, we may call that the option is at the money (exercise price = spot price).

Option out of Money a call option whose exercise price is above the current spot price and a put option having exercise price is below the current spot price are out of money.

Option in the Money In the case of a call option, the option is said to be in the money if the market price of the underlying currency exceed the exercise price. In the case of put o t' n, the option is said to be in the money if the current spot rate is below the exercise price."

Option Trading on Exchanges: Options on currencies are traded over the counter in the inter bank markets. The options may be standardized or tailor made to suit the requirements of customer. Apart from this trading, these are being traded in organized exchanges. The important exchanges are: Philadelphia Stock Exchange (PHLX), London Stock Exchange (LSE), and Chicago Board Options Exchange (CBOE). The options on futures are traded at Chicago Mercantile Exchange (CME), London International Financial Future Exchange (LIFFE). The American option is traded at PHLX and LSE and European option at CBOE. Reading Price Quotations of Options: Table 9.4 gives the price quotations as these look in the news papers (Wall Street Journal). The first column indicates the underlying asset and the amount included in a single contract is given in the first row of the table. The option on British pound is indicated for BP 31,250. The second row in the first Colum provides the spot rate of BP on the previous day 174.65 cents per BP ($1.7465/BP) the next column gives the strike price. The second column gives the range of strike prices traded during a given day. For example, according to the table 9.4, the range of strike price had been 162.5 to 175.5 cents. The next three columns give the option premix existing in the case of March, April and June. For example, in the case of March option, the premium was 4.22 cents per pound with the strike price of 170 cents. The word 'r' means that the particular option was available but was not traded on the particular date and the word's' implies that the option was not available. After indicating American type of options, the European type of options is quoted as shown. The table shows the options prices of British Pound (BP) and Deutsche Mark (DM) quotations of options. The call and put options are quoted separately in blocks and the block has the heading which indicates whether the quotation pertains to call or put.

Speculating with Options speculating with call option: Suppose 'A' expects an appreciation in dollar in next two months. He does not have large amounts to purchase dollars and keep these till the dollar appreciates to realize the expected profit. But 'A' has an amount to pay the premium on option. The call option on dollar is available at a premium of Rs.0.75 per dollar with an exercise price of contract size is $100,000.00. W pays

Rs. 35.75. The current spot rate is Rs. 35.00. The Rs. 75000 as premium and buys an option. The dollar

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appreciates before the expiration date and the spot rate is Rs. 36.90/$. The speculator sells the currency at Rs. 36.90 and exercise the call option and buys the currency at Rs. 35.75/$. The possible gains are given as follows: The amount received from selling currency per unit = Rs. 36.90 The exercise price per unit = Rs: 35.75 The premium paid per unit = - Rs. 00.75 Net gains per dollar sale = Rs. 00.40 Gains on the option contract = 100,000 x 00.40 = Rs. 40,000 Since the option contract has two perspectives: (i) the writer's perspective and (ii) the seller's perspective, therefore we have to examine the option writer's perspective as well. In the above example, the speculator was expecting that the dollar will appreciate rupees beyond Rs. 36.50 and so the speculator will be gaining and at the same time the option writer was expecting that the option price will not rise more than 36.50 and therefore he ensures profits till Rs. 35.75 and protects further by obtaining premium of Rs. 0.75 per dollar.

Profit from an option may be given from two perspectives as follows: W Profit from a call option: Bitter's perspective: For a call option the profit and loss for by year's perspective is given as.

If OP is the option premium, S, is the spot price and X, is the exercise price then. =Si-X1-0P for S1>X1 Loss = OP for S1 > X1 = option premium only. or Profit = - OP Factors Affecting Call Option Premium: There are three main factors affecting the call option premium: 1. Spot price relative' to strike price: Level of existing spot price relative to strike price is an important determinant of call option premium. Higher the spot rate relative to the strike price, higher will be the option price. This is due to the greater probability that the option will be exercised.

2. Time to expiration: Length of time before the expiration date is another determinant of option premium. Greater is the time period before expiration, the greater will be the option premium.

3. Volatility of the currency: If the currency is volatile, greater is the option premium.

Hedging with Call Option: The corporations with open positions in foreign currencies can use the call option to protect liabilities when the foreign currency is expected to appreciate. For example, some importer has imported a machine from America. To protect itself from the appreciation, it can buy a call option in which it can fix the maximum price of the dollar to be paid. If the dollar appreciates beyond the exercise price, it would

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buy the dollars at the exercise price from the writer of the option and if the appreciation remains within limit the importer can let the option expire.

Speculating with Put Option: In the case of put option, again, we have two perspectives (a) buyer's perspectives, and (b) Seller's perspective.

Buyer's Perspective Suppose 'A' expects the dollar to depreciate in nE t two months. He does not want to borrow and sell the dollars because this would require creation of liability and liquidating it afterwards. Lot of difficulties are involved, therefore the speculator decides to speculate with put option.

Put option on dollar is available at a premium of Rs. 0.75 per dollar with an exercise price of Rs. 35.75.

The current spot rate is Rs. 36.00. The contract size is $100,000.00. W pays Rs. 75000 as premium and buys an option. The dollar depreciates before the expiration date and the spot rate is Rs. 34.90/$. The speculator buys currency at Rs. 34.90 and exercise price of put option. That the writer accepts the selling of currency at Rs. 35.75/ $. The possible gains are given as follows: The amount to be paid for buying = - Rs, 34.90 currency per unit The exercise (selling) price per unit = Rs. 35.75 The premium paid per unit = - Rs. 00.75 Net gains per dollar sale = Rs. 00.10 Gains on the option contract = 100,000 x 00.10 = Rs. 10,000 Since the option contract has two perspectives: (i) the buyer's perspective and (ii) the seller's perspective, therefore we have to examine the option writer's perspective as well. In the above example the speculator was expecting, that the dollar will depreciate beyond Rs. 35.00 and so the speculator will be gaining and at the same time the option writer was expecting that the option price will not drop beyond the exercise price and that he protects against further depreciation to the tune of Rs. 00.75 by charging premium. Profit from a Put Option may be given from the two perspectives as follows: Profit from a Put Option: Buyer's Perspective Profit

OP for St > Xt where OP is the option

premium, St is the spot price and Xt is the exercise price. = Xt â&#x20AC;&#x201C; St â&#x20AC;&#x201C; OP for St < X t As per the above example, the profit of the buyer is: Profit = 35.75 - 0.75 - 34.90 = Rs. 0.10 per dollar The payoffs have been shown in Figure 9.3(a) which is based on the above example.

Factors Affecting the Premiums of Put Option: There are three main factors influencing put option: The Spot Rate of the Currency Relative to The strike Price the lower the spot rate relative to the strike price, the more valuable will be the put option, because there is greater probability of exercising the option.

The Length of the Time until Expiration Date Longer the time to expiration the greater will be the

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option premium because during the longer time to expire the probability of exercising the option increases. The Variability of Exchange Rate the greater is the volatility of currency, the greater will be the premium on the option.

Hedging with the Currency Put Option: Suppose an exporter has exported goods worth $100,000, to insulate itself against possible depreciation of dollar, it could purchase a put option, through this contract the exporter ensures the price of the dollar if the dollar appreciates the exporter lets the option expire and if it depreciates beyond the exercise price the selling price is assured in the exercise price.

9.3. INTEREST RATE SWAP An interest rate swap is an arrangement whereby one party exchange one set of interest rate payments for another. Most common arrangement is an exchange of fixed interest rate payment for another rate of over a time period. The interest rates are calculated on notional values of principals.

Provision of a swap is: 1. The notional principal value upon which the interest rate is to be applied.

2. The fixed interest rate to be exchanged for another rate.

3. Formula type of index used to determine the floating rate.

4. Frequency of payments, such as quarterly or every six months is also agreed.

5. Life time of the swap.

Interest Rate Szvap: A finance company, accepts deposits and pays floating interest rate (FR) plus 1% (FR + 1%) on its deposits and lends money to house building societies building houses at fixed interest rate of 12%. To hedge the interest rate risk due to payment to depositors at floating rate, it enters into a swap with a swap dealer and makes an agreement that the finance company will be receiving from the swap dealer floating rate plus 2% (FR 2%) and in lien, it will be paying 12% fixed interest rate on some notional amount: In this way the finance company 'Fin A' ensures a profit of 1% on notional amount.

To hedge risk the swap dealer enters into a deal with another finance company 'Fin B' with whom the finance company agrees to pay at FR + 2.15% and receive 12% fixed on notional amount; because it is paying 12%. Fixed to its depositors and receiving FR + 2.25% from its borrowers. In this way each participant has ensured a profit. The swap structure is shown in Figure 9.4.

We see that with this swap both the companies have achieved their objectives and profiting from the swap. The swap dealer also earns.

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Various Types of Interest Rate Swaps Following are the most important types of interest rate swaps: (1) Plain Manila Swap, (2) Forward Swap, (3) Callable Swap, (4) Puttable Swap, (5) Extendable Swap, (6) Zero Coupon for Floating Swap, (7) Rate Capped Swaps, and (8) Equity Swaps.

Plain Vanilla Swap This swap involves the periodic exchange of fixed rate payment for floating rate payments. It is some times referred as fixed for floating swap.

Zero Coupons to Floating In this swap, the fixed rate payer makes a bullet payment at the end and floating rate payer makes the periodic payments throughout the swap period.

Rate Capped Swap Rate capped swap involves the exchange of fixed rate payments for floating rate payments, Whereby the floating rate payments are capped. An upfront fee is paid by floating rate party to fixed rate party for the cap.

Forward Swap Forward swap involves an exchange of interest rate payments that does not begin until a specified future point in time. It is a swap involving fixed for floating interest rate.

Calloble, Swap Another use of swap is through swap options or (Swaptions). A callable swap provides the party making the fixed payments with the right to terminate the swap prior to its maturity. It allows the fixed rate payer to avoid exchanging future interest rate payments if it so desires.

Puttable Swap a puttable swap provides the party making the floating rate payments with a right

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to terminate swap.

Extendable Swap Extendable swap contains an extendable feature that allows fixed for floating party to extend the swap period. Suppose, a financial institution that negotiates a fixed for floating swap for eight years believing that interest rates will rise. Now suppose the interest rate increased over this time period as expected. If the institution believes that interest rates will continue to rise, it may prefer to extend swap period. If parties agree, they can create a new swap.

Equity Swap An equity swap involves the exchange of interest payments linked to the change in the stock index. For example, an equity swap arrangement could allow a company to swap a fixed interest rate (-,.f 7% in exchange for the rate of appreciation in BSE index each year over the next four years.

We see that each of these swaps had a particular characteristic that makes it different from the other.

Risks of Interest Rate Swaps are also not free from risk. There is several risks involved lust the most important risks are: W Basis risk, (ii) Credit risk, and (iii) the Sovereign risk.

Basis risk The interest rate of the index for an interest rate swap may not move necessarily in tandem with the floating rate instruments of the parties involved in the swap. The index used on a swap may rise by 0.7% while the deposit rate may change by 1%.

Credit Risk There is a risk that a firm involved in the swap may not honour its commitment. This credit risk is not overwhelming because as soon as a firm recognises that the other party is not paying its dues (interest payments), it can also stop paying the other party.

However, the willingness of the banks and security firms to provide guarantees has increased the popularity of interest rate swaps.

Sovereign Risk Sovereign risk reflects potential adverse effects resulting from country's political conditions. Various political conditions can prevent the counterparty from meeting its obligation in the swap agreements.

Pride Determinants of Swaps Setting interest rate for swap transaction is called pricing of swap. The main determinant of price of swap is: 1. The prevailing market interest rates: higher is the interest rates lower is the price.

2. Availability of counterparty: more difficult to find counter party; the higher is the price.

3. Credit risk involved: less is the credit worthy counter party; higher in the price 4. Expected sovereign risk: greater is the sovereign risk higher is the price of swag Currency future is a standardised agreement to deliver or receive a specified amount of specified currency at specified price (exchange rate) and the date. The buyer of the future contract receives the currency while seller of the future contract delivers the currency. The currency future contracts are traded on organised exchanges which establish and enforce the rules of trading. (Only the members of the future exchange can engage in futures transaction on the exchange floor, unless such a privilege have

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been leased to some- one else-; The members of future exchange can be classified as either commission brokers (floor brokers or brokers) or floor traders. Floor brokers (brokers) execute order for their customers, while others work independently. Floor traders (also called locals) trade on their own account.

Contract Specifications: Future contracts are standardised agreements. The major features of the futures are the following: It is a Standardised Specific Sized Contract the trading is done in contract size multiples. The sizes of various contracts in different currencies are given in the table 9.1.

The Quotations are quoted in Direct Quotes, i.e. dollars per unit of foreign currency at IMM (or rupees per unit of foreign currency if futures are traded in a hypothesized future exchange in India).

The Contract has a Standard Maturity Date at International money market (IMM) Chicago contracts mature on the third Wednesday of March, June, September and December. There is another category of future contract called 'Spot month'. These are short term futures contracts that mature on the following third Wednesday, that is on the following standard maturity date.

A Specified Last Trading Day at IMM, the contracts may be traded through the second business day prior to the Wednesday on which these mature. Thus unless the holidays interfere, the last day of trading is Monday.

Collateral Requirement The purchaser must deposit a sum as initial deposits called 'margin' as collateral. In addition to initial margin, the customers are required to deposit the maintenance margin. This is because the value of the contract is marked to market every day.

Commission Payment Customers pay commission to their brokers to execute the order.

Clearing House as a Counter Party All futures contracts are agreements between clients and the exchange clearing house rather than the two parties involved in the transaction. Thus there is no default risk.

Settlement on the Final Date of Delivery Only 5% of the contracts is settled by physical delivery of foreign exchange between buyers and sellers. Most often buyers and sellers offset their original position prior to delivery date by taking an opposite position. This is because; the future contracts are predominantly speculative instruments.

The quotations are read as follows: 1. The first line mean that German Marks were traded on IMM in contracts of DM 1,25,000 each at the dollar per mark prices shown in the table.

2. The next three lines deal with the contracts that expire in December, March and June. These are the only maturities for mark contracts being traded.

3. March contracts, means contract that expires on third Wednesday in March opened trading at $0.6672/13M. The highest trading price during the day was $0.6719/DM and lowest trading price

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was $0.6672/DN-' 4. The column 'settle' refers to settlement price, implies the day's closing price.

5. After the settle column, there is a column 'change', which refers to the change in closing price in comparison with the previous closing price.

6. Next two columns refer to the life time high and low prices of the contract.

7. The last column 'Open Interestâ&#x20AC;&#x2122; is the sum of all long (buy) and short (sell) contracts outstanding.

This column is important because if open interest is large, then large orders can be affected without change in price. But if the Open Interest reflects the small amount, then large orders can be affected only by changing the price of the currency.

8. The last line in Table 9.2(a), indicates the day's trading volume in terms of number of contract, previous day's trading volume, total open interest and the change in open interest from the pervious day. Negative sign implies the decline in the open interest.

9. The last line in Table 9.2(b) is the index of future prices. This line indicates the movement of index. The high and low of the day's index and the closing level are recorded in this line.

The open interest can be calculated as follows: For example, open interest of June contract is 2700. Its value is given as 2700 x 125,000 x $0.6702 (spot $/DM rate) = $226,192,500. The spot dollar-Deutsche mark rate is not given in the table. The exchange rate is obtained from the forex market.

Trading in Futures Contract?

The customers who desire to buy or sell futures have to contact a broker or a brokerage firm.

Customers are required by the future exchange to establish a margin deposit with the respective broker before the transaction is executed. This is called initial margin. The margin deposit may be between 520% of the value of the future contract. The margin deposit is regulated by the future exchange depending on the volatility in the price of future. When the contract value moves in response to change in exchange rate, gains are credited and the losses are debited to the margin account. If the account falls below a particular level known as maintenance level, the trader receives a margin call and must make up, the account equal to initial margin. If trader fails to make up, the position is liquidated.

There are two types of orders which are placed with the brokers: (i) Market orders: when broker is asked to buy or sell certain number of contracts at the best available price, (ii) limit orders: when a limit is placed on the price with in which the order is to be executed.

For each contract, the exchange specifies the last trading day. Those who have held the positions are required to liquidate the position prior to the last trading day or accept or make deliveries as the case may be.

Future markets have market makers who quote buy and sell quotes, thus forming the 'bid-ask' spreads. The floor traders who perform this service are known as scalpers. The rules of futures trading

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ensure that a single market price is produced at each instant.

Pricing Futures (Cost of Carry Model): The price of the future depends on cash price of the underlying financial asset (i.e. currency in this case) plus the cost of carrying it till the maturity of the future contract. This is nothing but the application of cost of carry model. The cost of carrying the asset to the delivery date of the contract rests upon the idea of arbitrage and the model defines the price relationship between spot price of the currency and its future (forward) price that precludes arbitrage. We assume in this case that the future markets are perfect.

The cost of carry model for commodity future emphasizes that for no arbitrage between carrying commodity assets and the futures price following relationship must hold: FU1 = (A + C) x [1 + r(N) ]

9.1

Here N is the time to maturity. If time is measured from the arbitrary origin then N = T — t, where T is the maturity period of the future and t is the time at which the future is bought or sold then T — t[one, two or three months] represents the maturity period, 'A' is the amount involved in the purchase of the commodity, 'C' is the cost of storage and 'r' is the risk less rate of interest.

If

FU1 > (A + C) x [1 + r(N) ]

The arbitrageurs would sell future and would make delivery by carrying the commodity till maturity and the arbitrage profits would be: Profit = FU1 — (A + C) x [1 + r(N) ] conversely if, FU1,< (A +C) x [ 1 + r(N) ] The arbitrageur would buy the future and take delivery and sell the commodity in the market as future price is less than the cost of carrying the commodity and would make profit which would equal: Profit = (A + C) x [I + r(N) ] — FU1 Since it is a case of commodity therefore the cost of storing the commodity 'C' is positive. In the case of financial assets the cost of storing 'C' is negligible therefore it becomes zero. However the financial assets provide a rate of return (i.e. income) '1' therefore in this cases the cost of carry model for no arbitrage situation would require the following equality to hold: FU1 = (A — I) x [1 + r(N) ]

9.2

Where 'I' is the income flow from the financial asset. 'I' has been subtracted from the price of the commodity because it is the income from the asset and not the cost of storing the commodity we can apply this model for deriving the no arbitrage price of the future.

Suppose FU1 is the future price of currency and let S, is the spot price of the currency (Rs./ $) Suppose, risk free rate on deposit of rupees is r

RS

and that on dollar is 11. Now we want to find out what

should be the price of futures so that there is no arbitrage between the currency 790 International Financial Management carrying and the futures price of the currency. Suppose an investor invests Rs. 35.00(S,) to buy a dollar and possesses one dollar. The dollar deposit earns r$ interest and its present

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value is [r1(N)1(1+r1(N))1 and it can be converted into rupees by multiplying it by spot rate S,. Therefore the earning from the dollar deposit in terms of rupees is S,(N)[r11(I+r1(N))]. Now if we substitute these values in equation 9.2 we have: s

s

FU1 = [S1 – S1(r (N)1/ (1 + r (N))j][1 + r RS

RS

(N)]

RS

in this case I = S1(r (N)1(1 + r (N))I.

9.3

Following example explains the pricing concept of futures and shows how to examine the price of future on the basis of cash and carry model.

Suppose risk less interest rate on rupees is 9%, and that on dollar is 6% and if the spot rate is Rs. 36.00 then three month future price of dollar should be priced at: FU1

[36.00-36.00{(0.06/4.00)/(1 + (0.06/4))}][1 + (0.09/4)]

Rs. 36.27 This price would result into no arbitrage price of future. If price of future deviates from this price there would be arbitrage between the future and the carrying price of currency. The main formulation of the future price may tend to interest rate parity. Simplifying the equation 9.3 we have: 1

s

FU1 = [S1[1 + r (N)]]1[(1 + r (N))] 9.4 Which is nothing but the interest rate parity equation where FU, represent the forward rate.

Other concepts pertaining to futures: If

 = [1 + r -(N)]1[(I + r (N))] RS

RS

With the above assumption we have: FUt =  x S1  = Future price/Spot Price = FU1/S1 or FUt =  x S1

i.e. change in future price equals '' times the change in spot price.

Suppose for every unit long or short position in the underlying currency we sell or buy futures contracts not on unit to unit basis but on 1/ units to unit of currency basis. Even then our position may not be fully protected or hedged because corresponding to a change S1 in the underlying asset (currency), the change in our futures position would be (1/) FU1 The ratio [FU/ S1] is called the delta of the future. There is another concept of 'hedge ratio'(HR). It is the number of units on which the futures are traded per unit of exposure in the underlying asset. Similarly, concept of basis risk is also important to be understood because when a transaction is hedged, the basis risk remains. This is because the correlation between the spot price of currency and the future price of the currency is less than perfect, therefore the basis does not remain constant. These concepts have been explained in Example 9.2.

Hedging Exposure through Futures: As we have already stated that a long position (receivable) is to b(- hedged by selling future and a

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short position (payables) are required to be hedged by buying future therefore in the following example we take up hedging exercise and explain how to hedge a receivable and ,iiso explain other concepts discussed above.

EXAMPLE 9.2 Suppose on September 1, the spot rate for dollar was S(Rs./$) = 35.55 and the December future was trading at Rs. 35.45/$, therefore there is a difference of Rs.0.10 (or 1000 basis points) between the spot price and the future price. Now if the spot price moves to Rs. 35.10/$ and that of the future Rs. 34.90/$. We see that the difference between the spot price and, the future price is Rs.00.20/$ (i.e. 2000 basis points). The basis risk remains because there is less than perfect correlation between the movements of spot price and fittiire price of the currency.

Since

FU, =  x S, therefore on September I the

 = FU1/S1 = 35,45/35.55 = 0.997

Now if we suppose that an exporter has to receive $100,000 in three months then if the exporter has to hedge it through future, then if we ignore the standardised nature of futures then it has to sell future to hedge the receivable (I/) x 100,000 = (1/0.997) x 100,000 = 100282.087 Now if we examine whether the hedge was proper or not we find that there remains a risk and the hedge is not perfect.

Since there were receivable of $100,000, the loss due to depreciation is: 100,000 (35.55 — 35.10) = Rs. 45000.00 the gain due to hedge is: 100282.087 (35.45 — 34.90) = Rs. 55155.15 Therefore there are excess gains from hedging because the P had changed from 0.997 to 0.994, i.e. [(34.90/35.10)].

The delta of future is: FU1/S1 = (35.55 — 35.10)/(35.45 — 34.90) = 0.818 In the above example, we had dispensed with the fact that the futures are standardised instrument now if we move to the real world, we may be able to hedge through one future whose standardised size is $100,000, then a part of receivables will remain exposed to exchange rate movement

9.4. FINANCIAL ENGINEERING AND FINANCIALY ENGINEERED PRODUCTS The concept of financial engineering extends the basic ideas of risk management in finance. The engineering metaphor highlights the specialized nature of financial structure that can be created to manage particular risk.

In financial engineering, combinations of financial asset holding are done and financial structures are created which otherwise by holding one asset might not have been possible.

All these financial structures generate profit profiles which ensure risk management. The general

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classification of these combinations generating profit profiles are: 1.

The combination of options to generate profit profile that are not available with positions in single option, and

2.

The relationship between underlying securities, futures, securities, forwards and swaps. Some of the important products are:

(1) Straddles, (2) Strangles, (3) Bulls and Bears spreads, (4) Butterfly spread, (5) Options Forwards, (6) Option Cylinders, and (7) Synthetic Derivatives.

Straddle: A straddle is an option position involving a put and a call option that have the same expiration and same strike (exercise) price on a currency.

Consider a put and a call option and ' assume that Loth have an exercise price of $1 = Rs 36.00.

Suppose the call sells at Rs. 2-0(Yand put sells at Rs. 1.00. If the currency price equals the strike price, both the call and the put are worthless and the cost of the straddle is Rs. (2 + 1) = Rs. 3.0, the entire premium paid for the straddle. Any movement away from the exercise price of Rs.36.00 gives a better result and breaks even at (Strike price (Âą) price of call and put), i.e. Rs. (300 + 3) = Rs. 39.00 or Rs. (36 3) = Rs. 33.00. Tables 9.6 the payoffs in the case of a .straddle.

Strangle: A strangle is similar to straddles. A long position in a strangle consists of a long position in call and long position in put on the same underlying asset with the same terms to expiration with the call having the higher exercise price than the put. Consider the same put option of the straddle which had exercise price $1 = Rs. 36.00 and premium equal to Rs. 1.00 and call 216 International Financial Management Straddle

Option having exercise price $1 = Rs. 37.00 and a premium of Rs. 2.0. Any movement away from

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the exercise prices give a better result and breaks even at (Strike price (Âą) price of call and put), i.e. Rs. (37.0 + 2) = Rs. 39.00 and Rs. (36 - 1) = Rs. 35.00. Table 9.7 shows the payoffs in the case of a strangle 1, Bull and Bear Spreads A bull spread in the option market is a combination of two call options designed to profit, if the price of the underlying goods rises. Both the calls in a bull spread have the same expiration, but they have different exercise prices. The buyer of a bull spread buys a call with an exercise price below the currency price and sells a call option with an exercise price above the currency

price. Spread is a bull spread beCaSLie the trader wants to capitalize on the price rise of the currency. If we compare it to the buying of the currency as such, the bull spread with call option limits the trader's risk and simultaneously it also limits the profit potential compared to the buying of the currency itself.

Assume that the dollar is trading at Rs. 36.00. Two call options are being sold: one with exercise price of $1= Rs. 35.00 having price of Rs. 3.00. and the other call is being sold with an exercise price of $1 = Rs. 37.0 and the price Rs. 1.0. The trader buys a call with and exercise price of $1 = Rs. 35.00 having price Rs. 3.0 and sells the call option with the exercise price of $1 = Rs. 37.0 and a premium of Rs. 1.0 (Figure 9.9).

Now the long position profits if the stock price moves above Rs. 38.00 and the short position profits if the price remains below Rs. 38.00. Table 9.8 provide, us the bull spread.

Butterfly Spreads: To buy a butterfly spread, a trader buys one call with a low exercise price and another call with a high exercise price-and sells two calls with medium exercise price. The trader profits the most when stock price is near the medium exercise price at the expiration.

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Thus the situation is described in the Table 99.

Table 9.10 shows the payoffs of various options and the butterfly spread and Fig. 9.10 graphs the payoffs of various options and the butterfly spread.

Table 9.9 Nature of

Nos. of

Exercise

Options

the call

options

price

price

Long Call

1

Rs. 39.0

Rs. 1.0

Short Call

2

Rs. 37.0

Rs. 2.0

Long Call

1

Rs. 35.0

Rs. 4.0

Accounting for Foreign Currency Transactions and Indian Accounting Standard AS-11 Whenever a foreign currency transaction takes place, it has to be accounted for in terms of domestic currency using an exchange rate. If the total transaction is not settled, then we have monetary item appearing in balance sheet. Suppose a transaction is to be settled partly on some other date during the same financial year in which the transaction took place, the exchange rate used will be different from the date on which the first part of the transaction was settled. Thus there would be exchange gains or loss due to exchange rate movement. The three issues in respect of this transaction which required to be addressed are: (a) How to fix the exchange rate to be used when such a transaction takes place. (b) How to deal with exchange gains or loss full settlement of transaction during the same financial year. (c) How to deal with exchange gains and losses due to translation of items on the balance sheet when these transactions are not settled during the same financial year.

Fixation of initial Exchange Rate: The foreign currency transaction which is required to be accounted for by an Indian enterprise is to be translated into Indian rupee by using spot rate at the day of transaction. When there are several transactions in a given foreign currency an average rate based on the transactions of the week or a month can be used. If there are wide fluctuations in exchange rates, then care has to be taken to ensure that the single rate used is an appropriate representative of the host of actual rates prevailing during the period of transactions.

Recognition of Exchange Gains and Losses: Of transaction in foreign currency is settled either partly or fully on a date later than the date of transaction by converting into rupees or vice-versa, will result into exchange gain or loss and is recognized in the profit and loss account of the financial year in which the settlement takes place.

Transaction at the Balance Sheet Date: All foreign currency monetary items are translated into rupees at each balance sheet date by ing the closing rate and the resultant exchange difference is recognized in the profit and Is account. The non-

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monetary items are translated at historical price.

Suppose a company in India imported goods worth $10,000. The terms of the payment are that the amount is to be paid in instalments: Its instalment of $5000 in Dec. 30th 1997 2nd Instalment on April 15, 1998.

The exchange rates prevailing on December 1, 1997 was Rs. 35.00/$; Dec. 30, 1997 Rs. 3x.50/$; - March 31st 1998: Rs. 36.00/$ 15 April, 1998 Rs. 34.50/$.

9.4. QUESTIONS Section – A short type answers questions 1. What is a currency option?

2. Give the meaning of option trading on exchanges.

3. What is call option?

4. What is put option?

5. Give the meaning of price Quotations Section – B Short type answer questions 1. Give the four functioning of option markets.

2. Mention about the some related concepts of option markets.

3. Give the details of Interest rate swap.

4. What are the various types of interest rate swaps?

5. Explain contract specifications.

Section – C Long answer type questions 1. What are the factors affecting call option premium? Discuss 2. Explain speculating with put option.

3. What are the factors affecting the premiums of put option? Discuss 9.7. SUGGESTED READINGS 1. Multinational enterprises and economic analysis - Caves. R 2. International financial management - Madura Jeff 3. International financial management – A K Seth

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CHAPTER â&#x20AC;&#x201C; 10 FOREIGN INVESTMENT STRUCTURE

10.0. INTRODUCTION 10.1. THE INTERNATIONAL FINANCING DECISION. 10.2. CAPITAL BUDGETING FOR MULTINATIONAL CORPORATIONS 10.3. COST OF CAPITAL FOR OVERSEA INVESTMENT 10.4. QUESTIONS 10.5. SUGGESTED READINGS 10.0. INTRODUCTION When ever a foreign direct investment is proposed in a multinational corporation, the proposal is evaluated by means of capital budgeting analysis. Since there are two entities, the parent and the subsidiary, therefore the basic and important issue that is required to be addressed is that whether the capital budgeting exercise should be assessed from the parent's, or subsidiary's perspective. Some may argue that it should be evaluated from the subsidiary's perspective because it is responsible for administering the project and that it should be viable over there. But a counter argument is that when a parent is financing the project, then why it should be viewed from subsidiary's point of view.

As we know that the feasibility of the project may change if the perspective changes. This is because the net after tax cash inflows will change from the subsidiary to the parent. 'The after tax cash inflows are changed due to the following reasons.

10.1. THE INTERNATIONAL FINANCING DECISION The previous section provided a broad picture of the funding options open to a corporation in the global debt market. In the present section we proceed to analyse the various issues involved in the financing decision.

The issue of the optimal capital structure and subsequently the optimal mix of funding instruments is one of the key strategic decisions fora corporation. Our aim is to bring out the critical dimensions of this decision in so far as it involves international financing and examine the analytics of the cost-return tradeoff. The actual implementation of the selected funding programme involves several other considerations such as satisfying all the regulatory requirements, choosing the right timing and pricing of the issue, effective marketing of the issue and so forth. We only touch upon some of these aspects.

Exhaustive treatments can be found in specialist works on the subject such as Joshi (2001). Figure 19.5 presents a schematic view of the international financing decision.

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The optimal capital structure for a firm or in other words corporate debt policy has been a subject of a long running debate in the finance literature since the publication of the seminal paper by Modigliani and Miller (1958). The reader can consult any one of a number of texts on corporate finance to get a flavour of this controversy. We assume here that the firm has somehow resolved the issue of what is the appropriate level of debt it should carry.

Next comes the issue of the optimal composition of a firm's liability portfolio. The firm usually has a wide spectrum of funding avenues to choose from. The critical dimensions of this decision are discussed below.

1. Interest rate basis: Mix of fixed rate and floating rate debt.

2. Maturity: The appropriate maturity composition of debt.

3. Currency composition of debt.

4. Which market segments should be tapped?

Note that these dimensions interact to determine the overall character of the firm's debt portfolio.

For instance, long term financing can be in the form of a fixed rate bond or an FRN or short-term debt like commercial paper repeatedly rolled over. Each option has different risk characteristics. Further, the possibility of incorporating various option features in the debt instrument or using swaps and other derivatives can enable the firm to separate cost and risk considerations. Individual financing decisions should thus be guided by their impact on the characteristics of the overall debt portfolio such as risk and cost as well possible effects on future funding opportunities.

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Next let us address the question: "What should be the overall guiding principles in choosing a debt portfolio?" Giddy (1994) provides the following answer: "The nature of financing should normally be driven by the nature of the business, in such a way as to make debt-service payments match the character and timing of operating earnings. Because this reduces the probability of financial distress, it allows the firm to have greater leverage and therefore a greater tax shield. 19 Deviation from this principle should occur only in the presence of privileged information or some other market imperfection. Market imperfections that provide cheaper financing exist in practice in a wide range of circumstances".

Let us discuss this recommendation in a little more detail. What it seems to say is that there should some correspondence between, on the one hand, the sensitivity of the firm's operating cash flows to environmental risk factors such as exchange rates and interest rates and the sensitivity of debt-service payments to the same factors. Also, the time profile of debt-service payment should be similar to that of operating cash flows. Deviations from this are justified either when the firm possesses superior information so that' can "beat the market" or some market imperfection allows it to rise cheaper funding.

Let us see how this principle should be applied to the different dimensions of the borrowing decision mentioned above. Consider the choice between fixed and floating rate financing. Firms such as utilizes manufacturing firms etc. have relatively stable earnings or at least their operating cash flows are not hi sensitive to interest rate fluctuations. Such firms should naturally prefer fixed rate funding. On the of hand, financial institutions with floating rate assets would be natural floating rate borrowers. If a firm has stable revenues in US dollars, it can reduce the probability of financial distress by borrowing in fixed rate dollars. Companies undertaking long gestation capital projects should ensure those sufficient financing fixed terms are available for long periods and hence should prefer to stretch out their debt servicing obligations by borrowing for long-terms. A factoring company on the other hand should finance itself with short-term borrowings.

Note however that this principle should not be followed blindly. Suppose for instance that the yield curve is currently steeply sloping upward; a manufacturing firm is convinced (on the basis of superior information or analysis) that it will flatten out fairly soon. It may choose to borrow short-term and roll over such funding rater than lock itself into high-cost long-term debt. Or consider another example. Borrowing cost for Swiss franc loan is 5% whereas a dollar loan would cost 9%. The UIP condition tells us that this reflects market's expectation that the CHF is likely to appreciate with respect to the dollar at roughly 4% per annum. A firm has export revenues in dollars but believes that the strength of the CHF is overestimated. It may choose to borrow in Swiss francs despite the additional exposure it is subjecting itself to.

Sometimes, such a decision may be motivated by considerations of market access or special factors such as availability of concessional finance from state. supported export finance agencies. At other times, some peculiar features of tax legislation may render borrowing in a particular currency more attractive even though the firm has no natural hedge against fluctuations in that currency. 20 There have been

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cases where firms have been able to raise cheap funding by offering the investors some options embedded in the debt instrument which were otherwise inaccessible to them because of regulatory restrictions. 21 Recall the discussion in Chapter 16 where we saw that many swap deals are motivated by the various imperfections in global capital markets which allow a borrower to tap one market and then swap the liability to achieve the desired structure.

Overriding these considerations are issues of regulation and market access. Governments in some countries impose restrictions which prevent a firm from tapping a particular market segment even though that may be the optimal borrowing route under the circumstances. For instance, during the first half of 1990's Indian government decided to discourage recourse to external debt finance and in particular did not permit short-term borrowing in foreign currency. On the other side, a particular market segment may be closed to a firm either because of its inadequate credit rating, investor unfamiliarity or inability of the firm to meet all the requirements—accounting standards, disclosure etc.—specified by the regulatory agency supervising the market.

In viewing the risks associated with funding activity, a portfolio approach needs to be adopted.

Diversification across currencies and instruments enables the firm to reduce the overall risk fora given funding cost target. It also helps to increase investors' familiarity with the firm which makes future approaches easier.

Finally, it should be kept in mind that currency and interest rate exposures arising out of funding decisions should not be viewed in isolation. The firm should take a total view of all exposures, those arising out of its operating business and those on account of financing decisions.

In evaluating a particular borrowing alternative the following parameters have to be examined under alternative scenarios. (a) The all-in cost of a particular funding instrument. The term "all-in" means that among the costs should be included not just the interest but all other fees and expenses. We will illustrate below how to compute the all-in cost fora specific funding alternative. (b) Interest rate and currency exposure arising from using a particular financing vehicle. Floating rate borrowing or short-term borrowing repeatedly rolled over exposes the firm to interest rate fluctuations. In the latter case even the spread the firm will have to pay over the market index becomes uncertain. On the other hand, a long-term fixed rate borrowing without a call option locks the firm into a given funding cost so that the firm is unable to take advantage of falling rates. Funding in a foreign currency exposes the firm to all forms of currency exposure—transactions, translation and operating,

10.2. CAPITAL BEDGETING FOR MULTINATIONAL CORPORATION A REVIEW OF THE NEW APPROACH Consider the well known Net Present Value (NPV) formula widely used in evaluating domestic investment projects

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Here, Co is the initial capital cost of the project incurred at t = 0 and CFt is the net cash flow from the project at the end of period t. Each cash flow CFt is discounted by the discount factor (1 + k,,,)t where k,. is the weighted average cost of capital defined by k,, = a k, + (I â&#x20AC;&#x201C; a)(I â&#x20AC;&#x201C; -c)kd In this equation, k, is the cost of equity capital, kd is the pre-tax cost of debt, t is the corporate tax rate and a is the proportion of equity finance for the projects.

Keep in mind that the cash flows in the numerator of Eqn (20.1) must be incremental cash flows attributable to the project. This means among other things that (1) Any change in the cash flows from some of the existing activities of the firm which arise on account of the project must be attributed to the project3 (2) Only net increase in overheads which would be on account of this project should be charged to the project.

The virtue of the simple formula, Eqn (20.2) is that it captures in a single parameter viz. k,,, all the financing considerations allowing the project evaluator to focus on cash flows associated with the project.

The problem is, there are two implicit assumptions. One is that the project being appraised has the same business risk as the portfolio of the firm's current activities and the other is that the capital structure of the project viz. the debt-equity proportion in financing the project is same as the firm's existing debt-equity ratio.4 If either assumption is not true, the firm's cost of equity capital, k, changes and the above convenient formula gives no clue as to how it changes. Thus even in a purely domestic context, the standard NPV approach has limitations.

The Adjusted Present Value (APV) approach seeks to disentangle the effects of particular financing arrangements of We project from the NPV of the project viewed as an all-equity financed investment. In the next section, we will briefly review this approach for purely domestic projects before extending it to foreign ventures.

The Adjusted Present Value (APV) Framework: The APV framework6 described below allows us to disentangle the financing effects and other special features of a project from the operating cash flows of the project. It is based on the well-known value Additivity principle. It is a two-step approach: 1

In the first step, evaluate the project as if it is financed entirely by equity. The rate of discount is the required rate of return on equity corresponding to the risk class of the project.

2

In the second step, add the present values of any cash flows arising out of special financing features of the project such as external financing, special subsidies if any and so forth. The rate of discount used to find these present values should reflect the risk associated with

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each of the cash flows.

Consider for a moment a purely domestic project. It requires an initial investment of Rs 70 million of which Rs 40 million is in plant and machinery, Rs 20 million in lands and the rest is in working capital.

The project life is five years. The net salvage value of plant and machinery at the end of five years is expected to be Rs 10 million and land is expected to appreciate in value by 50%. The projected cash flow statement is laid out in Table 20.1. (For simplicity we have used straight line depreciation of fixed assets including land. The rate is 20% for plant and 10% for land).

The cash flows (Rs in million) from the project are thus: Year:

0

Cash Flow: (70.0)

1

2

3

4

5

22.0

23.2

31.0

31.0

81.0

The firm estimates that the required rate of return on an all-equity financed project is 20%. The NPV of the above cash flows at a rate of discount of 20% is Rs 24.91 million. The gross present value (GPV) is Rs 94.1 million.

Now suppose, the firm estimates that based on the GPV of 94.1 million, it can raise fresh debt of Rs 30 million. Since interest payments on debt are tax deductible, the present value of tax savings must be attributed to the project. In general, the additional borrowing capacity is given by AB = TDE x GPV Here TDE is the target Debt: Equity ratio. If the pre-tax cost of debt is RD and the tax rate is r, the tax saving in each year equals: (RD x r)-AB = (RD x r)(TDE x GPV) The PV of this is and using a discount rate equal to RD. In the present example suppose RD is 15%.

Then with Rs 30 million of added borrowing capacity, the annual tax saving is (0.15 x 0.40)(30) = Rs 1.8 zn million. The-present value at 15% discount rate is Rs 6.03 million.

Cash Flows from the Proposed Project (Rs in million) Year 0

1

2

3

4

1.

Plant and Machinery

(40.0)

2.

Land

(20.0)

3.

Working capital

(10.0)

4.

Revenues,

50.0

60.0

80.0

80.0

80.0

5.

Costs (Other than Depreciation)

20.0

28.0

45.0

45.0

45.0

6.

Depreciation

10.0

10.0

10.0

10.0

10.0

7.

Profit before tax

20.0

22.0

35.0

35.0

35.0

8.

Tax(@40%)

8.0

8.8

14.0

14.0

14.0

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Profit after Tax

12.0

192 13.2

10. Net Salvage value of fixed

21.0

21.0

21.0 40.0

assets 11. Recovery of working capital

10.0

Further suppose that the project would be located in a backward area and the government provides a cash subsidy of Rs 5 million. The firm will have to raise new equity at an issue cost of Rs 2 million. The APV of the project is therefore, 24.91 + 6.03 + 5.00 - 2.00 = 33.94.

However, there are a couple of difficulties with this approach, in particular with computation of tax savings on account of increased borrowing capacity. First, we have assumed that the firm will be able iď&#x20AC;´ utilize the tax shield fully in every year; this may not be true if in a particular year the profit after inters-A is negative. Even if the tax shield is carried forward, it still represents loss of time value of money. Seccq).i we have considered taxation only at the corporate level. Taxation is a complicated topic. Taxation of dividends received by the shareholders at personal level may offset some of the benefits of tax saving at the corporate level; interest income may be taxed differently than dividend income and capital gains: shareholders may obtain credit for taxes paid at the corporate level. When the firm's shareholders and creditors are subject to diverse tax regulation, it is difficult to figure out who gets what share of the interest shield.

The very fact that interest is tax deductible will motivate creditors to capture a part of the saving by raising the pre tax rate they demand on their lending. In general, the calculation of the interest tax shield as presented here probably represents an overestimate of the true benefit from added borrowing capacity.

The essence of the APV approach is to separate out the investment and financing aspects of a project. As we will see below, this principle enables us to use a stepwise approach to evaluation of foreign projects.

International Project Appraisal with bullet repayment. If the firm's borrowing cost in the Zimbabwean market is say 15%, the loan adds to the project's NPV. This is found by discounting the cash outflows related to the loan at a discount rate of 15% and subtracting the discounted value from the face value of the loan viz. Z$ 5 million.

Note that so far we have done all computations in Zimbabwean dollars. The project must be valued from the point of view of the parent firm's shareholders. To do this we must compute the NPV of all cash flows which will accrue to the parent, valued in parent's functional currency. One modification immediately needed is to apply the withholding tax to all cashflows remitted to the parent. In addition, we must resolve the issues of exchange risk and the appropriate discount rate. As we will see below, the choice of discount rate depends upon the extent of integration of the capital markets of the home and host countries, a topic that was discussed in Chapter 18.

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10.3. EXCHANGE RATE RISK AND COST OF CAPITAL Valuing Foreign Currency Cash flows: First consider the problem of valuing risk-free cash flows in foreign currency. There are three possible methods: 1. Find the present value of the cash flows in terms of foreign currency and translate at today's spot rate.

Thus if FCF, is the cash flow at time t and rF is the risk-free foreign currency discount rate, the home currency PV is [TFCFt/(l + rF)']SO Where so is today's spot rate in terms of units of home currency per unit of foreign currency.

2. Translate each cash flow FCF, at the forward rate Fo,, and discount at the home currency risk-free discount rate. The PV is given by (F0,t)(FCFt)1(I + rH)t 3. Translate at the expected spot rate EO(S) and discount at a home currency discount rate that reflects exchange risk. 10 [EO(S,)](FCFt) l (l + rH)t Where r, is the risk-adjusted home currency discount rate.

All the three methods would yield identical results if the home and host country capital and money markets are free and integrated." When the markets are segmented (1) and (2) cannot be used. It may happen that a project which is financially viable when evaluated from the local point of view is not acceptable from the parent point of view or vice versa—a project may not be viable from the local point of view but appears acceptable from the parent point of view. We will demonstrate this with some simple numerical examples. (a) Consider first the case where global capital markets are fully integrated, investors are risk neutral and all the parity conditions—Purchasing Power Parity (PPP), Covered Interest Parity (CIP) and Uncovered Interest Parity (UIP)—hold continuously. Suppose an Indian firm is considering a project in Shangri-La with the following cash flows measured in Shangri-La dollars (SGD) million Year

0

1

2

Cash Flow

–50

40

60

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Recall from Chapter 18 the teethed for obtaining the risk premium for exchange risk. The equivalence of (1) and (2) can be obtained from the interest parity condition. Equivalence of (2) and (3) is due to the fact that with free and integrated money markets. The forward rate is the markers certainty— equivalent of the future spot rate.

Suppose the risk free real rates in India and Shangri-La are 5% p.a., the inflation rate in India is 5% p.a. while inflation in Shangri-La is 10% p.a. The nominal risk free rates are 10.25% in India and 15.50% in Shangri-La. The current SGD/INR exchange rate is 0.2000 (i.e. 5.00 SGD per INR) while the one and two year forward rates are 0.1909 and 0.1822. These in turn equal the spot rates expected at the end of year 1 and 2 respectively. The project evaluated from a local point of view yields an NPV of SGD {-50 + (40.0/1.1550) + [60.0/(1.1550)]) million = SGD 29.61 million Translated into parent currency using the current spot rate this gives an NPV of INR 5.92 million.

Now let us translate each SGD cash flow into its INR equivalent using the appropriate forward rate which also equals the expected spot rate at the relevant time and discount these using the risk free nominal rate in India. This yields an NPV of

1(-50.015.0) + [(40.0 x 0.1909)/(1.1025)] + [(60.0 x

0.1822)/(1.1025 )] = INR 5.92 million This shows that when global capital markets are perfectly integrated and all the parity conditions are satisfied, evaluation of projects can be, done from either local or parent perspective. (b) Now consider the case when there are capital controls in place which segment the international capital markets. In particular, suppose the government of Shangri-La has imposed capital controls which government the real rate of interest in Shangri-La. The inflation rates in India and Shangri-La are, as before, 5% and 10% p.a., the real risk free rate in India is 5% but that in Shangri-La is 10%. The risk free nominal rates are therefore 10.25% in India and 26.50% in Shangri-La. The forward rates are 0.1743 and 0.1519. However, due to capital controls and intervention on the part of Shangri-La’s central bank the SGD is expected to remain at 0.20 INR. Consider a project in Shangri-La with the following net cash flows (SGD million): Year

0

1

–50

30

40

2

Using a discount rate of 26.50%, the NPV of these cash flows is f-50 + (30/1.2650) + [40/(1.2650)1) million SGD = –1.29 million SGD Hence from a local perspective, the project is unviable. Now translate these SGD cash flows into their INR equivalents using the expected spot rate of 0.20 INR per SGD through the life of the project and discount the resulting INR cash flows using a discount rate of 10.25%. The cash flows are (-10, 6, 8) million INR and the NPV is INR 2.02 million. Thus it appears that the project is acceptable from parent perspective.

This would be a misleading conclusion. In accepting the project, the parent would really be hop-

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ing to make speculative gains by betting on the SGD/INR exchange rate. Instead it should look for projects which are viable from local perspective and undertake speculation directly via financial markets if permitted by exchange controls. For instance it should buy SGD forward at the markets' quoted forward rates hoping to sell back at the expected spot rate of 0.20. Of course it is possible that Shangri-Laâ&#x20AC;&#x2122;s exchange controls would not permit such transactions and hence there would be an incentive for foreign firms to achieve the same result via direct investments. (c) The opposite case is easy to construct. Consider a Shangri-La firm contemplating a direct investment project in India under the same circumstances as in case (b) above. Suppose the cash flows from the project are (-10, 6, 8) million INR. With a discount rate of 10.25%, this yields an NPV of INR 2.02 million from the local perspectiveâ&#x20AC;&#x201D;which now is the Indian perspective. Translated into SGD at the expected spot rate of 0.2000 INR per SGD, these cash flows would be (-50, 30, 40) million SGD. With a discount rate of 26.50%, the NPV works out to be -1.29 million SGD. It appears that the project is viable from the local point of view but not from parent point of view. What should the Shangri-La firm do?

The answer is that it should try to acquire local financing for the project. Suppose it can borrow INR 12.02 million at 10.25% in India. It can finance the project construction with INR 10 million out of this and immediately remit the rest to the parent company. It invests the first year's net cash flow at 10.25%. At the end of two years it has INR 14.61 million, which is enough to pay-off its two year loan.

These simple examples bring out the crucial point that when global capital markets are segmented and parity conditions are violated, the correct procedure is to value the project from parent perspective allowing explicitly for exchange rate risk. Also note that in these examples we had assumed away the project's business risks by assuming the projects cash flows in local currency to be risk free.

The problem becomes more complicated when the firm must take into account project-specific risks in addition to the exchange rate risk. We now turn to these issues.

When parity conditions are violated,' exchange rate forecasting then becomes necessary and so does estimation of risk-adjusted required rate of return rH. Neither task is very easy.

Next consider the case where the foreign currency cashflows are risky. Suppose in the case of the Titus watch project, the sales revenues depend upon the state of the economy in Zimbabwe. Cash flows to parent measured in rupees are subject to the further risk of exchange rate fluctuations. Table 20.3 below shows an illustrative calculation. Suppose we are estimating the cash flow in year 4.

Depending upon whether the Zimbabwean economy is in a state of boom or recession, the sales will be 7,00,000 or 5,00,000 watches. The probability of a boom is estimated to be 60% and of a recession 40%.

Exchange rate uncertainty is captured in two possible values of the Rs /Z$ exchange rate - Rs 7.5/Z$ and Rs 5.5/Z$-each with a 50% probability. It is assumed that recession is more likely when the Zimbabwean currency is ruling high.

Thus high joint probability of a boom with Rs/Z$ at 7.5 is only 10% while the joint probability of a

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boom with Rs/Z$ at 5.5 is 50%. Joint probabilities of a recession are 0.30 (Rs/Z$ = 7.5) and 0.10 (Rs/Z$ = 5.5) respectively.

After-Tax Cash flow (Z$ million) Boom

Recession

(prob. = 0.6) 13.8

(prob. = 0.40) 10.5

Cash Flow Translated to Rupees (Million) Z$/Rs 7.5

103.5

(prob. = 0.5)

78.75

(prob. = 0.1) (prob. = 0.3)

Z$/Rs 5.5

75.9

(prob.= 0.5)

(prob.= 0.5)

57.75 (prob.= 0.1)

Once again, with integrated capital markets and validity of parity conditions, we can discount the expected foreign currency cash flow, Zimbabwe dollars [0.6 x 13.8 + 0.4 x 10.5] million, using a discount rate which equals the rate of return required by Zimbabwean investors from similar projects and translate into rupees at the current spot rate. In obtaining this discount rate we must employ the international CAPM discussed in Chapter 18 which takes account of the covariance of the project with the world market portfolio and the Rs/Z$ exchange rate.

If host and home country capital markets are segmented this procedure cannot be employed. The expected value in home currency, of a risky foreign currency cash flow at a future date is given by E,(CFHT) = E,(CFFT) x E,(ST) + cov[CFFT, ST] Here CFHT denotes the home currency value of the cash flow which will occur at time T, CFFT is its foreign currency value and ST is the spot rate at time T. All the three are random variables, E, is the expectations operator and "cov" denotes covariance. In the example given above the expected value is (103.5 x 0.1) + (75.9 x 0.5) + (78.75 x 0.3) + (57.75 x 0.1) = Rs 77.7 million To estimate this, we need forcasts of future spot rate and an estimate of the covariance between the spot rate and the foreign currency cash flow. This has to be discounted at a rate equal to the rate of return required by home currency investors on similar projects. This must be estimated with a single-country CAPM augmented by exchange risk.

Thus the main issue involved in handling exchange rate risk and choice of a discount rate is the degree of capital market integration. Since in the case of most developing countries, capital market integration has not proceeded very ~far, evaluation of foreign projects involves formidable difficulties.

Reliable exchange rate forecasts are notoriously difficult to obtain; the only guideline available for longrun exchange rate forecasting is the purchasing power parity doctrine. However, as we have seen in Chapter 11, its empirical validity is far from firmly established. Linking the performance of the project with the exchange rate is no less difficult. If the project is intended to serve not only the host country market

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but also third-country markets, the issues are still more complex since the performance of the project now depends upon several exchange rates and not just the home country-host country exchange rate. Finally, the appropriate risk premium to be added for exchange risk is far from easy to estimate in practice.

International taxation introduces further complications. Treatment of dividend income by home country government, withholding taxes, treatment (by host and home country tax authorities) of other forms of transfers such as interest, 7,, royalties, etc. between the subsidiary and the parent, existence or otherwise of double taxation avoidance treaties and their scope, the possibility of using transfer prices which are different from arms-length prices are all highly complex issues best left to the specialists in this area.

In practice, firms use their all-equity required rate of return and add a risk premium which is supposed to reflect not only exchange risk but also other risks such as political or country risk and in some cases also the fact that the firm may be totally unfamiliar with the host country and may have to incur additional costs. 12 This is a rather arbitrary procedure. Some kinds of political risks are insurable, and a better way to incorporate them is to debit the insurance premium to the project. Similarly, while foreign projects are subject to exchange risk, they also yield some diversification benefits to the parent.

An arbitrary risk premium may err on the conservative side and result in the parent firm foregoing potentially high NPV projects. In general, some risks are better accounted for by adjusting the project cash flows rather than the discount rate. Lessard (1996) provides taxonomy of the various risks which need to be taken into account in appraising a foreign project and discusses the issues involved in incorporating them via discount rate adjustments versus adjustments to the cash flows.

Despite these theoretical considerations, it appears that multinational corporations continue to use the discount rate adjustment procedure. 13 Given the conceptual difficulties involved in the estimation of the "correct" discount rate this is not difficult to understand. Section 20.7 contains a brief discussion of how practitioners approach the task of evaluating foreign direct investment projects and in particular estimation evaluating foreign direct investment project and in particular estimation of the appropriate cost of capital for such projects. We will see that given the enormous conceptual and empirical difficulties involved in extending the CAPM to international context and incorporating exchange rate risk most practitioner use some ad-hoc procedure of adding a risk premium to the cost of capital used for domestic projects.

Options Approach to Project Appraisal: The discounted cash flow approaches discussed aboveâ&#x20AC;&#x201D;whether NPV or APVâ&#x20AC;&#x201D;suffer from a serious drawback. Both ignore the various operational flexibilities built into many projects and assume that all operating decisions are made once for all at the start of the project. In many situations the project sponsors have the freedom to alter various features of the project in the light of developments in input and output markets, competitive pressures and changes in government policies. Among these flexibilities are:

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1. The start of the project may be delayed till more information about variables such as demand, costs, exchange rates, etc. is obtained. For instance starting a foreign plant may be postponed till the foreign currency stabilizes. Development of an oil field may be delayed till oil prices harden. For instance consider a project to develop an oil field. The current oil price is $15 a barrel and the project NPV is $10 million. In one year's time the oil price may rise to $30 or fall to $10. The NPV of the project then would be either $18 million or -$10 million. By delaying the start of the project the firm can add greater shareholder value avoid getting locked into an unprofitable project.

2. The project may be abandoned if demand or price forecasts turn out to be over-optimistic or operating costs shoot up. It may even be temporarily closed down and restarted again when market conditions improve e.g., a copper mine can be closed down when copper prices are low and operations re-started when prices rise. Some exit and re-entry costs may of course be involved.

3. The operational scale of the project may be expanded or contracted depending upon whether demand turns out to be more or less than initially envisioned.

4. T4e input and output mix may be changed or a different technology may be employed.

The conventional DCF approaches cannot easily incorporate these features. In recent years the theory of option pricing has been applied to project appraisal to take account of these operational flexibilities. For instance, the option to abandon a project can be viewed as a put optionâ&#x20AC;&#x201D;the option to sell the project assetsâ&#x20AC;&#x201D;with a "strike" price equal to the liquidation value of the project. The option to start the project at a later date can be viewed as a call option on the PV of project cash flows with a strike price equal to the initial investment required for the project. Similarly, the option to expand capacity if demand turns out to be higher than expected can be viewed as a call option on the incremental present value with the strike price being equal to the additional investment required to expand capacity.

In many cases, these choices can be incorporated and evaluated using a decision tree approach; in other cases option pricing models such as the Black-Schools model and its refinements can be employed.

In the appendix to this chapter, we will illustrate the basic principles of the options approach with a highly simplified example. An introductory exposition is available in Buckley (1996). A comprehensive but advanced treatment can be found in Trigeorg is (1996).

The Practice of Cross-Border Direct Investment Appraisal: How do practitioners approach the problem of appraising investment projects in foreign countries? Some survey results have been reported which seem to indicate that many participants use DCF methods with some version of asset pricing model to estimate the cost of capital but make lot of heuristic adjustments i,: the discount rate to account for political and exchange rate risks.

In a recent paper Keck, Leven good and long field (1998) have reported the results of a survey of practitioners pertaining to the methodologies they employ to estimate cost of capital for international investments. Their findings can be broadly summarized as follows:

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1. A large majority of practitioners employ DCF as at least one of the methods for valuation.

2. Most practitioners are de facto multi-factor model adherents. More segmented the market under consideration greater is the number of additional factors used in valuation. Even those who claimed to use the single factor CAPM include more than one risk factor proxies.

3. The use of local market portfolio as the sole risk factor is less frequent when the evaluator is dealing with countries which are not well integrated into the global capital markets. However, they then add other risk factors rather than using the global market portfolio. For integrated markets such as the US or the UK, global market portfolio is used more frequently.

4. In the case of less integrated markets like Sri Lanka or Mexico, exchange risk, political risk (e.g. expropriation),,,sovereign risk (e.g. Government defaulting on its obligations) and unexpected inflation are considered to be important risk factors in addition to market risk.

5. Most practitioners adjust for these added risks by adding ad-hoc risk premia to discount rates derived from some asset pricing model rather than incorporating them in estimates of cash flows. This goes against the spirit of asset pricing models which are founded on the premise that only no diversifiable risks should be incorporated in the discount rate.

Godfrey and Espinosa (1996) present a "practical" approach to computing the cost of equity for investments in emerging markets. It essentially involves starting with the cost of equity for similar domestic projects and adding on risk premia to reflect country risk and the total project risk. The former is estimated by looking at the spreads on dollar denominated sovereign debt issued by the host country government and the latter by the volatility of the host-country stock market relative to the domestic stock market. For details the reader is referred to the original article.

International Joint Ventures: The previous section dealt with the case of a foreign wholly owned subsidiary. A more common form of cross-border investment is joint venture and other modes of alliances between a firm in the host country and a foreign firm. The purpose of this section is to briefly discuss some key issues in evaluation of joint venture projects.

Over and above the pure economics of the joint venture project, the most crucial issue is the sharing of the synergy gains between the partners. Two or more partners join in a venture only because they have strengths that complement each other, in terms of technology, distribution, market access, brand equity and so forth. The joint venture is expected to yield gains over and above the sum of the gains each partner can obtain on its own.

Game-theoretic models of bargaining suggest that the synergy gains should be split equally. 14 One way of achieving this is proportional sharing of project cash flows. Thus of the two partners, A brings in 30% of the investment and B the remaining 70%, cash flows should be shared in the same proportion.

This conclusion however needs modification when the two partners are subject to different tax regimes and tax rates.

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Fair sharing of synergy gains can also be achieved by other means. Thus a properly designed license contract wherein the joint venture pays one of the partners a royalty or license fee for "know-how" can achieve the same result as proportional sharing of cash flows. Alternatively, one of the partners brings in some intangible asset (e.g. a brand name) the value of which is negotiated between the partners.

The topic of valuation of a joint venture under these different arrangements and related tax complications is not pursued here. The interested reader can consult Sercu and Uppal (1995) and the references cited therein.

Long-Term borrowing in the Global Capital Markets 571 investors by issuing their own paper.

Investor preferences shifted towards short term commitments. Due to enforcement of capital adequacy norms and intense competition in the traditional business of taking deposits and making loans, banks started looking around for ways of making money without inflating their balance sheets. The combined result of these factors was the emergence of whole new ways of arranging funding for borrowers with good track record and reputation. Note Issuance Facilities (NIFs) and its variants was one of them.

According to the BIS definition, "A NIF is a medium-term legally binding commitment under which a borrower can issue short-term paper in its own name, but where underwriting banks are committed either to purchase any notes which the borrower is unable to sell, or to provide standing credit" [Joshi (2001)]. The borrower obtains medium-term funding by repeatedly rolling over its short-term notes. If at any rollover the borrower is unable to place the entire issue with the market, the underwriting banks either take up the remainder or provide a short-term loan. The arrangement under which the banks provide credit to make up the shortfall is known as a Revolving Underwriting Facility (RUF).

Cost of funding with an NIF includes interest and participation and underwriting fees where relevant. The interest rate is set 17 pt as a margin over LIBOR. 1 number of flexible structures emerged after the NIF made its entry in 1981. These relate to different ways of "placing" the notes with the investors sole placing agency, tender panel system and continuous tender panel. For details of these arrangements as well as the mechanics of issue, documentation etc. the reader is advised to consult Joshi (2001). Another innovation was the Multi Option Facility (MOF). Under this the borrower could draw funds in a number of different ways as a part of a given NIF programme. With the imposition of capital adequacy norms against such commitments as well as thinning fees, NIFs and related devices have lost their popularity.

10.4. QUESTION Section â&#x20AC;&#x201C; A Very short answer type questions 1. What is Multinational Corporation?

2. Give the expansion of APV.

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INTERNATIONAL FINANCE MANAGEMENT 3. What is NPV? 4. What is GPV? 5. Give the meaning of cost of capital.

Section – B Short type answers questions.

1. Mention about the valuing foreign currency cash flows.

2. Describe BIS and details.

3. What are the foreign currency cash flows?

Section – C Long type answer questions 1. Discuss cross border direct investment appraisal.

2. Explain international joint ventures.

3. What are the adjusted present value frameworks? discuss

10.5. SUGGESTED READINGS 1. Multinational enterprises and economic analysis - Caves. R 2. International financial management - Madura Jeff 3. International financial management – A K Seth

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CHAPTER – 11 INTERNATIONAL FINANCING STRUCTURE 11.0

INTRODUCTION

11.1

INTERNATIONAL FINANCING

11.2

INTERNATIONAL DEBT INSTRUMENTS

11.3

PROJECT FINANCE

11.5

QUESTIONS

11.6

SUGGESTED READINGS

11.0. INTRODUCTION When ever a foreign direct investment is proposed in a multinational corporation, the proposal is evaluated by means of capital budgeting analysis. Since there are two entities, the parent and the subsidiary, therefore the basic and important issue that is required to be addressed is that whether the capital budgeting exercise should be assessed from the parent's, or subsidiary's perspective. Some may argue that it should be evaluated from the subsidiary's perspective because it is responsible for administering the project and that it should be viable over there. But a counter argument is that when a parent is financing the project, then why it should be viewed from subsidiary's point of view.

11.1 INTERNATIONAL FINANCING The world is emerging as a global economy because of flow of goods, services and capital for each transaction of goods and services there is corresponding currency transaction which forms a part of international net work of payments. All these activities concerning international payments either as a payment for a transaction in commodities or services, transfer payments, or international borrowing or lending form a part of the study of international finance.

11.2. INTERNATIONAL DEBT INSTRUMENTS Debt management, whether at the domestic or international level, is part of the company’s armory of techniques which is designed to maximize the present value of shareholder wealth. It is often speculated that the key determining factors are as follows: 1. The amount of business risk affecting the firm.

2. The ability of the firm to service debt, in terms of interest payments and capital repayments, under varying scenarios regarding future outturns.

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3. The limits imposed by financiers’ lending policies and practices.

4. The perceived norm for the sector.

5. The firm’s historic track record in terms of debt raised and the volatility of its earnings.

Beyond the debt / equity ratio, there are a number of factors include maturity profile, fixed / floating interest mix, interest rate sensitivity and currency mix.

Long-term assets should be funded by long-term finance; short-term assets would logically be backed by short-term funds. In terms of maturity profits of debt, the treasurer is well advised to ensure that repayments of borrowings are evenly spread. This reduces exposure to repayment vulnerabilities, which may be magnified due to unforeseen recession. Short-term debt is riskier than long-term debt.

Long-term interest rates are generally more stable over time then short-term rates. The firm which borrows predominantly on a short-term basis may experience widely fluctuating interest rate payments.

Short-term borrowings have to be renewed regularly. The interest rate on a fixed rate loan is fixed for the entire life of the loan regardless of changes in market conditions. A floating rate loan is one where the interest rate varies in line with the market. The loans are usually made at an agreed margin over a published market rate. This may be a clearing bank’s base rate for sterling or prime rate for US dollar, or LIBOR (London inter-bank offered rate) for term loans whether in sterling, dollars or Eurocurrency, and so on.

(A) Short-term borrowing: Short-term debt is defined as borrowings originally scheduled for repayment within one year. A wide range of short-term debt finance is available. Trade credit is the major source. In its normal transactions, the firm buys raw materials on credit from other firms. The debt is recorded as trade creditors in its books of account. This is a customary aspect of doing business in most industries. It is a convenient and important source of financing for most no financial companies.

The next most frequent form of short-term finance, at least in the UK, is the overdraft. An overdraft is a credit arrangement whereby a bank permits a customer to run its current account into deficit up to an agreed limit. The overdraft is flexible and is for providing seasonal working capital. Bankers like to see overdrafts run down to zero at some point during the year. Nowadays companies tend to finance some of their core borrowing needs by overdraft. The overdraft borrower is at liberty to operate within the established limit and to repay and redraw any amount at any time without advance notice or penalty.

The interest charged is usually on an agreed formula, such as between one and four or five percentage points above the bank’s base rate. The size of this spread depends on the credit rating of the borrower.

Turning now to money-market sources of short-term debt, the domestic sterling inter-bank market provides a source of corporate borrowing. In this market, the corporate customer obtains very competitive borrowing and deposit rates. The interest rate is usually based on a margin over LIBOR. Large companies may obtain funds at LIBOR or at a very small spread over LIBOR. Transactions are for fixed

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terms, which can be anything from overnight to twelve months.

Sterling eligible bills – or bankers’ acceptances are bills of exchange and they are the oldest instrument in the UK money market. The purpose of the UK bill market is to provide trade finance.

Acceptances are issued on a discounted basis. Clearly, the true cost of borrowing is higher than the nominal discount rate. If the discount rate plus commission is quoted as 15 ½ per cent, this amounts to a true rate of interest of well over 16 ¼ per cent. The procedure for companies wishing to use this market is to discount the bills with an accepting bank. The bill will be discounted at the eligible bill rate. The accepting bank receives an acceptance commission for discounting the bill. The bank pays the proceeds of the discounted bill to the company’s bank account. Once the accepting bank receives the bill, it will endorse it. The bank may either hold it for its own trading purposes or rediscount it with a discount house.

On maturity, the company – or its agent – pays the face value of the bill to the holder at that firm.

Another source of short-term funds is borrowing via commercial paper – basically an IOU. Since April 1986 there has been a market in sterling commercial paper. This paper is in the form of unsecured promissory notes. Its duration is from 7 to 364 days. There are strict rules about which corporations can, and cannot, issue sterling commercial paper. The virtue of this market to the company is endorsed by the fact that a top rate corporation may raise money at around five basis points below LIBID, the London inter-bank bid rate, which is, of course, always less than LIBOR. Unlike US commercial paper, credit rating is not a prerequisite of issue in the UK. The greatest source of short-term funding in the USA is commercial paper.

B) Medium-term borrowing: Medium-term debt is defined as borrowings originally scheduled for repayment in more than one year but less than ten years. Until about fifteen year ago, European corporate treasures had few options when seeking to raise debt – the opportunities included overdraft or short-term bill discounting and longterm debentures and mortgages. This range of choice was poor compared to that confronting the treasurer in the USA, where there has always been an array of medium-term finance available. The expansion of US banks in the international arena aided by the colossal expansion of the Euromarkets and the widespread demise of exchange controls have meant that these financing techniques have been exported to European companies.

Nowadays, medium-term borrowing facilities are widely available. Repayment schedules are negotiable but the usual practice is to require periodic repayments over the life of the loan. The rationale of amortization is to ensure that the loan is repaid gradually over its life in equal instalments commensurate with corporate cash generation rather than falling due all at once. Medium-term loans are normally priced on a basis related to LIBOR. The spread over LIBOR depends on the credit standing of the borrower and the maturity of the facility. They normally vary between 0.25 and 2 per cent.

There are two types of fee associated with medium-term facilities. First, there is the commitment fee. The bank is usually committed to lend once the loan agreement is signed. This commitment fee is

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usually payable for the portion of the loan which is undrawn. The size of the fee may be ten to fifteen basis points.

When the facility is arranged via a syndication of banks, it is normal for the borrower to pay a management fee. The fee is similar to underwriting fees associated with public issues.

Euromarkets: Euro-dollar or Euro-currency markets are the international currency markets where currencies are borrowed and lent. Each currency has a demand and a supply in these markets. Thus, dollar deposits outside USA or sterling deposits outside UK are called off-shore funds and have a market so long as they are convertible and readily usable in international transactions.

Euro-currency market is a market principally located in Europe for lending and borrowing the world’s most important convertible currencies, namely, dollar, sterling, DM, French franc, yen, etc. On the same basis, the Asian currency market or the African currency market can also be defined. The Euromarkets are usually defined to include the markets for Eurocurrency, Euro credits and Eurobonds.

The Eurocurrency market is that market in which Euro banks accepts deposits and make loans denominated in currencies other than that of the country in which the banks are located. Eurodollars is that they are dollars held in the form of time deposits in banks outside the United States. EuroDeutschmarks are marks deposited in banks outside Germany. The prefix ‘Euro’- really means external and refers to funds that are intermediated outside the country of the currency in which the funds are denominated. The Eurocurrency market is made up of financial institutions that compete for dollar time deposits and make dollar loans outside the United States, plus IBFs, financial institutions outside Germany that bid for Deutschmark deposits and make Deutschmark loans, financial institutions outside the UK that bid for sterling deposits and loan sterling, and so on.

Definitions of key Eurocurrency terms: The Euromarkets are banking markets for deposits and loans. They are located outside the country of the currency in which the claims are denominated. Eurobonds are bonds denominated in currencies other than that of the country in which the bonds are sold – for example, dollar-denominated bonds in London or Deutschmark denominated bonds in Luxembourg. Euro banks are financial intermediaries that bid for time deposits and make loans in currencies other than of the country in which they are located. LIBOR, the London inter-bank offered rate, is the interest rate at which London Euro market banks offer funds for deposit in the inter-bank market. It is the most usually quoted base for Eurocurrency transactions. The interest cost to the borrower is set as a spread over the LIBOR rate.

Spreads over LIBOR have ranged from around 0.25 per cent to 2 per cent. There is, of course, a separate LIBOR for each of the many currencies in which inter bank loans are made in London.

Domestic and foreign banks taking deposits and lending in the currency of the country in which they operate are, in most financially sophisticated countries, required to hold asset reserves equal to a

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specified percentage of their deposit liabilities. This situation contrasts with that relating to Eurocurrency deposits. Eurocurrency holdings are not subject to reserve asset requirements.

Euro banks are therefore able to lend at more competitive rates than their domestic counterparts, since part of their portfolio of assets is not tied up in low interest- bearing reserve assets.

Euro credit lending is the medium-term market for Eurocurrency loans provided by an organized group of financial institutions.

Eurodollar deposits and loans: The most important distinction between the Eurodollar banking market and domestic banking is that Eurocurrency markets are not subject to domestic banking regulations. Euro banks may obtain same profit levels as domestic banks even though they achieve lower spreads on lending depositorsâ&#x20AC;&#x2122; funds than their domestic counterparts. The absence of reserve requirements and regulations enables Euro banks to offer slightly better terms to both borrowers and lenders.

Eurodollar deposit rates are higher, and effective lending rates a little lower, than they are in domestic money markets. The absence of regulations is the key to the success of the Eurocurrency markets.

Deep Euromarkets exist only in those currencies, such as the US dollar, the German mark and the pound sterling, that are relatively freely convertible into other currencies.

A Eurodollar deposit may be created and lent on in the manner set out below. A US corporation with $2 million surplus funds decides to take advantage of the more attractive Eurodollar rates on deposits relative to domestic dollars. The companyâ&#x20AC;&#x2122;s surplus funds were held originally in a time deposit with a demand deposit in the local US bank. The company transfers ownership, by payment, of the demand deposit in the local US bank to the US bank in London, where a time deposit is made. This process creates a Eurodollar deposit, substituting for an equivalent domestic time deposit in a US bank.

The London branch of the US bank deposits the cheque in its account in a US bank. The US Company holds a dollar deposit in a bank in London rather than in the USA. The total deposits of the banks in the USA remain unchanged. However, investors hold smaller deposits in the USA and larger deposits in London. The London Bank now has a larger deposit in the U.S.A. The increase in the London bankâ&#x20AC;&#x2122;s deposits in the US bank is matched by the increase in dollar deposits for the world as a whole.

The volume of dollar deposits in the USA remains unchanged, while the volume in London increases.

The London bank will not leave the newly acquired $2 million idle. If the bank does not have a commercial borrower or government to which it can lend the funds, it will place the $2 million in the Eurodollar inter bank market.

In the words, it will deposit the funds in some other Euro bank. If this second Euro bank cannot immediately use the funds to make a loan, it will redeposit them again in the inter-bank market. This process of red positing might proceed through several Euro banks before the $2 million finds its way to a

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final borrower. At each stage the next bank will pay a slightly higher rate than the previous bank paid. But the margins involved in the inter bank market are very small - of the order of 1/8 per cent. As a rule, larger, better-known banks will receive initial deposits while smaller banks will have to bid for deposits in the inter-bank market. This inter-bank red positing of an original Eurodollar deposit merely involves the passing on of funds from bank to bank. It does not, of course, add to the final extension of credit in the financial markets. Only when the $2 million is lent on to a corporation or a government is credit eventually and effectively extended. To evaluate the true credit-creation capacity of the Eurodollar market, inter-bank deposits have to be netted out. The ultimate stage in the credit-creating process occurs when a Euro bank lends funds to a non-bank borrower.

Loans made in the Euro market are similar to those made domestically by UK and US banks and so on. More lending is done on a corporate reputation or name basis, as it is sometimes called, to wellknown entities, with less credit investigation and documentation being involved than in domestic lending.

When the amount needed is greater than one Euro bank is prepared to provide, borrowers obtain funds by tapping a syndicate of banks from different countries Borrowers often have the option of borrowing in any of several currencies. Eurocurrency loans may be for short-term working capital or trade finance, or they may have maturities up to ten years. The latter would be called medium term Euro credits, although they are basically no different from their shortterm counterparts. When a Eurocurrency loan has a maturity of more than six months, the interest rate is usually set on a roll-over basis – that is, at the start of each three – or six – month period, it is reset at a fixed amount (e.g. 1 per cent) above the prevailing London inter-bank offered rate.

Eurocurrency deposits often carry interest rates of ½ per cent higher than domestic deposits and borrowers can obtain cheaper money in Euromarkets as opposed to domestic ones. So why do not all depositors and borrowers shift their business into the Eurocurrency market. One reason is the existence of exchange controls. Many governments make it difficult for depositors to invest abroad, and many restrict foreign borrowing by domestic companies. Another reason is the inconvenience and cost involved with maintaining balances or borrowing in a foreign country. Furthermore, the market is largely a wholesale one, and deals in sums of under $1 million are not available. Euro banks also prefer to lend to large, well-known corporations, banks or governments. But the most important difference is that Euro deposits, because they are located in a different country, are in some respects subject to the jurisdiction of the country.

11.3. PROJECT FINANCE Since early—eighties, specialized funding packages have been developed to finance large projects such as power projects, road construction, port and harbour development, hotels, theme park developments, etc. Two of the most famous such projects are the Euro tunnel linking France and England and the Euro Disney amusement park near Paris. A very comprehensive reference on project financing is

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Nevitt (1989). Polio (1999) also deals with project finance in addition to appraisal of international projects.

The central idea in project financing is to arrange a financing package which will permit the transfer or share, of various risks among, several parties including project promoters with a no recourse or limited recourse feature. The lenders evaluate the project as an independent entity and have claims on the cash flows generated by the project for their interest payments and principal repayments. They have no claims on any other assets or cash-flows belonging to the sponsors or promoters. The borrowing may be in one or more of the forms described above viz. bank loans, bond issues, etc.

In a pure project finance transaction, the lenders would naturally wish to monitor control all aspects of the execution and subsequent operation of the project till their money is recovered. For instance they will have a substantial say in the choice of the contractor(s) to build the project and may insist on giving the contract on a turnkey basis to a reputed construction firm to minimize construction delays. Also such limited recourse finance will generally be available only in cases where the lenders are satisfied that the project output has a ready market, assured supplies of raw materials, energy, etc. and are satisfied with the technological feasibility of the project. Some of these risks can be reduced or eliminated by devices such as unconditional take-or-pay contracts,18 requiring the project contractors to put in some equity stake into the project and bringing in export finance agencies who will finance part of the acquisition of project equipment.

In other cases, the lenders may require guarantees. An obvious choice of guarantor is the project's sponsors. This implies that the project's debt appears as a liability on the sponsor's balance sheet. In some circumstances, third party guarantees can be arranged e.g. from the government of the project's host country, user of the project's output, a major supplier to the project, the project contractor or a multilateral institution such as the World Bank or a regional development bank. A reputed financial institution may agree to provide a guarantee for a fee. Such guarantees cover a variety of risks. For some types of risks, insurance may be available. The guarantees need not always cover the entire borrowing but may be limited in amount or time of coverage. For instance, guarantees only to cover project cost over-runs or a guarantee which provides cover only till the start-up time. Depending on the nature of the project, lenders may be satisfied with such limited guarantees.

The sources of equity and debt finance for projects have been numerous. Commercial banks, institutional lenders, finance and leasing companies, project contractors, suppliers of raw materials and users of project output, multilateral institutions and government export financing agencies such as EXIM banks have all been involved in project finance.

An innovation in project finance is the BOT device which stands for Build, Own and Transfer (some times also called BOOTâ&#x20AC;&#x201D;Build, Own, Operate and Transfer). Under this arrangement, a foreign company undertakes to design, finance and construct the project, operate it for a specified number of years and then transfer the ownership to a local agency such as the host government. During the last few years, a number of projects in countries such as Turkey have been initiated using such a structure. See

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Barrett (1987) for a brief description of some BOT deals.

In the context of project finance, mention must be made of the concept of co-finance. Introduced by the World Bank in the mid-seventies, it refers to an arrangement in which funds provided by supranational development institutions such as the World Bank, the Asian Development Bank etc. are combined with other sources of external finance to fund a major project or programme. Apart from providing funds, the development institution also provides its expertise in appraising the project which the other providers of funds may not possess. The other sources of funds may be government departments, export credit agencies and private financial institutions. All the lenders poor their information and agree on a common set of procedures for appraising the project and subsequently administering the loan. There are a number of alternative forms of co-financing. The reader can consult Joshi (2001) for further details.

Project finance has become a very complex area in recent years. A variety of funding techniques, risk sharing strategies and risk management tools such as swaps and options are packaged together for a large project. Apart from Nevitt's work cited above, the interested reader may also consult the special supplement on project financing published by Euro money [Euro money (1988)].

This completes our brief survey of markets and instruments which potential borrowers can employ to raise medium and long term funding in the global debt markets. The reader is reminded that aside from these, medium term funding facilities related to exports of capital goods, project exports and so forth are also available. Some of these were discussed in the appendix to Chapter 4. It should also be kept in mind that the nature of all these markets and instruments is very dynamic. Different market segments undergo cycles of boom and bust. New products and variations of existing products are continually emerging_ Regulatory changes and changes in financial norms and practices keep these markets in a constant state of flux. Our treatment here is no more than an introductory perspective.

References cited at the end of the chapter will enable the reader to gain more in-depth knowledge of this topic. Even then, at any given point of time, the best source of up-to-the-minute knowledge and information are the practitioners who are operating in these markets on a day-to-day basis. In the Indian context, another aspect to bear in mind is the Indian government's regulatory stance on accessing these funding avenues. This too is subject to frequent changes. In the appendix to this chapter, we have provided the salient features of the most recent (July 1999) guidelines issued by the MOF, Government of India.

11.4. QUESTIONS Section â&#x20AC;&#x201C; A Very short type answers questions.

1. What is a short term borrowing?

2. What is medium-term borrowing?

3. Give the meaning of euro markets.

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4. Define the Eurocurrency.

5. What do you mean by Eurodollar deposits?

Section – B Short type answer question 1. Mention about the project finance 2. Explain Eurodollar deposit.

3. What is euro market and details?

Section – c Long type answers questions.

1. Explain medium term borrowings.

2. Discuss Eurocurrency 11.5. SUGGESTED READINGS 1. Alan C Shapiro, Multinational Financial Management (2002), Prentice-Hall of India, New Delhi.

2. Prakash G Apte, Global Business Finance, Tata McGraw-Hill Publishing Company Limited, New Delhi.

3. David K. Eiteman, Arthur I. Stonehill, Michael H Moffett, Multinational Business Finance, Addison Wesley Longman (Singapore) Pte. Ltd, New Delhi.

4. Prakash G Apte, International Financial Management, Tata McGraw-Hill Publishing Company Limited, New Delhi.

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CHAPTER â&#x20AC;&#x201C; 12 INTERNATIONAL ACCOUNTING AND REPORTING STRUCTURE 12.0. INTRODUCTION 12.1. IMPORTANT ISSUES OF MULTINATIONAL ACCOUNTING. 12.2. FINANCIAL REPORTING 12.3. INTERNATIONAL CONTROL SYSTEM AND PERFORMANCE EVALUATION 12.4. PERFORMANCE EVALUATION 12.5. PERFORMANCE MEASUREMENT 12.6. QUESTIONS 12.7. SUGGESTED READINGS

12.0. INTRODUCTION To maximize stock holder's wealth, finance manager performs three major functions (a) Investment decision, (b) financing decision, and (c) financial planning. All these functions cannot be performed effectively without timely accurate accounting information. The two financial statements of crucial importance are: (1) balance -heed and (2) the income statement. Balance sheet measures the assets and liabilities of the company at a particular point of time. The income statement measures the profit and loss of a company over a period of time. It is a flow statement and matches expenses to revenue during a period to determine net income.

Multinational companies have flow of assets across national boundaries therefore this complicates the accounting functions and process. The company must learn to deal with the complexity of multinational accounting environment. The complexities arise due to different inflation rates in various countries of subsidiaries and variations in exchange rates. A multinational company must evaluate the performance of its subsidiaries so that required rate of return may be provided to the shareholders of the company.

12.1. IMPORTANT ISSUES IN MULTINATIONAL ACCOUNTING The problems of accounting are complex because: 1. MNCs operate in many countries therefore these face multi-economic systems, the accounting practices which may be acceptable in one country and may not be acceptable in the other, and 2. Multi-operations have many special problems in accounting such as transfer pricing, taxes, tariffs, varying rates of inflation, segmented capital markets, inventory evaluation, etc. In this chapter, we

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discuss important issues in multinational accounting, financial reporting, consolidation of account and accounting information system.

12.2. FINANCIAL REPORTING Since multinational corporations operate in many nations therefore these make financial statements in different formats and forms of presentation. These also differ in details and disclosures.

Dual Reporting System Accountant International Study Group in US recommended that the primary and secondary financial statements be recognized as part of formal generally accepted accounting standard and principles. Primary financial statements are prepared in accordance with the accounting and reporting standards and practices of company's country of origin-. These statements are prepared in the language and currency of the country. Secondary financial statements are prepared according to the accounting and reporting standards of another country. These financial statements are translated into a foreign currency; they are expressed in the form commonly used in the foreign country.

If primary statements satisfy information requirements of financial reporting in other countries then secondary statements are not necessary. The dual system of accounting and reporting produces information of high quality. The dual accounting and reporting system poses problems in two situations: (a) when mergers and other investment decisions are made with an eye on the effects these decisions have on financial statements, and (b) translation gains and losses and the inventory valuation limit the validity of secondary statements.

Areas of Differences: In this world there are as many accounting systems as there are countries and no two systems exactly match. The differences are to be noted and understood because these statements are basic information for decision making at the subsidiary and parent level. Differences in accounting and reporting systems reflect the environmental differences among nations. Accounting principles differ world-wide. The main differences are: (i) In some countries it is the income statement which is most important of all the financial statements (US), whereas in other countries, especially in Europe and Latin America, it is the balance-sheet. This difference arises because of the difference in the perception about investment. American investors are concerned with the increased wealth in terms of dividend and stock prices where as European investor believe in the strength of ownership as represented by the strength of the company in relation to its creditors. Usually the European companies establish various reserves to smoothen out income fluctuations from year to year basis. (ii) Consolidation of accounts is another area of difference. In some countries the consolidation is required while in other this is not required. In U.S and U.K. rules of consolidation have been laid where as in developing countries these rules have not been laid including in India.

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Adequate Financial Disclosures: Adequate disclosures are necessary to understand and analyse the correct information. Normally, the issuers of financial statements limit the disclosure. General accounting standards and practices of disclosure evolve over time from the educational, political, legal, socio-cultural and economic forces of a country.

Since disclosed information is also used to take investment decisions, this purpose may be achieved by requiring the companies to disclose proper and adequate information. To protect investors, regulatory bodies have made mandatory norms of disclosure for listing of the stocks at stock exchanges.

Before the disclosure of financial data, every company has to decide and examine who will be using the information and for what purpose. It has also to decide, what amount of disclosure is required. The financial information is used by: investors, employees, creditors, customers and government agencies.

The amount of disclosed information has to be adequate, fair and complete. Thus the disclosure standards have to be made by regulatory bodies.

The disclosure norms in US (Statement of Financial Accounting Standards, SFAS #14, are strict and adequate for diverse audience. Because of these disclosure norms, the companies do not obtain funds through equity, instead they go for GDR or ADR. The Financial Reporting of Business Enterprise norms are divided in four categories: (i) industry, (ii) foreign operations. (iii) Export sales, and (iv) major customers.

The disclosure norms differ from country to country. In most of the countries, adequate information is not disclosed about as to how the assets are evaluated. Income statements often fail to disclose cost of goods and sales. So it is not possible to determine the comparative strength of the company. For example a US. Executive feels that tougher disclosure norms put US companies at disadvantage. But SEC (Security and Exchange Commission) has enacted the disclosure norms for investor's protection.

Auditing Standards: To ensure that the information disclosed is correct, fair and adequate auditing is required this is because the managers and business owners have vested interests in manipulating the data. Thus the opinion of a competent professional is essential to maintain high quality and reliability of information.

Auditing standards differ from country to country, but these are less diverse as compared to accounting standards. In US, Germany, UK, Japan, Norway and many European countries the auditing standards are approximately same. Moreover, the firms in India may be audited by a multinational auditing firm. A business firm in South Africa is audited by a firm in UIC Therefore auditing standards are more likely to be similar.

Auditing procedures are more diverse. The procedure in US is strict because of strict physical verification standards of inventories and accounts receivables. These verifications are not being carried in Europe and other countries strictly. Even in India the verification is not done.

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Consolidation of Accounts: Consolidation of accounts is done to report the growth of the company to the shareholders. The consolidated statement presents the results of both foreign and domestic operations as if they were a single economic unit. This statement disregards the legal status of different subsidiaries overseas and consolidates the balance sheets and income statements of all the subsidiaries. However the method of consolidation vary across countries. The accounting laws determine the subsidiaries whose financial statements are required to be consolidated, e.g. as per US accounting requirements, a US multinational company is required to consolidate the financial statements of affiliate into those of parent if the parent owns more than 50 percent of voting equity. Companies account for their foreign investments on the basis of the equity method if the parent owns between 20 to 50% of the subsidiary Under the equity method, the parent carries its affiliates at the initial cost of the investment plus its proportionate share of profits or losses. Companies are required to carry their foreign affiliates on the basis of the cost method if the parent owns less than 20 percent of the subsidiary Under the cost method the parent carries its affiliate at the initial investment plus its dividends received.

The theoretical methods of consolidation have already been discussed in the chapter dealing with translation exposure. Examples of translation have also been provided. In addition to this the case of AS11, i.e. translation as per Indian Accounting standard have also been provided.

Options of Consolidation: There are three basic options for presenting the results of a company's operations: (1) consolidated financial statements only, (2) parent's financial statement only, and (3) parent's and consolidated financial statements only In Bahamas, Bermuda, Canada, Philippines and US the results are presented through consolidated financial statements. In most of the countries parents and consolidated financial statements are requited to be presented. These countries include France, Germany, Japan, and United Kingdom, etch) Users of Consolidated Statements: The principal users of consolidated financial statements of multinational companies are: (i) stockholders of the parent company, (ii) creditors of the parent and the affiliate, (iii) management of parent company and (iv) the investors of the affiliate.

The stockholders of the parent company need consolidated financial statement to assess the value of their stocks. Although the consolidated statement may distort certain items because of the dressing of the balance sheet but a rough assessment is possible.

Parent's creditors have genuine interest in the financial statement because short term obligations are paid from the cash flows of the parent. The long term creditors of the parent are interested in financial statements because the satisfaction of their claim depends primarily on the profitability of the enterprise as a whole.

Creditors of the subsidiary are concerned mainly with the financial statements of the subsidiary.

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The consolidated statements are also useful to these creditors if the debt obligations of the subsidiary are guaranteed by the parent.

The management of the multinational is interested in the financial statement firstly to report to the stock holders, the performance of the company under their management and secondly the standards of internal performance are decided on the basis of present level of performance. The statement is also used to set the new levels of output and marketing efforts required to perform the targeted level of performance.

The stockholder of the affiliate is not likely to take interest in the consolidated financial statement because the value of their share depends on the performance of the single affiliate whose share they hold. These stock holders may have an indirect interest in the consolidated financial statements because the financial statements indicate the financial strength of the parent and its subsidiaries as whole.

12.3. INTERNATIONAL CONTROL SYSTEM AND PERFORMANCE EVALUATION Form of Organisation and Accounting Information System Multinational companies have various types of hierarchical structure which determines the organisational structure. Forms of organisation determine the level and authority of managers. Different levels of managers have varying degrees of authority and responsibilities. Five forms of organisation used by multinational companies are the international department, a grouping by product line, a grouping by function, a grouping by geographic area, and the global matrix organisation. In these structures different managers at different levels require different amount and level of information. The information system must cater to these requirements.

Where an international department is constituted, it is evaluated separately as an independent operation and compared with domestic division. This department separates the inter-national operations from the domestic operations. The organisation by product line integrates domestic operation with foreign operation. It evaluates product lines based on worldwide result. A company grouped by function is called functional organisation. In this type of type of organisation, management maintains centralised controls over functions. Geographic organisation separates operations into geographic areas such as Africa, North America, Asia, etc. A company would use this type of organisation when it has substantial foreign operation in a particular region of the world. Lastly the global matrix organisation blends two or more forms indicated above.

Once the structure of organisation is determined, the information required by a particular unit depends on its assigned goals and functions. The designer of accounting information system must understand the nature and purpose of the company. It must be aware of the crucial aspects of the organisational structure, the degree of centralization, the level of decision making and the needs of each decision maker. The designer of the accounting information system must be aware of these factors because major firm characteristics affect its accounting information system. Each characteristic should be identified studied and evaluated and incorporated in the accounting information system.

A multinational corporation has a parent and subsidiaries in foreign countries. The basic

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requirement of the accounting information system is the continuous collection and dissemination of data on a worldwide basis from subsidiaries and parent. This system consists of (1) impersonal communications and (2) personal communications.

Impersonal communications are: budgets, plans, programmes and regular reports and the personal communications include meetings visits, and telephone conversations etc. Communication is an essential dement for subsidiary's evaluation of performance. The effective communication system requires an efficient data collecting and information defusing system. Communication is an essential element in evaluating performance of an organisation. An effective communication requires efficient reporting system for collecting information regarding results of various operations, deviation from predetermined objectives. The more efficient is the system, the more quickly the corrective action is taken.

Financial performance has usually been a key measure of performance of organisation. Financial performance of the organisation depends on economic environment of the country where the subsidiaries are functioning. Since subsidiaries and parent are functioning in different countries therefore financial performance of subsidiary would be largely affected by inflation and changes in exchange rate, because the financial performance is to be evaluated from parent's perspective.

Inflation, Exchange Rate Movement and Financial Performance: The performance of the subsidiary can be evaluated by comparing budgeted financial statement with the actual financial statement. The budgeted statements are prepared without taking into account the expected inflation or exchange rate fluctuation and the actual statements are prepared after these processes have taken place i.e. actual statements are ex-post statements.

The Impact of Inflation on Financial Statements: The impact of inflation on income statement and balance sheet has been shown separately in Tables 26.1 and 26.2. It was found that during an year there was 10% inflation in US economy where subsidiary is situated. Since during the whole year 10% inflation occurred, if the sales were evenly distributed over the whole year, therefore on an average the sales increased by 5% and the costs also increased by 5%. Table 26.1 shows the impact of inflation on income statement.

The difference, that is being observed in the treatment of 10% inflation in the income emend and balance sheet is because of the fact that balance sheet is prepared on a day and is a stock concept, where as income statement represent a flow over the year. In balance sheet the items were inflated by 10% where as in income statement these were inflated by 5%, this is because, the increase in price in the sales have occurred over the year therefore a weighted average of inflation rate has to be used. Since we have assumed sales to be uniform over the year therefore the increase is 5% only.

Impact of Exchange Rate Fluctuation: The impact of exchange rate fluctuation on financial statements has already been discussed in the chapter dealing with accounting exposure.

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12.4. PERFORMANCE EVALUATION Basic purpose of effective accounting information system is to provide information to all levels of managers the requisite information for making decisions. Performance evaluation is the central feature of this information system. An efficient information management system should provide all levels of management the amount and level of information they need so that the managers are able to plan their economic activities in advance. The deviation of earlier planning and achievements are to be analyzed and incorporated in new strategy.

Every subsidiary is unique in its characteristics therefore each should be evaluated against the specific targets and objective set forth for each. According to William Persell aril Van Lessig (1979), there are four purposes of evaluation: (1) Profitability, (2) early warning system if some thing goes wrong, (3) provides basis for allocation of resources, and (4) evaluation of a managers. The study also indicated that MNCs use more than one criterion for evaluation of their subsidiaries to measure actual performance against budgeted objectives as well as earlier bench marked results. The evaluation system should monitor and control performance on yearly basis. To evaluate alternative performance criterion have to be evolved because the subsidiary is to be evaluated not only on the basis of single criterion for the reason that one criterion can not capture all the aspects of performance.

Criterion of Evaluation: The criterion that is to be fixed for evaluation must contain the objective of evaluation as perceived by management. Moreover no single basis of measurement is equally appropriate for all subsidiaries of MNCs and that no single criterion can capture all the aspects of a firm's performance. For example, for a production unit the measure of evaluation may be cost reduction, quality control and meeting shipment targets. But for a sales unit, these criterion are not appropriate. In this case, market share and addition of new segment of consumers may be appropriate criterion. There are two broad groups of performance criterion: (i) Financial, and (2) Non-financial. In financial criteria we have return on investment (ROI) as an accepted criterion. A study by Abdullah aril Keller indicated that the multinational corporations use four different criterions to evaluate financial performance of subsidiaries. These criterions are: (i) return on investment (ROI), (ii) profits, (iii) budgeted ROI against actual ROI, and (iv) budgeted profits against actual profits.

The companies using non-financial criterion believe that there are certain activities that do not contribute to the profitability in the long run. For example,increase in market share may or may not increase profitability in the short run, but in the long run it increases the profitability of the firm. Similarly growth of sales or sales promotion activity, quality control, productivity improvement, training and development of the staff, efforts to improve relationship with the host governments, will be increasing profitability in the long run.

Once the criterion is fixed, the company must ascertain that the criterion fixed can also compare

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the performance of the subsidiary against its competitor in the host nation or some where else.

12.5. PERFORMANCE MEASUREMENT Performance before MNC is that the performance of a subsidiary is measured in terms of a foreign currency this can further be measured (changed into) in terms of parent's currency or a third country currency. This choice of currency is crucial in determining the performance. There may be big profits when performance is measured in terms of local currency and the project may not be viable if performance is evaluated in terms of parent's currency It has also been observed that fluctuation in exchange rate pose a great problem in evaluating performance of subsidiaries. In most of countries, the accounting practices are also different. Therefore results may not be exactly comparable. Similarly different rates of inflation at various locations pose problems in evaluation.

12.6. QUESTIONS Section – A Very short type answers questions.

1. What do you mean by multinational accounting?

2. Give the meaning of dual reporting system.

3. What is the adequate financial disclosure?

4. Mention the performance evaluation.

5. Give the meaning of performance measurement.

Section – B Short type answers questions.

1. What is the financial reporting?

2. Mention the importance of multinational accounting.

3. What is Criterion of Evaluation?

Section – C Long type answers questions.

1. Explain important issues in multinational accounting.

2. What is the financial reporting? And explain 3. Explain performance measurement.

4. Explain performance evaluation.

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12.7. SUGGESTED READINGS

1. Alan C Shapiro, Multinational Financial Management (2002), Prentice-Hall of India, New Delhi.

2. Prakash G Apte, Global Business Finance, Tata McGraw-Hill Publishing Company Limited, New Delhi.

3. David K. Eiteman, Arthur I. Stonehill, Michael H Moffett, Multinational Business Finance, Addison Wesley Longman (Singapore) Pte. Ltd, New Delhi.

4. Prakash G Apte, International Financial Management, Tata McGraw-Hill Publishing Company Limited, New Delhi.

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