INTERNATIONAL FINANCE

What is Foreign Exchange?

Foreign Exchange loosely refers to any foreign currency. In deeper sense, it is purchase and sale of one
currency against sale and purchase for another currency. Here, currency does not necessarily mean
bank notes and coins but includes Travellers Cheues, !ills of Exchange, "etters of Credit, any drafts,
etc as #ell. In essence any financial instrument that entitles you to get another currency in lieu of one
currency is treated as currency for this definition.
International Foreign Currency market is almost round the clock market starting in Tokyo$%ydney in
the morning and closing in &est Coast of '%( shortly before it is time for opening of next day market
in Tokyo (effect of changing time zones).
Indian Forex Market
Indian Forex )arket is still in nascent stage of development. *rior to +,,+, #e had FE-( #hich made
possession of Foreign currency a criminal offence. Exchange rate #as decided by the -!I and Forex
market virtually did not exist. *ost +,,+, after replacement of FE-( #ith FE)(, and current account
convertibility, Indian forex market has begun to develop. &ith exports volume gro#ing steadily at
good pace, forex market is becoming important.
The Foreign Exchange )anagement (ct .+,,,/ popularly kno#n as FE)( came into force from 0une
1+, 2111. FE)( replaced the Foreign Exchange -egulation (ct of +,34 .FE-(/. &hile FE-( #as
aimed at conserving foreign exchange by restricting expenditure, FE)( is aimed at facilitating
external trade and payments for promoting orderly development and maintenance of foreign exchange
market in India. 5iolations under FE)( are considered civil offence and not criminal offence as #as
the case under FE-(.
In India most of the trade happens in '%6. !esides '%6, Euro, 7reat !ritish *ound, and 0apanese 8en
are other ma9or currencies that are traded. :ther currencies are also dealt but in small volume. %!I
deals in +; currencies in all.
Exchange rates are not constant and keep changing on minute to minute basis like stocks in stock
market. 'nlike stock exchange, there is no Forex Exchange #here there is a central intermediary
available for every transaction and hence single uote for any currency is not available. It is more like a
vegetable market #here there are so many shops and each is uoting its o#n rate and #illing to bargain
#ith you. :r, in the market language, it is :ver the Counter .:TC/ trade.
Foreign Currency Exchange Rate
The primary basis for exchange rate movement on day to day basis is 6emand and %upply of foreign
currency. 6emand can spurt due to various reasons like large companies #ith considerable import
reuirements (like Maruti requiring import from Suzuki, Japan) of foreign currencies stocking forex for future
reuirement. %imilarly, exporters may dump their forex holding if they perceive that rupee is going to
appreciate leading to sudden excess availability of foreign currency in the market.
(lthough the exchange rate is affected by market forces of demand and supply, #e do not have a fully
flexible exchange rate, or as it is called Floating Exchange -ate, as yet. &hat #e actually have is a
)anaged Exchange -ate.
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&hat it means is that exchange rate is being macro managed by the 7ovt through -!I. -!I keeps a
ha#k eye on the forex market and keeps manipulating exchange rate by either buying excess forex or
in9ecting liuidity by selling forex from its o#n holding of +;< !illion '% 6ollars. "ike, %E!I is the
controller of the %ecurities market, -!I is the controller of Forex market. It authorises certain entities
like banks and even other companies like Thomas Cook to deal in Forex. It has a dealing room #hich
keeps a track on exchange rate movement in the market on continuous basis. If the exchange rate starts
moving #ildly in either direction, it intervenes by either buying or selling forex in the market to control
it.
Factors Affecting the Exchange Rate
.a/ !alance of *ayment position of the country
.b/ %trength of economy
.c/ Fiscal and )onetary policy
.d/ Interest rates
.e/ *olitical Factors
.f/ Exchange control
.g/ Central !ank Intervention
.h/ %peculation
.i/ Technical Factors
.9/ :ther factors.
Balance of Payment - !alance of *ayment is the measure of demand and supply of foreign
currency. If the balance of payment is high and positive .Exports higher than imports/, it #ill
lead to excess supply of foreign currencies and therefore local currency #ill appreciate. In the
reverse case, domestic currency #ill depreciate.
Strength of the Economy - If the economy is strong and gro#ing, foreign investment$capital
#ill pour into the country again causing excess supply of foreign currencies leading to
appreciation of local currency.
Fiscal and Monetary Policy - If fiscal policy leads to high deficit, it #ill result in inflation
and therefore excess supply of local currency. High inflation rate leads to high interest rates
(interest rates are mostly maintained a few percent higher than inflation rate so that real effective interest rate is
positive) leading to #eakening of local currency.
Interest Rates - Higher interest rates attract foreign currency deposits provided local currency
is not depreciating faster than interest rate induced gro#th. Thus, higher interest rates coupled
#ith relatively stable local currency acts like a self sustaining process. )ore inflo# of foreign
currency leads to further stability of exchange rates.
Political Factors - If a govt is considered to be unstable, or change of govt #ith socialistic
inclination is expected, local currency #ill #eaken. Currency #ill strengthen if the ne# govt is
expected to take capitalistic policy decisions.
Exchange Control - Exchange control is generally aimed at free movement of capital flo#s and
therefore foreign nationals #ill be vary of investing in the country.
Central Bank Intervention - (lready explained as to ho# central bank can affect exchange rate
in the short term.
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2
Sec!lation - This is again a short run effect if some big players suddenly start accumulating
foreign currency or vice versa for speculative reasons. Constant buying by big players and
resultant up#ard movement in price leads even smaller player to start buying aggressively and
foreign currency appreciates.
"echnical Factors - Technical factors #ork best in regulated market. Indian forex market are
still not as free and therefore they do not have much effect.
#ther Factors - These are general factors #hich are hard to define. It could be #orld political
and economic situation, prices of ma9or import constituent like crude oil, etc. Fear of #ar #ith
*akistan can send the -upee do#n overnight.
Reference Rate
&hat #e have discussed above is mechanics of day to day changes in exchange rate. !ut ho# is the
basic exchange rate of one currency set against the other currency= Ho# is it determined that a dollar
should cost approximately -s >< and not -s 2<=
Current mean of -s >< or so is called Reference Rate. This reference rate is decided using various
different methods? @
.a/ Mint Parity System A %imply stated this system is based on amount of currency printed
by any country for each ounce or Bg of gold. If India prints -s 41,111 for each ounce of
gold held #ith govt and '% prints '%C ;11 for each ounce of gold held #ith '%(,
exchange rate bet#een '%C and ID- #ould be A 41,111$;11 E -s <1 per dollar.
.b/ $old Standard System A This system started in mid +F31s and lasted till +,+> ie till
start of &orld &ar I. In this system, the coins had a fixed gold content and ratio of gold
content in coins of any t#o countries denominated their exchange rate. In case of paper
currency, amount of gold freely payable by 7ovt$Central !anks of t#o countries for
each unit of paper currency determined the exchange ratio. The countries #ere
committed not to print currency in excess of their gold holding or dilute the gold content
in coins. Ho#ever, during the &orld &ar II, countries began to renege on this
commitment to meet the funding reuirement of the #ar and the gold standard collapsed.
)any countries tried to revive the 7old %tandard after the #ar ended in +,+, but
failed. In the economic depression that follo#ed the &&@I, #hen they tried to #ithdra#
additional money they had pumped into the economy during the #ar, it led to 6eflation
(reverse of inflation where commodity prices start falling due to low demand (because people do not have
money to buy goods) which deters the entrepreneurs and is therefore bad for economy) They,
therefore had to #ait for the economies to recover. !ut by the time they began their next
attempt a couple of decades later, &orld &ar II started in +,4, and lasted till +,>>.
Thus, this standard #as abandoned.
.c/ Bretton %oods System A *ost &orld &ar II, in +,>;, the ne#ly@created Economic and
%ocial Council of the 'nited Dations called a conference at the !retton &oods #here in
the troika of post@&ar economic agencies ie International )onetary Fund .I)F/, &orld
!ank and International Trade :rganisation .IT: A #hich later came in avatar of 7(TT/
#ere born. Countries #ere allo#ed to declare their currency value in gold or dollars and
'%( promised to freely exchange an ounce of gold for '%C 4< or vice versa. %ince this
system #as born during !retton &oods conference, this standard came to be kno#n as
!retton &oods system.
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4
The system #orked very #ell till +,;,. Ho#ever, #hen '%( got embroiled in
the long and costly 5ietnam #ar, its economy suffered. The '.%. balance on goods and
services shifted to a surprising deficit in +,3+. These deficits supported speculations
that the dollar #as overvalued. France realised that it #as beneficial to exchange its
forex holding into gold and began to convert it. !ecause of massive gold outflo#s from
the 'nited %tates, *resident Dixon suspended convertibility of the dollar in (ugust
+,3+. This ended the !retton &oods %ystem.
.d/ Smithsonian Agreement @ I)FGs attempts in the subseuent period to revive !retton
&oods system #ere unsuccessful as '%( did not agree to make dollar convertible to
gold. In the follo#ing period, there #as complete chaos. In an attempt to restore order to
the exchange market, +1 leading nations met at the %mithsonian on 6ecember +; and +3,
+,3+. The H%mithsonian (greementI #as a ne# system of exchange@parity values.
(lthough this ne# system #as still a dollar@standard exchange@rate system, the dollar,
#as still not convertible to gold. %mithsonian (greement collapsed #ithin +< months
and a de facto system of floating rates emerged.
.e/ Do# #e have follo#ing systems of Exchange -ate being follo#ed by different
countries as per their convenience?
.i/ Fixed Exchange Rate Systems
.aa/ Currency !oard
.ab/ Fixed *eg
.ac/ Flexible *eg
.ii/ Floating Exchange Rate Systems
.aa/ )anaged Float %ystem
.ab/ Independent Float %ystem
Scientific Way of Deciding Exchange Rate Beteen Currencies
+. P!rchasing Po&er Parity System @ This theory is based on the la# of one price, the idea
that, in an efficient market, identical goods must have only one price. This is thus Real
Effective Exchange Rate .-EE-/. ( basket of representative goods and services has been
identified and its cost in each country in its domestic currency is calculated. The ratio bet#een
its cost in any t#o countries in their respective domestic currencies is their exchange rate. To
understand it better, let us take a case of cost of hair cut in India and '%. &hile the average
price of a hair cut in India is -s +<, it costs upto '%C 4 in '%. If this #as to represent avarage
rate of costs for all the goods in the basket, purchasing po#er parity of ID- #ould be < against
'%C.
The differences bet#een *** and market exchange rates can be significant. For
example, on plain conversion of 8uan to dollar basis, per capita 76* in China is about
'%6 +,<11, #hile on a *** basis, it is about '%6 ;,211. (t the other extreme, 0apanJs nominal
per capita 76* is around '%6 43,;11, but its *** figure is only '%6 4+,>11.
Exchange -ate E *rice in domestic market for basket of goods E *
d
*rice in foreign market for basket of goods *
f
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>
This is called absolute version of ***.
These special exchange rates are often used to compare the standards of living of t#o or more
countries. The ad9ustments are meant to give a better picture than comparing gross domestic
products .76*/ using market exchange rates.
2. Relative P!rchasing Po&er Parity A This is a related theory, #hich predicts the relation
bet#een the t#o countriesJ relative inflation rates and the change in the exchange rate of their
currencies. This is the economists definition. In business terms, it helps in deciding For#ard
-ate of Forex from %pot -ate by taking inflation into account.
%uppose, present Exchange -ate of dollar in India is -s >3 and inflation in India is <K
and in '% +K. Thus, cost of same product after one year in India E *
6
.+L 1.1</ and in '% E *
F
.+L 1.1+/.
Thus, exchange rate after one year ! *
6
.+L 1.1</
*
F
.+L 1.1+/
E -s >F.F;
!ut Inflation is not the only element that affects the long term exchange rates. Interest
rate is another element that severely affects the exchange rate (although interest rates are often a
direct function of inflation, !nterest rates is pegged to covered the depreciation of money through inflation and a
little as incentive "hus, if inflation is low, interest rates would automatically be correspondingly low)
4. Interest Parity "heory A Effect of interest on exchange rate is called Interest *arity
theory. "et us see ho# an smart operator can benefit by playing currency of t#o countries
having differential interest rates and gain from it.
%uppose, current exchange for '%C is ID- >;. -!I bond interest rate is 3K and '%
treasury interest rate is 2K. ( smart (merican investor instead of investing in '% treasury bill
#ould invest in -!I bonds. (this is what #$!s do with #$% and other accounts). Ho#ever, #hole thing
is not as simple as it appears. &hen such arbitrage opportunity occurs, many people try to
utilise the opportunity and resulting excess supply leads to fall in exchange rate. Further,
inflation in India is higher than in '%. Therefore, on maturity of deposit, reverse conversion of
-upee deposit to dollars is going to be at higher cost than the original conversion rate Thus,
losing of some gains.
Sterilisation of Forex
&hile every country is bending over back#ards to earn as much forex as possible, there is limit of each
economy to absorb forex inflo#. 'ncontrolled influx of forex can be harmful, specially the hot money
#hich can be #ithdra#n at short or nil notice, like portfolio and stock market investment #ith capital
account convertibility ("his is what was the prime cause of South &sian %conomic crisis of '(()) (lso, influx of
huge funds leads to inflation. Therefore, there are times #hen forex inflo#s have to be checked or
controlled. Technically such a process is called %terilisation of Forex. -ecently, India adopted this
approach by reducing interest rates on D-E deposits #hich made parking of funds in India less
attractive. (nother #ay of sterilisation is to liberalise Imports. %urge in imports takes a#ay excess
supply of dollars in the market. 8et another method is to -epay the :ld 6ebts.
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<
The methods #e discussed above are the planned and controlled method of %terilisation of
Forex. In addition there could be host of uncontrollable and unpredictable reasons leading to
sterilisation, like A
.a/ Threat of &ar
.b/ Increase in oil prices
.c/ *olitical Instability
.d/ 7ovt *olicies
.e/ %ocial 6isturbance
Thus, there is al#ays a need for hedging.
Fixed Exchange Rate Systems
+. C!rrency Board A In this system, currency notes issued by the country depend upon the
declared exchange rate and the amount of foreign currency reserves. If India has a forex reserve
of '%C +<1 !illion and exchange rate is -s >1, India can issue +<1 x >1 E ;111 !illion -upees
#orth of currency notes. Ho#ever, in this case, monetary policies have to be in consonance #ith
other country. Thus, it kills the economic sovereignty of the nation and therefore difficult to
follo#.
Examples are Hong Bong, Estonia, and !ulgaria
2. Fixed Peg A In this system, exchange rate is declared by the country and ratified by the
I)F. Thereafter, exchange rate does not change till it is revised by the 7ovt. -eluctance by the
govt to revise the rate due to political or other compulsions can lead to long term conseuences.
%outh East (sian crisis #as partly result of this system.
Reasons for So!th East Asian Crisis '())*+
.a/ Countries had adopted complete convertibility on Current as #ell as Capital account.
This made flight of capital very easy. There #as no #ay to control out#ard flight of
capital at the time of crisis.
.b/ They adopted Fixed *eg system against dollar. There #as massive influx of foreign
currency through hot investments, foreign currency loans by banks, etc. This money #as
invested in assets like real estate and stocks. There #as massive rise in asset prices and
an asset bubble #as created.
.c/ There #as massive current account deficit. Imports far exceeded exports.
.d/ High inflation rates due to increased money supply. Inflation #as not reflected in
exchange rateM firstly, due to Fixed *eg system and secondly, due to govtsG reluctance to
revise the rate do#n#ards #hich #ould have affected investorsG sentiments. %peculators
suddenly realiNed that due to overvalued currencies, it #as beneficial to convert local
currency into dollars and they #ent for it hammer and tongs. 6ue to relatively small siNe
of economies .a fe# tens of billion dollars each/, in three trading sessions, Forex
reserves became nil.
4. Flexi,le Peg System @ This system provides a H*arity bandI #hich allo#s limited
flexibility for movement of exchange rate on either side of the parity rate. !ands can be very
narro# or very #ide. Examples are !angladesh, China, and Egypt.
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;
Floating Exchange Rate Systems
+. Managed Float A This is the system that #e are currently follo#ing in India. Exchange
rate is free to float but under constant #atch of Central !ank .-!I/. It generally intervenes only
on occasions #hen there are #ild movements. It basically acts as stabiliser.
2. Indeendent Float A In this system 7ovt is 9ust not bothered #hich #ay its currency is
moving. This is the system follo#ed by rich and advanced countries like '%(, Bu#ait, %audi
(rabia, etc.
India follo#ed Fixed *eg %ystem since independence. Indian rupee #as pegged against 'B . In +,;;,
rupee #as devalued. In +,3<, India moved a#ay from parity and pegged its rupee against an
unkno#n basket of < currencies. It devalued rupee once again during the !alance of *ayment Crisis in
+,,+. From +,,4, #e started follo#ing floating rate exchange system.
Im"ossi#le $rinity %$he three e&ents that can not occur together'
.a/ Having Fixed *eg system of Exchange -ate.
.b/ Having complete convertibility on current and capital account.
.c/ Having complete independence in deciding monetary policy.
Do country to date has ever been able to achieve all the three conditions together at any point of
time. That is #hy it is called impossible trinity.
%hy did economies of Argentina- Chile and Mexico crash.
(rgentina Economic Crash ) *++,
(rgentina had been having a see sa# economy ever since the beginning of 21
th
century. It #as the >
th
largest economy in early +,+<, fell do#n drastically in late 31s O F1s and then again recovered to
become <;
th
economy in +,,;. It suffered its first crash in +,2, during (merican %tock )arket Crash.
It recovered from there to become +<
th
largest economy only to suffer yet another crash in +,31s and
+,F1s. In +,F1, the inflation #as as high as <111K. In a matter 22 years, ie bet#een +,31 and +,,2,
money got devalued by +1 billion times. 8esP +1 billion pesos #ere reduced to a single peso.
Economic reforms launched in +,,+ reduced inflation from 2411K in +,,+ to 9ust +K in next fe#
years. Ho#ever, the recovery #as short lived. %ome #rong currency policies of 7ovt and economic
crisis in countries like )exico, !raNil and -ussia, triggered another economic crisis in 211+.
In +,,+, a currency stabiliNation regime established a currency board, #hich pegged the (rgentine peso
to the dollar on a +@to@+ basis. Inflation #as virtually eliminated. Foreign investment returned. 76*
gro#th #as strong in the early +,,1s, but unemployment increased as a result of extensive structural
reforms. (rgentina finally seemed to have a handle on its chronic economic problems. Ho#ever,
external events in the late +,,1s buffeted the (rgentine economy?
+,,<? )exico
+,,3? East (sia
+,,F? -ussia
+,,,? !raNil
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3
!ecause of its long history of economic instability, every economic crisis in the Third &orld,
particularly in "atin (merica, caused investors to pull out of (rgentina, creating a self@fulfilling
prophesy. It #as investorsG hair@trigger reaction to crises else#here that caused (rgentinaGs instability,
Thus, the adverse effects of these crises #ere greater in (rgentina than in most other ne#@gro#th
economies. (nother reason for this enhanced vulnerability is that (rgentina stood alone #ith its fixed@
exchange@rate policy, #hereas the floating currencies of its neighbours depreciated. !y 211+, the peso
#as significantly overvalued, in no small part due to the dollar itself having become overvalued. The
devaluation of the !raNilian real had a particularly large effect. It reduced demand from (rgentinaGs
largest trading partner, and businesses began to move from (rgentina to !raNil in search of lo#er
production costs. (s the credibility of the peso at its pegged value declined, and the government had to
expend huge sums to support the currency, #hich in turn necessitated more borro#ing. 'nder these
conditions, interest rates that #ere already high rose even higher, and as both debt and interest rates
rose, the ability of the government to service its debt became increasingly doubtful. (rgentina
continued to keep the peso pegged to the dollar by external borro#ings.
The buNNards came home to roost in 6ecember 211+. The nation rapidly descended into an
unprecedented chaos. (s economic activity shuddered to a virtual halt, governments resigned and #ere
hastily replaced amid sporadic rioting. The follo#ing month, #hen Eduardo 6uhalde .the fifth person
to hold the presidency in t#o #eeks/ unpegged the peso in 0anuary 2112, the peso crashed hard, losing
more than 31K of its value and inflation rising to >+K though it #as still far far better than the
expectations of four digit hyper inflation experienced in late F1s decades. !ut inflation had fallen back
to 4.2K by 2114.
%o, #e kno# no# #hat agony #as the country saved from by the much maligned and ever pouting )r
*5 Darsimha -ao, #ho displayed the rare courage to stand up against the economically blind political
class of the country .including his o#n party men/ in appointing )r )an )ohan %ingh as Finance
)inisterM and the practical economist )r )an )ohan %ingh himself, #hose economic prescriptions to
cure the ills of the economy #ere as effective as any measures ever #ere any #here in the #orld in its
modern history.
Mexican Economic Crisis
)exican Economic trouble of +,,> #as not a Q*rash+ but a Crisis as it lasted 9ust +1 months and the
melt do#n #as not as spectacular as in (rgentina. This crisis #as also triggered by #rong currency
policies of the govt. In 6ec +,,>, )exican *eso fell from the pegged rate of 4.4 peso to a dollar to 3.3
peso.
Though the crisis #as triggered byM first? the devaluation of currency in 6ecember +,,> and second?
floatation of currency soon afterM the seeds #ere so#n earlier.
)exico had a fixed exchange rate of 4.4 peso to a dollar. In +,,>, as the general election dre# near, the
incumbent govt #ent into a spending blitN (politicians are same every where). (s a result, current account
deficit ballooned to a record of 3K. In order to fund the spending, the govt issued bonds repayable in
dollars. High current account deficit and fixed exchange rate led to over valuation of *eso by
approximately 21K. %ome investors #ere alarmedM other smelled the opportunityM and together they
uickly encashed the bonds in dollars. Foreign exchange reserves fell drastically. 6eclining reserves
necessitated devaluation of currency. Ho#ever, political compulsions did not allo# this simple but hard
prescription till the incumbent govt lasted.
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F
Dext 7ovt #hich took over po#er in 6ec +,,>, devalued the currency to > pesos to dollar. That did not
prove adeuate and #ithin days peso #as allo#ed full float #hich led to crashing of peso to 3.2 pesos
to a dollar.
)exicoGs immediate neighbour, '%(, intervened immediately by first buying pesos from open market
and then arranging a loan of '%C <1 billion. The currency then stabiliNed first at ; pesos to a dollar and
thereafter gradually declining over next t#o years to 3.3 dollars before beginning a regular recovery.
)exico repaid all loans by +,,3.
/* 0!l /112
F#RE3 MAR4E" A56 F#RE3 ARI"7ME"IC
Forex market is open almost 2> hrs a day. It starts in Tokyo and ends in &est Coast of '%(. !y the
time it closes in '%( &est Coast, it is #ithin 2.< hrs of opening of Tokyo market for the next day.
Total trade in the Forex market is to the tune of over '%C < trillion per day. The Indian Forex )arket
turnover itself averages '%C <@+1 billions$day.
Communication %ystem A Forex )arket has a dedicated #orld#ide telecommunication net#ork called
%&IFT .%ociety for International Financial Telecommunications/.
Forex Dealers
There are t#o kinds of forex dealers in the market?
.a/ F!ll Fledged Money Changers A )ostly designated banks and Thomas Cook .an
exception/. These are the authoriNed dealers #ho are permitted to take positions. (n
authoriNed dealer deals in millions of dollars each day. They can go long or short
.overbought or oversold positions/. They are also allo#ed to appoint their franchisees.
.b/ Restricted Money Changers A These are the kind of money changers #ho line up the
streets in tourist centres. They can only ,!y forex. They are not allo#ed to sell. They are
essentially convenience centres for tourists for currency exchange.
:ne peculiarity of Forex )arket is that it is mostly unregulated and completely driven by the 6emand@
%upply principal. There are fe# benchmarks. -ates fluctuate minute by minute, dealer by dealer, and
customer by customer. There is nothing fixed. T#o people doing a sell deal #ith the same dealer at the
same time in the same place and of same currency may end up #ith vastly different rates. )oney
changers are free to uote their o#n rate for buying and selling any currency .technically called !id and
(sk rates respectively/ based on customer, siNe of deal, their o#n current positions, etc.
-o to make a .uote?
(ll money changers are connected to -euters through S%IF" (Society for ,orldwide !nterbank
-inancial "elecommunications). The -euters screen continuously flashes current going rate for various
currencies at different centres. Ho#ever, the rates are only indicative. They are representative rates for
market as a #hole. Individual rates #ith various dealers vary.
Exchange -ates are uoted in follo#ing format? @
'%6$ID- E
/ .
/ .
,111 . >; $ F111 . >;
&sk$ate
.id$ate
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,
(bove represents amount of currency in denominator .here ID-/ to be paid for each unit of currency in
numerator .here '%6/. Ruotation is al#ays in double numbers #ith minor difference bet#een the t#o.
First number is called the Bid Rate and second number is called Ask Rate. !id rate is al#ays lo#er
than the (sk -ate.
Bid Rate is the rate at #hich the money changer is #illing to buy a particular currency.
Ask Rate is the rate at #hich the money changer is #illing to sell same currency.
Sread A (s stated earlier, there is al#ays a positive difference bet#een (sk -ate and !id rate. This
difference is called %pread and it is the profit margin that the dealer earns by trade.
%pread E (sk -ate A !id -ate
%pread K E
+11

.$
.$ &$
Forex market behaves like any other commodity market. Here too, there is #hole sale and retail market.
&hole sale market consists of (uthorised 6ealers and !ig Corporate Houses like TC%, Infosys and
&ipro #ho have high forex exposures. !ut spreads in #hole sale market are lo#er.
-etail )arket is populated by money changers, ordinary citiNens, small exporters and importers and
small corporates.
/ositions
In any financial market, t#o positions can be taken A "ong or overbought position and
A %hort or oversold position.
%hy are ositions created.
*ositions are taken in anticipation of currency exchange rate movement in one direction.
If a position is taken and the trend appears to be reversing .currency depreciates against expectation of
appreciation or vice@versa/, the positions are liuidated by manipulating the !id and (sk rates.
Example @ If it is a long$overbought position, both (sk and !id rates #ill be lo#ered. %imilarly, if there
is an oversold position, both (sk rate and !id -ate #ill be hiked.
The uotations are normally in four decimal places. If a dollar is being uoted against -upee, it #ill be
uoted as follo#s? @
>;.<241$>;.<2<1
First figure of uote is !id -ate and second figure is (sk -ate. Third and fourth decimal places are
called PIPS. Thus, in the above case, 41 and <1 are pips.
In most cases, uotations are abbreviated to give only t#o or three digit pips in place of (sk -ate.
Thus, above uote could also be represented as? @
>;.<241$<1
Inter dealer uotes are further abbreviated to only three digit pips on both sides since base rate of up to
first decimal place is common across all dealers and therefore assumed to be kno#n.
Page of 47 - International Finance (Ver 1.1)
+1
(r#itrage
(s in any other trade, arbitrage opportunities exist in Forex trade also. (rbitrage is basically taking
advantage of differential in rates at t#o locations or markets or sources. For instance, .id (.uying)
$ate of one dealer may be higher than &sk (Selling) $ate of another dealer. ( smart operator can buy
from second dealer and sell to first dealer and earn some money. This transaction is called (rbitrage.
"et us see the above process in numbers.
6ealer ( 6ealer !
>;.<141$829:1;1 829:1)1$>;.<1,<
In the above case, !id -ate of 6ealer ! .>;.<1,1/ is higher than (sk -ate of 6ealer ( .>;.<1F1/. If a
person !uys one million dollars from 6ealer ( and sells to 6ealer !, he earns @ 1.11+1 x +1,11,111 E
-s +111
This is also called Single Point Ar,itrage since there is only one !uying and %elling operation
involved. It normally happens #hen the deal is in single market involving t#o dealers
Inverse <!ote A (lso called /Indirect <!ote0 Dormally, value of other currency is uoted in local
currency, ie amount of local currency to be paid for each unit of foreign currency. In India, all
currencies are uoted using ID- as the base, ie value of other currency is uoted in Indian -upees.
%imilar practice is adopted by all other countries, using their local currency as base and indicating
number of local currency to be paid for each unit of other currency.
Thus, a person #ill obtain '%6$ID- uote E >;.4121$>;.41,1 from a dealer in India and ID-$'%6
uote E 1.12+4$1.122> from another dealer in '%( (1S currency used as base in 1S& So, the quotation will be
number of 1S2 to be paid for each !#$). If the bases of uotes are different, ho# do #e compare the uotes=
Comparison of t#o uotes becomes difficult. Therefore, there is a need to I5=ERSE one of the uotes
so that the base is common.
'%6$ID- E >;.4121
Inverse the uote
ID-$'%6 E
12+; . 1
>;.4121
+
/ $ .
+

!#$ 1S2
That #as a simple case #hen only mean rate is given. Do# let us see #hat happens #hen bid
and ask rates are uoted.
'%6$ID- E >;.4121$>;.41,1

12+<,3 . 1
>;.4121
+
/ $ .
+

.!2
&S3 !#$ 1S2
1S2
!#$

12+<,> . 1
41,1 . >;
+
/ $ .
+

&S3
.!2 !#$ 1S2
1S2
!#$
Page of 47 - International Finance (Ver 1.1)
++
(4lease note that for finding .!2 rate, we have to inverse &S3 rate and for finding &S3 rate we have to inverse
.!2 rate ,hat is the logic for this5
*urrency trade is basically a .&$"%$ trade !n any other trade, commodity is traded against a currency
6owever, in currency trade, both sides have currencies but of different type !t is like one side having wheat and
the other side having rice and both ready to e7change their commodity for the other+s for a negotiated e7change
rate !n such a situation there is no seller and no buyer Saying it other way round, both are sellers and both are
buyers ,hen one buys other+s commodity, he simultaneously sells his commodity So, when one trader says 8 !
am willing to sell one dollar for
$s 9), it can also be interpreted as : he is willing to buy $upee for ';9) dollar "hus, his &S3 rate of $s 9) for a
dollar has become his .!2 rate for a $upee in inverse quote at ';9) dollar "herefore, when currency quotes
(e7change rates) are inversed, .id and &sk rates also have to be inversed)
"&o Point Ar,itrage A &hen t#o locations are involved in the dealing, it is possible to buy a currency
from one location$market and sell it in other market and earn arbitrage. For example, some one can
purchase dollars in India and sell them in '% market for -upee. This is called T#o *oint (rbitrage.
"hree Point Ar,itrage A %ome times (rbitrage opportunity is available by currency exchange
operations across t#o or three markets. In such an operation, first one currency is purchased in one
market and then sold in second market for a third currency. Third currency is then sold in third or first
market for original currency.
%uppose, there are three currencies (, ! and C. Ruotes are available for ($!, !$C and C$(
(*;&)
.!2
< (.;&)
.!2
X (*;.)
.!2
&S3 &S3
.!2
* . . &
& *
/ $ .
+
/ $ .
+
/ $ .
(D6
(*;&)
&S3
< (.;&)
&S3
X (*;.)
&S3
.!2 .!2
&S3
* . . &
& *
/ $ .
+
/ $ .
+
/ $ .
Forard .uotes
For#ard uotes are one #here a dealer uotes for purchase and selling of forex at a future date. These
uotes are mainly useful for exporters and importers #ho commit to sell their #are or buy the imported
stuff based on exchange rate prevailing on that date. Ho#ever, money is received or paid in foreign
currency at a much later date. (ny large adverse movement of exchange rate in the interim can lead to
heavy losses. Therefore, importers and exporters cover their risk by utilisation of these for#ard uotes.
5arious terminologies associated #ith for#ard uotes are as follo#s?
Sot 6eal A %ettlement on TL2 days .Q"> refers to Transaction 6ate. Thus, delivery of forex and
payment of cash for a transaction done on )onday has to be completed (settled) by &ednesday/
Sot
cash
6eal A %ettlement on T L 1 days .%ame day payment/
Sot
"om
6eal A %ettlement on T L + 6ay .Dext 6ay *ayment/
For#ard deals could be TL+1, T L 41, T L ,1, etc. (&dd = working days for each settlement).
Page of 47 - International Finance (Ver 1.1)
+2
Inter 6ealer For#ard Ruotes are not direct. :nly differential amount to spot deal rates are uoted.
Thus, if
7!*$ID-
spot
E F<.F;F1$F<.F,<1
Then, 41 days .one month/ F* is uoted as 41$>1 #hich means
41 days F* for 7!*$ID-
spot
E F<.F;F1 L 1.1141 $F<.F,<1 L 1.11>1
E F<.F3+1$F<.F,,1
It is possible that !id -ate for a For#ard Ruote is higher than (sk -ate. If such a situation occurs, it
means that local currency is expected to appreciate. If local currency appreciates, for each unit of
foreign currency, lesser amount of local currency #ould be paid. Thus, in such a situation, the uoted
differential amount is decreased rather than added to %pot uotes.
In the above example, if dealer uotes #ere >1$41, then 41 days F* #ould be
41 days F* for 7!*$ID-
spot
E F<.F;F1 @ 1.11>1 $F<.F,<1 @ 1.1141
E F<.F;>1$F<.F,21
In the For#ard 6eals there are more variations A
#!t Right For&ard 6eal A ( deal #here there is only one transaction of sell or buy at a future date. %o,
you decide to buy one million dollars after ;1 days.
Sot For&ard 6eal A ( deal #here there is a %pot 6eal and a covering deal on a future date. %o, you
buy one million dollars today and strike a for#ard deal for selling one million dollars after ;1 days.
For&ard For&ard 6eal A There is a !uy and a covering %ell deal on a future date .future dates of buy
and sell deals are different/. %o, you do a for#ard deal to buy one million dollars after 41 days and do
another for#ard deal to sell one million dollars after >< days.
Broken Date0Forard Rate Calculation
Ruotes are available for one month, three months or six months. There may be reuirement to calculate
for a date in bet#een these uoted dates, say for + S months or 4 months and 2< days. %uch
calculations are done by interpolation of uotes for available dates .extrapolation is never done for
dates beyond max uote/ "et us take an example for conceptual clarity?
%pot '%6$ID-
%pot
E >;.F111$>;.,111
+ month F* E <1$F1
4 months F* E +11$211
; months F* E 211$411
Find for#ard rates for + month +< days and also for 4 months 2< days.
Page of 47 - International Finance (Ver 1.1)
+4
(ns. For + month +< days E

,
_

days
days
days
days
+<
;1
F1 211
+<
;1
<1 +11
(/>?0 because @ months minus ' month < >? days)
E ( )
41
+4
E >;.F1<1 L .11+4 $ >;.,1F1 L 1.1141
E 1234+25 0 1236,,+
For 4 month 2< days E

,
_

days
days
days
days
2<
,1
211 411
2<
,1
+11 211
E ( )
31 . 23
3 . 23
( )
2F
2F
E >;.F+11 L .112F $ >;.,211 L 1.112F
E 1234,*4 0 1236**4
Forard /remium0Discount Com"utation
F* E
+11
+2

n S$
S$ -$
M$
M$ M$
(M$ means Mid $ate which is average of .id and &sk $ates)
If F* is .L/ve, then foreign currency is appreciating
If F* is .A/ve then for#ard deal is at a discount #hich means that local currency is expected to
appreciate.
%pot '%6$ID- E >;.F141$>;.F<11 )id -ate E >;.F2;<
4) F- E >;.,141$>;.,<11 )id -ate E >;.,2;<
n E 4 months
For#ard *remium E
+11
4
+2
>;.F2;<
>;.F2;< @ >;.,2;<

! +3471*
Thus, there is a 1.F<K premium on for#ard uotes.
In case the result #as in negative, then there #as a discount, #hich means that foreign currency is
going to depreciate and local currency is expected to appreciate.
Page of 47 - International Finance (Ver 1.1)
+>
Factors affecting the Forex for&ard ?!ote
+. Inflation A The currency of the country experiencing higher inflation rate
#ill depreciate in value
2. Interest Rate A Capital #ill move from lo# interest rate country to higher
interest country. Thus, currency of country #ith higher interest rate #ill appreciate due to higher
demand.
For#ard -ate E

,
_

+
+
$-
$2
!
!
Spot$ate
+
+
&here
I
-6
E Interest -ate in 6omestic )arket
I
-F
E Interest -ate in Foreign )arket
Pro,lem 1(
7iven %pot '%6$ID- E ><.1121
; )onths For#ard E ><.,1+1
Interest -ate '%( E 3K and India E +2K
For#ard -ate E

,
_

+
+
$-
$2
!
!
Spot$ate
+
+
E

,
_

1
]
1

,
_

+
1
]
1

,
_

+
+2
;
+11
3
+
+2
;
+11
+2
+
1121 . ><
E ><.1121 x .+.12>+/
E >;.1F,1
O the For#ard )arket -ate E ><.,1+1
Thus, six months For#ard *remium E
+11
+2

n S$
S$ -$
M$
M$ M$
E
+11
;
+2
1121 . ><
1121 . >< ,1+1 . ><

E 4.,,<K
'%6 is going at a premium of 4.,,<K.
(s per the interest rate differential, '%6 should be uoted at ID- >;.1F,1. (lso, Interest -ate
6ifferential bet#een t#o countries E +2 A 3 E <K #here as '%6 is being uoted at a for#ard premium
of only 4.,,<K. Thus, there is an opportunity to borro# '%6 from '%( T <K, convert to ID- and
Page of 47 - International Finance (Ver 1.1)
+<
invest in treasury bond at +2K #hile simultaneously buying '%6 ; months For#ard T ><.,1+1 and
earn an arbitrage of +.11<K on investment.
Scenario II
If for#ard rate #as >;.,1+1
Then premium E
+11
;
+2
1121 . ><
1121 . >< ,1+1 . >;

E F.>>K
Thus, if you invest in ID-, you #ould make a loss of F.>>K in for#ard deal #here as your earning
from interest #ould be +2 A 3 E <K. Thus, you be in net loss of F.>> A < E 4.>>K.
This kind of transaction is possible only #hen 7ovt gives freedom to buy and sell ID- or '%6 in both
countries.
Do# in this case, borro# ID- ><.1121 in India T +2K and convert to + '%6 at spot rate. Invest this
'%6 in money market in '%6 at 3K for six months. %imultaneously, sell '%6 +.14< in ; months
for#ard for ID- >F.<>2<. 8our liability against borro#ing in India E

,
_

,
_

+
+2
;
+11
+2
+ + 1121 . ><
E >3.312
Thus, there #ould be gain of ID- >F.<>2< @ >3.312 E ID- 1.F>1< per ID- >.1121 invested or 4.>>K.
Pro,lem 1/
%pot -ate '%6$ID- ? >4.31$>>.1<
F#d -ate .%ix )onths/ ? >4.31L1.>1$>>.1<L1.31
E >>.+1$>>.3<
(nnual Interest -ates in '%( and India are 2K and FK.
For buying '%6
f#d
, *remium E
+11
;
+2
-ate !id
-ate !id @ -ate (sk
%pot
%pot F#d

E
+11
;
+2
>4.31
>4.31 @ >>.3<

E >.F1K
Interest -ate 6ifferential E F A 2 E ;K
Thus, #hile #e lose >.FK in for#ard mkt, #e earn ;K in money mkt. Thus, net gain is ;A>.FE+.2K.
%tart #ith '%6 +11 borro#ed from '% market.
"iability in '% market after ; months E
,
_

+
+11
2
+2
;
+ +11
Page of 47 - International Finance (Ver 1.1)
+;
E '%6 +1+
%o, if #e borro# ID- and invest in '%6 is moving at a premium in ID- #e #ill make a loss
Interest (r#itrage
Interest (rbitrage refers to the international flo# of short term liuid capital .Fixed 6eposits
denominated in Foreign Currencies or Convertible local currency/ to earn a higher interest abroad. In
India #e have D-Is investing in fixed deposits to earn higher interest rates. Interest arbitrage can be
uncovered or covered.
@ncovered Interest Ar,itrage
In order to be able to able to take benefit of higher interest opportunity in foreign country, it is often
necessary to convert the domestic currency to foreign currency #hile investing in foreign country and
then reconverting principal and interest earned to local currency at the time of maturity.
In the countries #here interest rates are higher, inflation is also higher. .nominal interest rate is mostly
eual to real interest rate L inflation/. &hen inflation is higher, the currency mostly depreciates over
time. Thus, there is a risk of depreciation of investment due to lo#er exchange rate during the re@
conversion after maturity. If such a foreign exchange risk is covered, #e have covered interest
arbitrage, else, #e have uncovered interest arbitrage.
%uppose, interest rate in India is ++K #here as it is <K in '%. ( '% investor #ill earn ;K extra per
year or 4K every ; months if he invests in India. Ho#ever, since inflation rate is also high in India at
<K compared to 9ust 2K in '%, ID- is likely to depreciate. If ID- depreciates by 4K over one year, net
return on investment by '% investor falls to barely 4K. Ho#ever, in case ID- depreciates by more than
;K, the '% investor #ill end up as net loser (and we have not even considered the transaction costs in conversion
and reconversion processes)
Covered Interest Ar,itrage
The scenario given above is not beyond real life events. In order to insure against exchange rate risks,
investors usually go for covered interest rate arbitrage.
In this case, investor converts his investment into foreign currency at spot rate and at the same time
sells for#ard the amount of foreign currency he is investing plus the interest he #ould earn to coincide
#ith maturity date of investment. Though, he #ould be paying some premium for for#ard cover, he is
insured against depreciation of currency. His return on investment #ill reduce by the amount of
premium paid for for#ard deal compared to uncovered interest arbitrage but that is the price to be paid
for insurance.
!ut such opportunities do not last long due to t#o reasons.
.a/ (s funds move out of the home country, the interest rates rise there due to
resultant paucity of funds. 5ice versa as additional funds flo# in to foreign country,
excess liuidity of capital causes interest rates to soften.
.b/ (s demand for foreign currency rises, exchange rates move in favour foreign
currency. Currency appreciation coupled #ith excess demand for for#ard deals raise
premium on for#ard deals. Thus, the cost of conversion and reconversion of currency to
foreign currency increases and eats into profits to be earned from interest rate arbitrage.
Thus, the interest rate differential keeps reducing and for#ard premium keeps increasing till it
comes to a level #here it is no more advantageous to invest in foreign country.
Page of 47 - International Finance (Ver 1.1)
+3
Interest Rate 6ifferential- Covered Interest Ar,itrage and Interest Parity "heory
4
2
(rbitrage
+
1
@+ .
.
@2
@4
@4 @2 @+ 1 + 2 4
For#ard Exchange -ate A 6iscount or premium in percent per annum
Explanation of the above figure
Ar,itrage #!tflo& &ill take lace
+. If .L/ve interest rate differential is U For#ard 6iscount like at *oint (,
Interest -ate 6ifferential E 2, and F#d 6iscount E 1.<
2. If For#ard *remium U .A/ve Interest -ate 6ifferential like at *oint (G,
F#d *remium E 2.2, and Interest -ate 6ifferential E +.,<

Ar,itrage Inflo&
4. If For#ard 6iscount U .L/ve Interest -ate 6ifferential, like at *oint !,
F#d 6iscount E 2.3, and .L/ve Interest 6ifferential E +.2
>. If .A/ve interest -ate 6ifferential U For#ard *remium, like at *oint !G,
Ave Interest -ate 6ifferential E 2.2, and For#ard *remium E 1.3
Page of 47 - International Finance (Ver 1.1)
+F
(rbitrage
:utflo#
(rbitrage
inflo#
.(G
.!
(

I
n
t
e
r
e
e
s
t

6
i
f
f
e
r
e
n
t
i
a
l

i
n

f
a
v
o
u
r

o
f

f
o
r
e
i
g
n

c
o
u
n
t
r
y

i
n

p
e
r
c
e
n
t

p
e
r

a
n
n
u
m
Interest
*arity
!G
Sam"le /ractice .uestions on Exch Rate %Forex (rithmetic'
.,. The %pot -ate of t#o banks in '% )arket for 7!* is as follo#s?
7!*$'%6? !ank (? +.><<1$+.><;1
!ank !? +.>4F1$+.><>F
Find &hether (rbitrage is possible.
(ns. The (sk -ate of !ank ! is +.><>F #hich is less than !id -ate of !ank ( at +.><<1. Thus, it is
possible to !uy from !ank ! and %ell to !ank ( and earn an (rbitrage of 7!* of 1.1112 for each
dollar.
.*3 -ate for '%6 in Indian )arket is as follo#s?
'%6$ID-? >;.2111$4111
Inverse the uotes.
(ns.
2111 . >;
+
$
+
$
.!2
&S3
!#$ 1S2
1S2 !#$
E 1.12+;>
4111 . >;
+
$
+
$
&S3
.!2
!#$ 1S2
1S2 !#$
E 1.12+<,
.5. In the Forex )arket, follo#ing are the rates?
'%6$0*8? ++1.2<$+++.+1
'%6$('6? +.;<21$+.;<41
('6$0*8? ;F.41$;,.11
Find &hether (rbitrage is possible in terms of ('6$0*8.
(ns. In this case, if #e inverse the rate of '%6$('6 and get ('6$'%6, our 9ob #ill become easy.
;1<4 . 1
;<21 . +
+
$
+
$
;1<1 . 1
;<41 . +
+
$
+
$


.!2
&S3
&S3
.!2
&12 1S2
1S2 &12
&12 1S2
1S2 &12
&12;J4A < &12;1S2 B 1S2;J4A
(&12;J4A)
.!2
< (&12;1S2)
.!2
B (1S2;J4A)
.!2
Page of 47 - International Finance (Ver 1.1)
+,
2<44 . ;3 +1 . +++
;<21 . +
+
$
;,;, . ;; 2< . ++1
;<41 . +
+
$


&S3
.!2
1S2 &12
J4A &12
!y Three *oint (rbitrage @ ('6$0*8 E ;;.;,;,$;3.2<44
Forex )arket -ate for ('6$0*8 E ;F.41$;,.11
Thus, there is a difference of almost one 0*8 for each ('6 in t#o situations.
%o, to earn arbitrage, %ell 0*8 and buy '%6 T +++.+1.
Then sell '%6 and buy ('6 T +.;<21. Do# sell +.;<21 ('6 and buy 0*8 T 0*8 ;F.4 for
('6 +.
F4 . ++2 41 . ;F ;<21 . +
Thus, for every 0*8 +++.+1 put into market, there is a return of 0*8 ++2.F4.
.13 Follo#ing are the uotes in De# 8ork?
7!*$'%6? +.<23<$F<
'%6$CHF? +.<<41$4,
.a/ &hat rate do you expect for 7!* in !asle=
.b/ If !asle uote is +7!*E 2.4421$41 CHF then find #hether (rbitrage is possible=
(ns 7!*$'%6? +.<23<$F<, '%6$CHF? +.<<41$4,
*6-
C.4
*6-
1S2
1S2
C.4

43<+ . 2
4322 . 2
<<4, . +
<<41 . +
<2F< . +
<23< . +

43<+ . 2
4322 . 2

*6-
C.4
!asle Ruote E +7!* E 2.4421$41 CHF
7!* is cheaper to buy in !asle at 2.4441 CHF. Therefore, buy one 7!* in !asle and sell in
De# 8ork for '%6 +.<23<. Then sell '%6 +.<23< for 2.4322 CHF and earn an arbitrage of .2.4322 @
2.4441/ E 1.14,F CHF per 7!* or
2.4322 CHF E 4322 . 2
4441 . 2
+

E +.1+;F 7!*
%o, the (rbitrageur #ill make 7!* 1.1+;F for every 7!* invested.
Page of 47 - International Finance (Ver 1.1)
21
.73 Follo#ing are the E'-$ID- uotes?
%pot? >,.,<2<$F1
+ )onth For#ard? +11$+21
4 )onth For#ard? 22<$2<<
; )onth For#ard? 411$23<
(ns. + )onth For#ard? >,.,;2<$311
4 )onth For#ard? >,.,3<1$F4<
; )onth For#ard? >,.,22<$,41<
.23 ( bank is uoting follo#ing rates?
E'-$'%6? +.<,3<$F1
2 )onth For#ard *oints ?21$+1
4 )onth For#ard *oints? 2<$+1
Further,
(E6$'%6 rate is 4.3<<1$;1
2 month for#ards points? 21$>1
4 month For#ard points? 41$<1
( firm #ishes to buy (E6 against E'- 4 month for#ard. Find the rate to be uoted by the bank.
(ns. (E6$'%6 E 4.3<<1$;1
4 months For#ard -ate E 4.3<F1$;+1
2;;+ . 1
3<F1 . 4
+
$
$
+
$

&S3
.!2
&S3
&%2 1S2
1S2 &%2
&%2 1S2
2;<, . 1
3;+1 . 4
+
$
$
+
$

.!2
&S3
.!2
&%2 1S2
1S2 &%2
&%2 1S2
E'-$'%6 E +.<,3<$F1
4 months For#ard -ate E +.<,<1$31
E'-$(E6 E E'-$'%6 V '%6$(E6
Page of 47 - International Finance (Ver 1.1)
2+
E +.<,<1 V 1.2;<,
E 1.>2>+
Money Market 7edging
.,3 (n (merican Exporter #ill be receiving W +111,111 4 months from no#. %pot -ate for
7!*$'%6 E +.; -ate of interest in '%( and "ondon )oney market is +1K and <K respectively.
%uggest hedging strategies for the exporter.
.*3 (n (merican Importer has to pay W +111,111 to a party in "ondon for the denim exports it has
made@4 moths from no#. The %pot rate for 7!* is +.; '%6. It is expected that '%6 may depreciate
further in future. -ate of Interest in '%( is <K and in 'B it is +1K.
%uggest hedging strategies for importer.
Interest Rate Ar,itrage
.,3 Exchange rate for '%6 in India is
%pot? ><.1121
; month for#ard? ><.,1+1
Interest rate .annual/ in the money market is as follo#s?
'%(? 3K
India? +2K
&ork out the arbitrage opportunity.
.*3 In (pril 211< '%6$ ID- uotes #ere >4.31$>>.1<.
; moths %#ap points #ere >1$31
(nnual Interest -ate in '%( and Indian #ere 2K and ;K respectively.
&ork out the scope for arbitrage, if any.
.53 ( Customer obtains follo#ing uote@
E'-$'%6? +.2,41$+.4231
(nnual '%I!!-$'% I!:-? >$<.<K
(nnual "I!!-$"I!:-? ;$,K
Calculate the likely limits for the For#ard -ate bet#een the t#o countries.
Page of 47 - International Finance (Ver 1.1)
22
F#RE3 RIS4 MA5A$EME5" "7R#@$7 F@"@RES
( future is an e7change:traded derivative #hich is similar to a for#ard. !oth futures and for#ards
represent agreements to buy$sell some underlying asset in the future for a specified price. !oth can be
for physical settlement or cash settlement. !oth offer a convenient tool for hedging or speculation. For
little or no initial cash outlay, both instruments provide price exposure #ithout a need to immediately
pay for, hold or #arehouse the underlying asset. In this sense, both instruments are leveraged. Futures
and for#ards trade on a variety of underliers? #heat, oil, live beef, Eurodollar deposits, gold, foreign
exchange, the %O* <11 stock index, etc.
The fundamental difference bet#een futures and for#ards is the fact that futures are traded on
Exchanges. For#ards trade over the counter. This has three practical implications.
+. Futures are standardiNed instruments. 8ou can only trade the specific contracts supported
by the exchange. For#ards are entirely flexible. !ecause they are privately negotiated bet#een
parties, they can be for any conceivable underlier .currency/ and for any settlement date. *arties
to the contract decide on the notional amount and #hether physical or cash settlement #ill be
used. If the underlier is for a physically settled commodity or energy, parties agree on issues
such as delivery point and uality.
2. Forards entail both market risk and credit risk. ( counterparty may fail to perform on a
for#ard. &ith futures, there is only market risk. This is because exchanges employ a system
#hereby counterparties exchange daily payments of profits or losses on the days they occur.
Through these margin payments, a futures contractJs market value is effectively reset to Nero at
the end of each trading day. This all but eliminates credit risk.
4. The daily cash flo#s associated #ith margining can ske# futures prices, causing them to
diverge from corresponding for#ard prices.
( future is transacted through an authorised brokerage firm. &orking through their respective brokers,
t#o parties #ill transact a trade. "egally, that trade is structured as t#o trades, both #ith a
clearinghouse o#ned by or closely affiliated #ith the exchange. For example, suppose *arty ( and
*arty ! trade. *arty ( is long and *arty ! is short. This #ould be legally structured as
*arty ( being long on :ne million '%6 futures at -s >3 #ith the exchangeJs
clearinghouse being the counterpartyM and
The exchangeJs clearinghouse being long on :ne million '%6 futures at
-s >3 #ith *arty ! being the counterparty.
*arty ( and ! then have no legal obligation to each other. Their respective legal obligations are to the
exchangeJs clearinghouse. The clearinghouse never takes market risk because it al#ays has offsetting
positions #ith different counterparties.
!efore you can trade a futures contract, the broker collects a deposit from you called initial margin.
This may be in the form of cash or acceptable securities. The broker holds this deposit for you in a
margin account3 The amount of initial margin is determined according to a formula set by the
exchange. For a single futures contract, it #ill be a small fraction of the market value of the futuresJ
underlier. For futures spreads, or if you are using futures to hedge a physical position in the underlier,
initial margin may be even lo#er. 7enerally, initial margin is intended to represent the maximum one@
day net loss you could reasonably be expected to incur on a position.
Page of 47 - International Finance (Ver 1.1)
24
Through the margining process, futures settle every day. 'nlike a For#ard, #here all contract
obligations are satisfied at maturity, obligations under the futures contract are satisfied every day on an
ongoing basis as mark@to@market profits or losses are realiNed. This essentially eliminates credit risk for
futures.
Maintenance Margin is some fractionXperhaps 3<KXof initial margin for a position. %hould the
balance in your margin account fall belo# the maintenance margin, your broker #ill reuire that you
deposit funds or securities sufficient to restore the balance to the initial margin level. %uch a demand is
called a Margin Call. The additional deposit is called =ariation Margin. %hould you fail to make a
variation margin payment, your broker #ill immediately liuidate some or all of your positions.
Mechanism of F!t!res "rading
Comonents of F!t!res "rade
+. F!t!res Players
.a/ 7edgers A These are the importers and exporters #ho mitigate their risk of unfavourable
movement of exchange rate #hen they need to buy or sell the foreign currency at a
future date.
.b/ Sec!lators A These are investors #ho buy or sell foreign currency #ith the sole aim of
earning money through correct anticipation of movement of exchange rate.
.c/ Ar,itrage A These are people #ho utilise the opportunities presented by market due to
asymmetric forex exchange bid and ask rates in the same market or in different markets
2. Clearing 7o!ses A Futures trade is an organised trade. Futures are traded
through exchanges akin to %ecurities Exchanges #hich provide guarantee performance of all the
players. They play the role of buyer for every seller and vice versa. Thus, every trading party in
the futures market has obligation only to the clearing house.
4. Margin Re?!irement A The risk of default of any player is insured by
imposing the reuirement of depositing the margin money #hich is adeuate to cover the
adverse movement of currency in the short term. Thus, margins are not uniform and vary across
markets, contracts, currency and duration of contract. %ince the currency movement is not as
#ild as stocks, the margin reuirement is also relatively small. (1sually in the range of DE of contract
value)
>. 6aily Settlement A Dotional losses or gains incurred due to fall in the value
of the currency are reuired to be settled bet#een the party and the broker on daily basis to
ensure maintenance of original level of margin .security/ money. This is technically called
H)ark to )arketI.
<. 6elivery 6ate A There are t#o types of contracts A European Contract,
#hich are delivered$encashed only on the last day of the contract period and (merican
Contracts, #hich can be delivered$encashed on any day during the contract period.
;. Manner of 6elivery A The contract settlement, technically called
H2eliveryI, can be done by either of the follo#ing three modes?
.a/ *hysical exchange of underlying assets ie Exchange of currencies.
Page of 47 - International Finance (Ver 1.1)
2>
.b/ Cash %ettlement as in the case of %tock Index Futures. There is no exchange of currencies
and only differential amount is paid.
.c/ -eversing Trade @ It is the process of offsetting a long position by acuiring a short position
or vice versa. The t#o positions suare at the end of the day.
3. "yes of #rders A
.a/ Market #rder A :rder placed #ith broker to !uy or sell at prevailing market price.
.b/ Aimit #rder A !uy or sell order at a specific price or better.
.c/ Fill-or-4ill #rder A It instructs broker to fill an order immediately at a specified price.
.d/ All or none #rder A It allo#s broker to fill part of the order at specified price and remaining
at other price$s.
.e/ #n the #en or Close #rder A This represents order to trade #ithin a fe# minutes of
opening or closing of the exchange.
.f/ Sto #rder A It triggers a reversing trade #hen prices hit a prescribed limit.
F!nctions of F!t!res Markets
Futures )arkets function as
+. *rice 6iscovery (gent
2. %peculation Tool
4. Hedging Tool
Price 6iscovery
HFuturesI prices are generally treated as a consensus forecast by the market regarding prices of
currency$commodity at the contract expiry date. Thus, for all and sundry, it is a free forecast available
to them. Empirical studies have revealed that such forecasts are not very accurate, yet they are the best
among all the alternatives available. )ore often than not, they provide a reasonably good hint in case of
currencies and commodities but not eually accurately in case of stocks.
Sec!lation
Futures provide excellent tool for speculation since it is highly leveraged (only margin amount of
appro7imately DE needs to be paid upfront). (lso, the transaction costs are lo#er than in case of delivery.
Thus, percentage returns are higher.
%peculators are categorised based on the length of positions they hold.
.a/ Scalers A They have the shortest holding horiNons, typically closing a position #ithin
minutes of initiation.
.b/ 6ay "raders A They hold futures positions for a fe# hours but never longer than one
trading session. They open and close positions #ithin the same day. Their net holding at
Page of 47 - International Finance (Ver 1.1)
2<
the end of any day is al#ays Nero. They play on the scheduled announcements and ne#s
related to money supply, trade deficit etc.
.c/ Position "raders A They have longer holding horiNons, often a fe# months. There are
t#o types of position traders?
.i/ 8utright /osition -olders A He takes position based on his belief on the
underlying potential. He stands to make large gains or losses.
.ii/ S"read /osition -olders A He does not have belief on a particular currency or
commodity, but he speculates on relative movement of t#o commodities. %o he
holds simultaneous position in t#o commodities, long in commodity #hich is
likely to appreciate and short in commodity #hich is likely to depreciate. The
t#o commodities could be from same basket, like #heat and rice or could be
from different baskets like #heat and %teel. If the spread bet#een them #idens,
he gains else he loses. %uch positions are less risky than :utright *ositions.
7edging
Hedging is process of engaging in a futures or for#ard contract by paying a small premium to eliminate
risk associated #ith large unfavourable movement in exchange rate by the time payment or receipt is
due. There are three types of hedges?
.a/ Aong 7edgeBAnticiatory 7edge A Investor does not o#n the asset but #ants to
purchase the same in foreseeable future. He protects against adverse price movement of
the large escalation in prices of that asset by long hedge.
.b/ Short 7edge A (n investor already o#ns an asset #hich he #ants to sell in future. He
#ants protection against steep fall in its prices. He hedges the risk by selling its future.
.c/ Cross 7edge A The act of hedging ones position by taking an offsetting position in
another good #ith similar price movements. (lthough the t#o goods are not identical,
they are correlated enough to create a hedged position. ( good example is cross hedging
a long position in crude oil futures contract #ith a short position in natural gas. Even
though these t#o products are not identical, their price movements are similar enough to
use for hedging purposes. In currency matters, '%6 and Canadian 6ollars can be used
for cross hedging.
Page of 47 - International Finance (Ver 1.1)
2;
F#RE3 RIS4 MA5A$EME5" "7R#@$7 #P"I#5S
(n 8"tion is a contract #hich gives its buyer the right either to buy (*all Fption) or to sell (4ut
Fption) a specified amount of a currency #ithin$after a specified period at a predetermined price called
Strike Price9 (n :ption that gives the right to buy is called a Call #tion and an :ption that gives the
right to sell is called a P!t #tion9
(n option gives the buyer right to buy or sell but there is no obligation to do so. ( buyer is at liberty
not to exercise his option. !ut the seller is under obligation to honour the call or put option if the buyer
decides to exercise it. (nd the buyer #ill do it only #hen it is profitable to him. He #ill exercise his
Call :ption .right to buy/ #hen market rate of that currency is higher than the strike price. %imilarly, he
#ill exercise his put :ption, only #hen market price has fallen belo# the strike price.
%uppose, )r 8ash#ant buys a Call :ption from )r 0oseph T ID- >; for '%6 +,111,111 on 1+ %ep
211; #ith the expiry date of 41 %ep 211;. Do#, )r 8ash#ant can demand from )r 0oseph to sell '%6
+,111,111 on any day during this period. )r 8ash#ant #ill #ant to buy these '%6 from 0oseph only if
rate of '%6 in the open market is higher than strike price of ID- >;, say ID- >3. In case, open market
rate is lo#er than ID- >;, say ID- ><, )r 8ash#ant #ill be better off buying the '%6 from open
market.
If '%6 rate goes up to ID- >3 and )r 8ash#ant demands to exercise his Call :ption, )r 0oseph #ill
have to sell him those '%6 at strike price of -s >; #hich is no# at a discount of ID- +$@ to the market
price. Ho#ever, if the market price had fallen belo# the strike price to ID- ><, )r 8ash#ant is under
no obligation to buy '%6 from )r 0oseph at -s >;.
!ut #hy should :ption %eller (also called ,riter) take this risk= He sells the options for a price called
Premi!m #hich is non refundable. He hopes that option #ould not be exercised and he #ould be able
to keep the premium. In case an option is not exercised, it is his earning. In case the option gets
exercised, his loss is partly offset by this amount.
%peciality of :ptions contracts is that the #hile max loss for the buyer of :ption is limited to the
premium he paid for purchasing the contract, his profits have no limits. The situation is 9ust the reverse
for the seller. His max profit is eual to the premium he has received but his losses have no cap.
:ption Contracts also follo# the (merican and European systems. (n option #hich can be exercised at
any time during the currency of the contract is called H(merican %tyleI :ption. (nother type of :ption
#hich can be exercised only at the end of the contract period is called the European %tyle. The
probability of exercise of option is higher in case of (merican :ptions and therefore the premium is
also higher. %imilarly, if the contract period is longer, probability of exercise of option increases and
the premium goes up again. (nother factor #hich affects the premium is the Strike Price. Farther the
strike price from spot price at the time of deal, lesser the probability of exercise and so lesser the
premium.
(n option can be HIn the )oneyI, H(t the moneyI or H:ut of the moneyI depending upon %trike *rice
vis a vis market price of asset.
(n option is called HIn the MoneyI if the exercise of option at that market price #ould fetch him profit.
%o, in a Call :ption, if the dollarGs spot price is ID- >;, and strike price is ID- >>, exercise of option
#ill fetch a profit of ID- 2.11 per dollar.
Page of 47 - International Finance (Ver 1.1)
23
(n option is called HAt the MoneyI if the spot price and strike price are eual and therefore no gain or
loss #ould accrue to either side .premium is not considered/. Therefore, such options are not exercised.
(n option is called H#!t of MoneyI if its exercise #ould lead to loss to the buyer, ie, in a call option,
the spot price of the '%6 falls belo# the strike price. %uppose, a dollar call option #as purchased for
ID- >>. If the spot price of dollar falls to -s >4, it #ould be cheaper to buy shares from market than
exercise of option. Therefore, H:ut of )oneyI options are never exercised.
*remiums are also influenced by follo#ing factors?
.a/ =olatility A Higher the volatility, higher the chances of asset prices breaching the
strike price. %o, higher the premiums.
.b/ Interest Rate A -elative interest rate bet#een t#o currencies affect premiums.
.c/ *olitical uncertainty, inflation, etc, again pose risk of sharp movement in currency
exchange rates.
This flexibility and variability in pricing of options and premium gives a multitude of opportunities to
the players in the market. !y buying or selling a combination of options, profit opportunities are
created. %ome of the strategies adopted by people are listed belo#? @
5aked #tion A (n option for #hich the buyer or seller has no underlying security position. ( #riter
of a naked Call :ption, therefore, does not o#n the asset or even a "ong *osition in the asset on #hich
the call has been #ritten. %imilarly, the #riter of a naked *ut :ption does not have a %hort *osition in
the asset on #hich the put has been #ritten. Daked options are very risky@although potentially very
re#arding. If the underlying asset moves in the direction anticipated by the #riter$seller, profits can be
enormous, because the investor #ould only have had to put do#n a small amount of money to reap a
large return. :n the other hand, if the asset moved in the opposite direction, the #riter of the naked
option could be sub9ect to huge losses. It is also called uncovered option.
Straddle A (n options strategy in #hich the investor holds position in both, a call and a put #ith the
same strike price and expiration date. %traddles are a good strategy to pursue as a buyer if an investor
believes that a stockJs price #ill move significantly, but is unsure as to #hich direction .volatile
market/. The stock price must move significantly if the buyer of option is to make a profit. (s sho#n in
the diagram belo#, should only a small movement in price occur in either direction, the buyer #ill
experience a loss (due to premium he has paid for two contracts). (s a result, a straddle is extremely risky to
perform. (dditionally, on assets that are expected to 9ump, the market tends to price options at a higher
premium, #hich ultimately reduces the expected payoff should the stock move significantly.
Page of 47 - International Finance (Ver 1.1)
2F

There is a 9ong Straddle in #hich the person buys call and put options simultaneously.
Short Straddle : If the market is expected to be stable, the person can sell the call and put options at
the same time. Thus, he #ill collect t#o premiums and may have to pay back only a small portion of
that amount if the asset price moves in a narro# band. This is called a %hort %traddle because he is
selling #ithout o#ning the asset.
Strangle AIt involves buying a call and a put option at t#o different rates but of eual value and of
same maturity date.
In a "ong %trangle, Call is bought at a lo#er rate and *ut is bought at higher rate. "ong %trangle is
again a strategy for a volatile markets.
In the short %trangle, Call is sold at higher rate and *ut is sold at lo#er rate. %hort %trangle is used for
stable markets.
In case of straddle, if the market is not volatile, purchaser loses the premium on both the sides. !ut this
is not the case in %trangle.
Page of 47 - International Finance (Ver 1.1)
%elling a *ut %elling a Call
>;
><.<1 >;.<1
*
r
o
f
i
t
"
o
s
s
& 4ut Fption Short Straddle
2,
Take a hypothetical case #here a "ong straddle has been entered into #ith *ut :ption purchased at
%trike *rice of ID- >3 and a Call :ption at %trike *rice of ID- ><, both #ith a premium of ID- + each
.7raph as sho#n by dotted lines/. Theoretically, profit #ill start in the call option the moment price
goes above -s ><. Ho#ever, #hen #e consider that #e paid a premium of -e +, the profit #ill actually
start only after market price exceeds -s >;. %imilarly, in the put the option, theoretically profit #ill
start the moment price falls belo# -s >3. Ho#ever, in order to recover the premium that #e paid, price
should fall to minimum -s >;. Thus, #hen #e account for premiums also, the lines shift and ne#
graph #ill look like as sho#n by firm lines. Do# #e see that at any exchange rate, the person does not
suffer any loss. In the #orst case scenario, at the spot rate of ID- >;, he #ould break even. In any other
situation, he #ould make some profit. There could be some loss at times in case the premium is too
high and spread bet#een the call and put rate being relatively small (situation represented in graph with light
blue lines Goss is shown in such case as orange shaded area which is comparatively small/.
Exotic #tions
&hat have been discussed so far #ere 5anilla :ptions Contracts as practiced in India. These #ere the
contracts #here there #ere no conditions attached to the contracts. In many countries, options contracts
are available #ith additional conditions. %uch contracts are called Exotic :ptions Contracts. &hile
these options contracts are not available in India through official channels, there is no bar in entering
into them on :TC .:ver the counter/ basis.
+. "!nnel #tion Contract &ith Cero Premi!m @ This contract is
also called cylinder options contract. In this case, the upper limits of exercise price for Call
:ption is specified. Even if the spot price of asset exceeds the limit price, deal #ould be done at
limit price only. Thus, the loss to the Call %eller has been limited. %imilarly, limit price for
exercise of *ut option is also specified thus limiting the max loss of the *ut option #riter. %ince
the loss of #riter has been capped, and the possible gain of the buyer has been capped, there is
Nero premium.
Eg. *ut :ption sold at %trike *rice of ID- >;.2< #ith the exercise price capped at ID-
>;. Do#, even if the spot rate falls to ID- >>, the exercise price #ill be considered to be ID- >;
only and the seller #ill pay only ID- 1.2< per dollar to the buyer.
2. 4nock #!t #tions A This is a further amendment to the Tunnel
:ption. In this case, if the spot price moves beyond the limit price, the contract is knocked out
#hich means that contract becomes null and void and no settlement takes place. %uch kind of
Page of 47 - International Finance (Ver 1.1)
*ut :ption %trike
*rice "ine
Call :ption
%trike *rice "ine
*ut :ption
minus *remium
Call :ption plus
*remium
Gong Strangle Craph
>;
><
>3
*
r
o
f
i
t
"
o
s
s
41
contract is not possible under (merican Contracts method. This happens only in European
contracts #here the contract expiry date is fixed. The premium for such contract is again very
lo# because sellerGs position is #ell protected.
4. Aook Back #tion A This is one option #hich has very high
premium because it is heavily loaded in favour of buyer. 'nder this option, the deal is done at
most favourable price for the buyer in the period preceding the settlement date. It allo#s the
buyer to look back and select the most favourable rate in the past for settlement. %o, if the rates
in the past #ere >;.++, >;.4+, >;.<<, >;,32, 829):, >;.><, >;.4,, >;.21 on the days from
contract to the settlement date, Call option buyer can look back into the past and select 829):
#hich is the highest in the period as the settlement price. (t the same time a put option buyer
#ill be allo#ed to select >;.++ as the exercise price because that is most favourable to him.
>. Average Rate #tion Contract A This is also called (sian
Contract. 'nder this contract, the exercise price is the average of closing prices since contract
date.
S%APS
'nlike Futures and :ptions, Sa" is not a risk management strategy. It is a strategy to take
advantage of differential opportunities for different people.
%#ap, as the name suggests, is the exchange of liabilities. T#o people having liabilities of different
types exchange their liabilities for some perceived advantage. For example, a French company #anting
dollar loan might be getting better rates in French Francs. (nother company in '% might #ant French
Francs but it is advantageous for it to borro# dollars. The t#o can borro# #hat is advantageous to
them and then mutually exchange their currencies along #ith their payment liabilities #ithout involving
their lenders.
It could also be a s#ap bet#een current and future liabilities of same person. ( person may purchase
spot currency V by selling currency 8 and simultaneously selling for#ard currency V buying currency
8. Thus, there is one spot deal and one for#ard deal. %uppose, you are due to receive '%6 +111 three
months from no# and have some excellent investment opportunity in '%6. %o, you spot buy the '%6
+111 against ID- and for#ard sell .three months/ '%6 +111. :nce you receive '%6 +111 three
months later, you suare up the for#ard position and get back the rupees that you had invested.
%#ap comes in many forms, like interest rate s#aps, currency s#aps, positions s#ap, etc.
.a/ %pot For#ard %#ap A (s explained above.
.b/ For#ard For#ard %#ap A !oth transactions are in future but executable on different
dates.
.c/ Interest %#ap
.d/ Currency %#ap
Interest S&as
.a/ Fixed to Fixed Interest rate %#aps
.b/ Fixed to Floating Interest rate %#aps
.c/ Floating to Floating Interest -ate %#aps.
Page of 47 - International Finance (Ver 1.1)
4+
Exam"le )
Company ( is offered loan in the market T ++K fixed and "I!:- L 1.<K floating. Company (
prefers to take fixed rate loan. Company ! en9oys better credit ratings and therefore has been offered
loan T ,.<1 K fixed and "I!:- floating. Company ! prefers floating rate. Find the %#ap possibility.
Solution )
Fixed
Rate
Floating Rate
Company ( ++K "I!:- L 1.<1K
Company ! ,.<1K "I!:-
6ifference +.<1 1.<1
It is clear from above data that company ! has lo#er rate in both the cases. Ho#ever, company !
en9oys more benefit compared to ! in case of fixed rate #here the differential is +.<1K as against
floating rate #here differential is barely 1.<K. Ho#ever, company ! #ants floating rate #here its
relative advantage is less.
In order to derive full advantage of this situation, Company ( can take Floating -ate loan even though
it #ants fixed rate loan and Company ! should take Fixed rate loan. (fter taking the loans they can
mutually s#ap their liabilities. Do# let us dra# the table and see ho# both companies can benefit from
such a transaction.
Comany Pay to
Market
Receive
fm Co B
6ifferentia
l
Pay to
Co B
5et Rate of
Interest
$ain
( "ibor L 1.<1 "ibor 1.<K loss +1K +1.<K 1.<K
! ,.<K +1K 1.<K gain "ibor "ibor @1.<K 1.<K

To understand this problem, look at it from another angle. "et us take company ( and forget about
company ! for the time being. Company ( has taken loan from the market and lent to Company !. %o,
it #ill earn interest from company ! but has to pay interest to the market. There #ill be some
differential bet#een the t#o interest rates #hich #ill be gain or loss (gain at this stage is not mandatory).
Do# company ( has also taken a second loan from company ! and has to pay interest for it. This
interest plus the differential is the net interest cost to the company (. Compare it #ith #hat company (
#ould have paid had it taken the desired loan directly from the market and you kno# the gain. -epeat
same exercise for company !. &hat is very important to note here is that #hile gains to both the
companies may not be eual, neither company should be in loss else it #ill not enter into this s#ap
transaction.
International Financial Institutions .!anks/ are ever eager to s#ap their loans. These banks have their
assets at Floating rate #here as liabilities are at fixed rate. To cover this mismatch bet#een assets and
liability, they use s#ap.
%imilarly, long gestation period pro9ects like infrastructure pro9ects prefer fixed rate #hereas banks are
often reluctant to give fixed rate loans due to long maturity period.
Page of 47 - International Finance (Ver 1.1)
42
C!rrency S&as
Cross C!rrency S&as Along %ith S&a of Interest Rate Aia,ility9
First ever such deal #as bet#een I!) and the &orld !ank. I!) had CHF loan and #anted to convert
into '%6 loan. :n the other hand &orld !ank #anted CHF loan but interest rates in %#itNerland had
already risen uite a bit. The t#o agreed to s#ap the loan and &orld !ank floated '%6 bonds in '%
market for euivalent amount to CHF loan of I!). :nce the money #as collected, they s#apped their
loans. I!) began to service '% lenders on behalf of &orld !ank #hile &orld !ank began to service
I!) lenders in %#itNerland.
Do# suppose, &orld !ank issued bonds T 4K in '% market for '%6 +11,111,111 and I!) loan #as
CHF 411,111,111 #ith exchange rate being CHF 4 per '%6.
Comany Pay to Market #ther Party
ays to Co
Pay to other
Party
5et Rate of
Interest
$ain
&orld !ank 4K 4.+1K F.+1 FK
I!) FK F.+1K 4.+1 4K
!iggest Challenge in case of s#ap transaction is to find another party #hich has corresponding
reuirements #here amount, duration, and type match. To fill this gap, banks act as a mediator$broker.
They charge a small fees in form of percentage of interest gained from both the parties.
Even #ith banks acting as mediator, it is not al#ays possible to finding a matching company. %o, a
trend is emerging #here in the banks have started acting as the counter party. (!s it not the same as basic
function of banks5 !n case of direct lending and deposits, they do not match the tenure and amount Same is the condition in
this case).
( normal deposit and lending function carries t#o risks?
.a/ Credit Risk A The borro#er may default in payment.
.b/ Interest Rate Risk A In case of interest rates movement, the customer at disadvantage
may foreclose his account but the one #ho gains #ill not. The loss #ill then have to be
borne by the bank.
In case of s#ap functions there could be another risk, ie.
.c/ Exchange Rate Risk A The t#o currencies may move in a divergent fashion leading to
same situation as in case of interest rates.
Thus, it is necessary to cover their positions #ith counter s#ap.
Page of 47 - International Finance (Ver 1.1)
44
Pro,lem A
Comany Fixed Floating Preference
( ,+ ; "ibor L 1.<K Fixed
! ,.<K 9i#or < +3*7; Floating
6ifferential 1.<K 1.2< K 1.2< K .net/
Comany Pay to
Market
Receive
from other
Co
6ifferential
'Interest
lossBgain+
Pay to
#ther
Co
5et Rate of
Interest
$ain
( "ibor L
1.<K
"ibor L
1.43<K
1.+2<K loss ,.3<K ,.F3<K 1.+2<K
! ,.<K ,.3<K
632;
1.2<K gain "ibor L
1.43<K
+3,7;
"ibor L
1.+2<K
1.+2<K
+3+7
=al!ation of S&a
5aluation of s#ap is done by finding out present value of future earnings. 5aluation of Fixed rate s#ap
is easy since earnings every year are kno#n. In case of Floating rate s#aps, the interest is reset every
six months. Thus, calculating long term valuation beyond one or t#o periods is not possible.
*5 of earning of -s +11$year over < years E
< > 4 2
/ +1 . + .
+11
/ +1 . + .
+11
/ +1 . + .
+11
/ +1 . + .
+11
/ +1 . + .
+11
+ + + +
MI5I CASED "7E CE5"RAAIA C#RP#RA"I#5>S C@RRE5CE S%AP
The Centralia Corporation is a '.%. manufacturer of small kitchen electrical appliances. It has decided
to construct a #holly o#ned manufacturing facility in YaragoNa, %pain, to manufacture micro#ave
ovens for sale to the European 'nion market. The plant is expected to cost Z >,,21,111 and to take
about one year to complete. The plant is to be financed over its economic life of eight years. The
borro#ing capacity created by this capital expenditure is F(-*11-111M the remainder of the plant #ill be
euity financed. Centralia is not #ell kno#n in the %panish or international bond marketM conseuently,
it #ould have to pay , percent per annum to borro# euros, #hereas the normal borro#ing rate in the
euro None for #ell@kno#n firms of euivalent risk is 3 percent. Centralia could borro# dollars in the
'nited %tates at a rate of F percent.
Study .uestions=
+. %uppose a %panish )DC has a mirror@image situation and needs C+,311,111 to finance a capital
expenditure of one of its '.%. subsidiaries. It finds that it must pay a , percent fixed rate in the
'nited %tates for dollars, #hereas it can borro# euros at 3 percent. The exchange rate has been
forecast to be C1.,1$Z+.11 in one year. %et up a currency s#ap that #ill benefit each
counterparty.
2. %uppose that one year after the inception of the currency s#ap bet#een Centralia and the
%panish )DC, the '.%. dollar fixed rate falls from F to ; percent and the euro None fixed rate
Page of 47 - International Finance (Ver 1.1)
4>
for euros has fallen from 3 to <.< percent. In both dollars and euros, determine the market value
of the s#ap if the exchange rate is C1.,1>4$Z+.11.

Comany Pay to
Market
Receive
fm other
Co
6ifferentia
l
Pay to
other
Co
5et Rate of
Interest
$ain
Centralia FK F.<K 1.< K gain F K 3.< K +.< K
%panish
)DC
3K F K +.1 K gain F.< K 3.< K +.< K
Sol!tion
%ince both the countries have relative advantage in borro#ing from their respective countries, Centralia
#ill borro# from '%( C+,311,111 T FK and %panish )DC #ill borro# Z +F,FFF,FF, T 3K from
%pain. It is assumed that the t#o companies #ill go for plain currency s#ap #ithout any bargaining on
interest rate. Thus, Centralia #ill take over loan of Z +F,FFF,FF, .C+311111 x 1.,/ and hand over C
+,311,111 loan to %panish )DC along #ith liability for payment of interest and principal.
*ayments that needs to be paid$received by each party? @
(*entralia will receive payment H IE per annum (ie 1S2 ',@>,???) from Spanish M#* for ) years and then a lump sum
payment of 1S2 ',)??,??? at the end of ) years Spanish M#* will receive payment H ) E annum (ie %uro ',@=,==)= from
*entralia over the same period and then %uro 'IIIII( at the end of the ) years)

"oan 8 + 8 2 8 4 8 > 8 < 8 ; 8 3 8 F 8 F
Centralia +311111 +4;111 +4;111 +4;111 +4;111 +4;111 +4;111 +4;111 +311111
%pain
)DC
+FFFFF, +42222 +42222 +42222 +42222 +42222 +42222 +42222 +FFFFF,
Calculating *resent 5alue of above payments?
(4lease note that above are &##1!"!%S (where a fi7ed amount is paid every year for a number of years) of ) year each at
different rates of interests "here are three methods to calculate the 4resent Jalue of an annuity and can be calculated by
any of the three methods -irst method is e7plained on previous page)
Second Method ? *5 of an annuity E
( )
1
]
1

n
r r r
*
+
+ +
"hird Method? @ Tables are available at the end of every F) book #hich give value of annuity factor
for any given combination of interest rate and duration. The annuity factor can be used to multiply #ith
principal amount to arrive at the present value of any annuity.
("he problem with first method is that it is too long and cumbersome, where as third method requires availability of tables
!t also does not give value for fraction of interest rates like DD "hus, second method is by far the best method)
%o, *5 of Centralia Income E +4;111
( )
1
]
1

3
1; . 1 + 1; . 1
+
1; . 1
+
E +4;111 x <.<F2 (Aou will find same value against column >E and line )E in -M
tables)
Page of 47 - International Finance (Ver 1.1)
4<
E C 3<,,+<2
*resent 5alue of lump sum payment of '%6 +,311,111 E
( )
1
]
1

+
3
1; . 1 +
+311111
E
1
]
1

<14; . +
+311111
E C +,+41,<,3
Total *resent 5alue of Centralia "oan E 3<,,+<2 L+,+41,<,3 E C+,FF,,3>,
*5 of %panish )DC Income E +42222
( )
1
]
1

3
1<< . 1 + 1<< . 1
+
1<< . 1
+
E +42222 x <.;F4 (Aou can take average value of D and >E from the table)
E Z 3<+,>+4
%imilarly, *resent 5alue of lump sum payment of Euro +,FFF,FF, E
( )
1
]
1

+
3
1<< . 1 +
+FFFFF,
E
1
]
1

><>3 . +
+FFFF,
E Z +,2,F,>,2
Total *resent 5alue of %panish )DC "oan E 3<+,>+4 L +,2,F,>,2 E Z 2,1>,,,1<
Converting the Euro into dollar amount Z 2,1>,,,1< x 1.,1>4 E C+,F<4,32,
Det "oss to %panish )DC E +,FF,,3>, @ +,F<4,32, E C 4;121
For&ard Rate Agreement 'Possi,ly a short note+
( For#ard -ate (greement .F-(/ is a for#ard contract #here the parties agree that a certain interest
rate #ill apply to a certain notional loan or deposit during a specified future period of time. ( F-( is
similar to an Forex for#ard contract #here the exchange rate for a future date is set in advance. It is
purely notional as the parties do not actually pay or receive the principal sum but only settle the
differential amount arising out of difference bet#een agreed rate of interest and the market rate of
interest. Thus, suppose, a company negotiates #ith a bank on +> %ep 211; a loan of '%6 <11 million
for < years T ;K interest starting on 1+ 0an 2113. If the interest rate in the market at the start of the
loan period, ie on 1+ 0an 2113, increases to 3 K, bank #ill pay the company interest T +K for < year
period on '%6 <11 million. Ho#ever, if the interest rate falls to <K, company #ill be obliged to pay to
the bank same amount. There is no option to back out of contract.
Interest Rate #tions A In case of interest rate options, often there is a floor and a cap. In case of #ild
movement of interest rates, these floor and cap come into play. They restrict the upside and the do#n
side for both the parties. The settlement is done #ithin the band of floor and cap even if the interest
rates move beyond these limits.
For uite a fe# years 0apan had a Q1G interest rate regime. The interest rates have begun to harden a bit
no#. Ho#ever, they are still abysmally lo#. "ibor for 8en is currently at 1.+< A 1.+FK. 8en loans are
Page of 47 - International Finance (Ver 1.1)
4;
available at "ibor plus > to < K #here as -upee loans cost as much as F to +1K. Thus, there is still
margin of 4 to < K available for an Indian Company.
&hen an Indian company or bank takes a 8en loan, it is hoping that the 8en #ont appreciate compared
to Indian currency, nor #ill the interest rate in 0apan fluctuate #ildly during the loan period. !ut,
lendersG expectations are 9ust the opposite. They are hoping that 8en #ill appreciate and even the
interest rates in 0apan #ill harden. The deal takes place because of contrary expectations of t#o parties.
%imilarly, %#iss Frank "ibor rate is currently at 2K. (dd a fe# percent and it is still cheaper to borro#
but #ith the risk of "ibor increasing as also appreciation in value of %#iss Frank #hich may #ipe out
all the gains of lo#er interest rate prevailing no#.
&hile there is a cap placed on EC!, there is no cap on %#ap deals.
Balance of Payment ConcetBAcco!nting
!alance of *ayment (ccount is (ccounting record of economic transactions #ith the #orld. (ny
transaction #hich can be converted into money terms is recorded. !alance of *ayment account has
three main heads? @
.a/ Current (ccount .-evenue Transactions/
.b/ Capital (ccount
.c/ -eserve (ccount ."iability of Central !ank/
The rules for accounting are A
.a/ Cr all transactions #hich lead to receipt of Forex from rest of the #orld and 6r the
receipt of forex itself.
.b/ 6r all transactions #hich lead to payment of forex to -est of &orld .-o&/. Cr the
payment of forex itself.
This account also follo#s the typical double entry book keeping system. There is a debit entry
for every credit entry and vice versa. (!t is the same principle which we studied while studying &ccounting
*redit the account which generates the income (so *r sales account for sales) but debit the account which receives
the payment (so 2r cash account)
-eserve !ank !ulletin for !alance of *ayment status .%ep 211;/ is available at
http?$$rbidocs.rbi.org.in$rdocs$!ulletin$*6Fs$32<43.pdf .internet/ or !alance of *ayment.pdf
file separately.
Clarifications regarding some terminologyD
Merchandise A *hysical goods #hich can be seen and felt
Invisi,les A &hich have no physical existence, like services, soft#are, !*:, etc
"ravel A )oney spent by tourists in India or by Indians tourists else #here. Includes inland
travelling ticket expenses.
Page of 47 - International Finance (Ver 1.1)
43
"ransort A Fares paid for material and men for international movement. Ticket fares paid for
international travel are accounted under this head but not the travel fares #ithin the
country.
$9n9i9e9 A $overnment 5ot Included Else#here
Some "yical "ransactionsD
+. (n Indian Company exporting goods #orth -s +11 million to rest of the #orld
and receiving payment in bank.
!y )erchandise Cr +11 million
To !anking 6r +11 million
2. Indian Co. exporting to -o& on '%6 <11 million of goods of #hich it receives
<1K payment immediately and rest in instalment over next 4 years
!y )erchandise Cr <11 million
To !anking 6r 2<1 million
To Commercial "oan 6r 2<1 million
%uppose after one year '%6 <1 million is received.
!y Commercial "oan Cr <1 million
To !anking 6r <1 million
4. Indian 7ovt receives a grant of goods #orth '%6 <11 million after 7u9arat Earth
Ruake from 7ovt of '%
!y Transfer *ayment (c .official/ Cr <11 million
To )erchandise (c 6r <11 million
(for accounting purpose cases of goods grant are treated as import)
>. !HE" floats out EC! deal to -o& #orth <11 million and uses the money for
buying plant and machinery for use?
!y Commercial !orro#ing Cr <11 million
To )erchandise 6r <11 million
<. Infosys receiving part of profit '%6 <11 million #hich is outcome of investment
in soft#are entities in %ingapore, '%( and 'B
!y Foreign Investment ($c. Cr <11 million
To !anking ($c 6r <11 million
Page of 47 - International Finance (Ver 1.1)
4F
CAPI"AA ACC#@5" C#5=ER"IBIAI"E
The govt has allo#ed 6e@0ure *urrent &ccount *onvertibility but not 6e@Facto convertibility.
&hat it means is that current account convertibility is only in the name. &hile there are no limits
placed on current account convertibility for import and export purposes, there are logical limits
imposed on convertibility for other reasons like personal travel, business travel, medical treatment,
%tudies, )aintenance, etc.
Convertibility on Capital (ccount, also called full float of rupee, is still far #ay off. Even
though Tarapore Committee (Salient $ecommendations listed below) had recommended Capital (ccount
Convertibility, 7ovt and -!I are treading a cautious approach. The repercussions of Capital (ccount
Convertibility can be disastrous if things go #rong. The #orld learnt it through East (sian Economic
Crisis in +,,3. !ooming Economies suddenly collapsed in a matter of days.
:nce Capital (ccount convertibility is allo#ed, every one is allo#ed a free hand to invest in
and dis@invest from the country as much as and #henever he #ants. (t the first sign of trouble,
investors rush to dis@invest and the cascading effect on economy is crippling. Currently, there are caps
on ho# much can one invest abroad or ho# much can a foreign company invest in #hich
company$sector. In addition, before investing, companies have to register themselves. There are caps on
EC! as #ell.
For further details on Capital account, read last semester notes on FE)( compiled and
for#arded by )r *arab.
REC8MME>D($I8>S 8F $(R(/8RE C8MMI$$EE 8>
C(/I$(9 (CC8?>$ C8>@ER$IBI9I$A
( committee on *apital &ccount *onvertibility, #as setup by the -eserve !ank of India .-!I/ under
the chairmanship of former -!I deputy governor %.%. Tarapore in to [lay the road map[ to capital
account convertibility. The committee submitted its report in +,,3. (t the moment it is still a report and
central bank has to accept the recommendations of the committee.
The five@member committee had recommended a three@year time frame for complete convertibility by
+,,,@2111. The highlights of the report including the preconditions to be achieved for the full float of
money are as follo#s?@
Pre-Conditions
+. 7ross fiscal deficit to 76* ratio has to come do#n from a budgeted >.< per cent in
+,,3@,F to 4.<K in +,,,@2111. .8et to be achieved/.
2. ( consolidated sinking fund has to be set up to meet governmentJs debt repayment
needsM to be financed by increased in -!IJs profit transfer to the govt. and disinvestment
proceeds.
4. Inflation rate should remain bet#een an average 4@< per cent for the 4@year period
+,,3@2111. (had come down but inched up again over last two years)
>. 7ross D*(s of the public sector banking system needs to be brought do#n from the
present +4.3K to <K by 2111. (t the same time, average effective C-- needs to be brought
do#n from the current ,.4K to 4K. (,e are almost there)
Page of 47 - International Finance (Ver 1.1)
4,
<. -!I should have a )onitoring Exchange -ate !and of plus minus <K around a
neutral -eal Effective Exchange -ate. -!I should be transparent about the changes in -EE-
;. External sector policies should be designed to increase current receipts to 76* ratio
and bring do#n the debt servicing ratio from 2<K to 21K
3. Four indicators should be used for evaluating adeuacy of foreign exchange reserves
to safeguard against any contingency. *lus, a minimum net foreign asset to currency ratio of >1
per cent should be prescribed by la# in the -!I (ct.
F. Phased Ai,eralisation of Caital Controls @ The CommitteeJs recommendations for
a phased liberalisation of controls on capital outflo#s over the three year period #hich have
been set out in detail in a tabular form in Chapter > of the -eport, inter alia, include?@
.a/ Indian 0oint 5enture$&holly :#ned %ubsidiaries .05s$&:%s/ should be allo#ed to
invest up to '% C <1 million in ventures abroad at the level of the (uthorised 6ealers
.(6s/ in phase + #ith transparent and comprehensive guidelines set out by the -!I. The
existing reuirement of repatriation of the amount of investment by #ay of dividend
etc., #ithin a period of < years may be removed. Furthermore, 05s$&:s could be
allo#ed to be set up by any party and not be restricted to only exporters$exchange
earners.
.b/ Exporters$exchange earners may be allo#ed +11 per cent retention of earnings in
Exchange Earners Foreign Currency .EEFC/ accounts #ith complete flexibility in
operation of these accounts including cheue #riting facility in *hase I.
.c/ Individual residents may be allo#ed to invest in assets in financial market abroad up to C
2<,111 in *hase I #ith progressive increase to '% C <1,111 in *hase II and '%C +11,111
in *hase III. %imilar limits may be allo#ed for non@residents out of their non@repatriable
assets in India. (4hase ! limits allowed)
.d/ %E!I registered Indian investors may be allo#ed to set funds for investments abroad
sub9ect to overall limits of C <11 million in *hase I, C + billion in *hase II and C 2 billion
in *hase III.
.e/ !anks may be allo#ed much more liberal limits in regard to borro#ings from abroad
and deployment of funds outside India. !orro#ings .short and long term/ may be sub9ect
to an overall limit of <1 per cent of unimpaired Tier + capital in *hase +, 3< per cent in
*hase II and +11 per cent in *hase III #ith a sub@limit for short term borro#ing. in case
of deployment of funds abroad, the reuirement of section 2< of !anking -egulation (ct
and the prudential norms for open position and gap limits #ould apply.
.f/ Foreign direct and portfolio investment and disinvestment should be governed by
comprehensive and transparent guidelines, and prior -!I approval at various stages may
be dispensed #ith sub9ect to reporting by (6s. (ll non@residents may be treated on part
purposes of such investments.
.g/ In order to develop and enable the integration of forex, money and securities market, all
participants on the spot market should be permitted to operate in the for#ard marketsM
FIIs, non@residents and non@resident banks may be allo#ed for#ard cover to the extent
of their assets in IndiaM all India Financial Institutions .FIs/ fulfilling reuisite criteria
should be allo#ed to become full@fledged (6sM currency futures may be introduced #ith
screen based trading and efficient settlement systemM participation in money markets
may be #idened, market segmentation removed and interest rates deregulatedM the -!I
should #ithdra# from the primary market in 7overnment securitiesM the role of primary
and satellite dealers should be increasedM fiscal incentives should be provided for
individuals investing in 7overnment securitiesM the 7overnment should set up its o#n
office of public debt.
Page of 47 - International Finance (Ver 1.1)
>1
.h/ There is a strong case for liberalising the overall policy regime on goldM !anks and FIs
fulfilling #ell defined criteria may be allo#ed to participate in gold markets in India and
abroad and deal in gold products.

I5"ER5A"I#5AA FI5A5CIAA MAR4E"S
International Financial )arket can be divided as follo#s?
.a/ Euro Currency )arket
.b/ International forex and bond market
.c/ International euity market
Euro Currency Markets
%hat is E!ro C!rrency.
Euro currency is not to be confused #ith currency of European 'nion. It has no relation to Euro or for
that matter #ith any currency in particular.
Eurocurrency is the term used to describe deposits residing in banks that are located outside the
borders$legal 9urisdiction of the country of currency the deposits are denominated in. For example, a
deposit denominated in '% dollars residing in a 0apanese bank is a Eurocurrency deposit, or more
specifically a Eurodollar deposit.
(s the example identifies, it is important to note that despite its name, Eurocurrencies are not limited to
Europe and as such it must not be confused #ith the Euro. The use of this idiosyncratic term arose from
the fact that Eurocurrency markets first developed in Europe during the +,<1s #hen the former %oviet
'nion asked "ondon banks to hold '% dollar denominated deposits in the fear that deposits in '%
banks #ould be froNen or even seiNed in the event of escalation of tension bet#een '%( and '%%-.
Today, the Eurocurrency markets are active for the reason that they avoid domestic interest rate
regulations, reserve reuirements and other barriers to the free flo# of capital.
Thus, Euro currency is not any currency in particular. ( Eurocurrency is any currency that is deposited
in a bank outside its country of origin. %o, there can be Eurosterling, Eurodollar, Euroyen, Euromarks
and so on.
Euro Currency operations are not limited to cash. They can be in any kind of financial instrument as
long as the deal is cross currency and cross national. They can be in the form of?
.a/ Euro cash deposits
.b/ Euro !onds
.c/ Euro Commercial *apers
%hat is E!ro C!rrency Market.
Euro currency market is the foreign currency market #hich specialiNes in the facilitation of borro#ing
and lending of currencies outside their country of origin. For example '%6 deposits or '%6 loans
made available by a bank in "ondon.
Reasons for Rise of E!ro C!rrency Markets
Euro currency markets emerged in the decade of +,<1sG and +,;1sG on account of follo#ing A
+. Cold %ar ,et&een @SA and @SSR A The dollars earned by '%%- through #eapons sale and
other exports needed to be invested outside '%%-.
Page of 47 - International Finance (Ver 1.1)
>+
2. #il crisis #hich benefited gulf countries. *etro dollars earned by middle east countries needed
to be invested. (merica has been having a love hate relationship #ith )iddle East for a long
time and therefore they did not #ant to part all their petro dollars in '%(. In addition, deposit
rates on external deposits #ere comparatively lo# in '%(.
4. -elaxation of banking norms in the European region.
)ain centers of Euro Currency markets are "ondon, Frankfurt, %ingapore, Hong Bong, etc.
CategoriGation of E!ro C!rrency Market
+. E!ro 6eosit Market B E!ro Credit Market A This refers to simple deposit and lending function
of a third country currency in Euro !ank.
2. Euro commercial paper market.
4. E!ro Bond Market A E.g. (n Indian Corporate house floating bond denominated in terms of
8en or dollars in "ondon.
Advantages of E!ro 6eosit B Credit Market
Euro !anks are normally beyond the tight controls of Central !anks of the country and do not need to
follo# the stringent %"- and C-- ratios, interest rate regulations, etc. This lo#ers their cost of
operation and Thus, they are able to offer better deposit and lending rates than normal domestic banks.
#ffshore Financial Centre
:FC are certain specific locations on the #orld map A
+. &hich are tax heavens
2. En9oy scenario of lo# or no government regulations and
4. :ffer the advantage of banking secrecy and anonymity. "ike erst#hile %#iss !anks #hich #ere
notorious for being repository of black money of the #orld, :ffshore Financial centres are
provide similar secrecy and anonymity though they do not en9oy same kind of confidence as
%#iss !anks.
There are some <<@;1 :FCs in the #orld. %ome #ell kno#n financial centers are A !ahamas, !ritish
5irgin Island, Cayman Island, Hong Bong, )aldives etc.
@se of #ffshore Financial Centers
+. For establishment of offshore banks.
2. For establishment of international business corporations.
4. For tax evasion and money laundering.
%EYs, #hich are mushrooming in India and China, are mini versions of :ffshore Financial Centres.
%hat is an #ffshore ,ank.
.a/ ( bank #hich carries deposits of such depositors #ho either are non@residents or are
residents but maintain the foreign currency accounts.
.b/ :ffshore banking entities do not bank in terms of the currency of the country #here they
are located but deal in forex deposits and loans only. Thus, an Indian :ffshore bank can
not deal in ID-. (ll its transaction #ill be in any currency but ID-.
Advantages of #ffshore Banking
.a/ %ecrecy of accounts.
.b/ Tax advantage
Page of 47 - International Finance (Ver 1.1)
>2
.c/ :ffshore banks do not need to follo# the reserve reuirement guidelines and have lo#er
regulatory expenses Thus, their lending rates are lo#er and deposits rates more
attractive.
Page of 47 - International Finance (Ver 1.1)
>4
International Bond Market
CategoriNation of International bond market A
.a/ Euro !onds
.b/ Foreign !onds
.c/ 7lobal !onds
E!ro Bonds
!onds #hich are floated in the currency other than the currency of the country in #hich they are floated
by a company of the third country called Euro !onds. Thus, if an Indian company floats '%6
denominated bonds in 'B, they #ill be called Euro !onds.
Foreign Bonds
!onds #hich are floated in the local currency of the country of floatation by a foreign company are
called Foreign !onds. Thus, if an Indian company floats '%6 denominated bonds in '%(, they #ill be
called Foreign !onds.
"yes of Foreign Bonds
.a/ Eankee Bonds A These are foreign bonds floated in '%(
.b/ B!lldog Bonds A These are foreign bonds floated in 'B
.c/ Sam!rai and Shi,osai Bonds A
.i/ Samurai A These are 8en bonds floated in 0apan in open market.
.ii/ Shi#osai A These are 8en bonds floated on *vt *lacement basis.
.d/ 6ragon Bonds A These are foreign bonds issued in local currencies of the %outh (sian
countries.
#ther "yes of Bonds
+. Straight Bonds A These are plain vanilla bonds #ith fixed rate of interest and fixed date of
maturity.
2. Floating Rate Bonds A These are "I!:- linked interest rate variable interest rate bonds #here
in interest rate is ad9usted every ; months.
4. Con&erti#le Bonds A These bonds convert into euity share after the specified period of time.
In this category, there could be fully convertible or partly convertible bonds.
>. Floating rate #ond ith collars A These floating rate bonds have upper and lo#er limits of
interest rate variation. Thus, the max and min interest payable are capped irrespective of
movement of interest rate in the market.
<. Bonds ith Warrants A These are the bonds #hich are accompanied by an option to the buyer
of the bond to buy specified number of euity shares for a specified price at some specified time
in future often prior to expiry of the bonds. He may or may not exercise this option depending
on the market price of the share vis a vis offer price. He may even sell this option to some one
else at a premium.
These are not same as Convertible !onds. There is a minor variation from convertible
bonds. In case of convertible bonds, the money #hich #as paid as bond price is not paid back
and shares are issued in lieu. In case of #arrants, additional money is paid for exercise of option
#hile bond money is paid back on maturity.
&arrant option is used as a s#eetener to float bonds #ith lo#er interest rate. In case the
probability of share price appreciation is very high, they could be even at Yero interest rate.
;. Bero Cou"on Bonds A These are also called 6eep 6iscount !onds. These bonds are issued as
Nero percent interest rate bonds but at a discount to the face value. !onds are paid back at face
value on maturity. Thus, the discount on the face value actually represents the interest
component. Ho#ever, this trick is played to bro#beat the tax system of the countries #here
interest is charged to income tax.
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3. Calla#le Bonds A These are the bonds #herein the company reserves the option to call back the
bonds prior to maturity but after the lock@in period. %uch bonds are issued #hen
.a/ It is a fixed rate bond and there is strong probability of softening of interest rates in future.
.b/ It is a floating rate bond and there is strong probability of hardening of the interest rate in
future.
F. /utta#le Bonds A These are bonds #herein the buyer has option to sell back to company any
time after the lock@in period. %uch bonds are issued if the company does not en9oy very good
credit rating in the market to give some confidence to the investors.
,. Dual Currency Bonds or -y#rid Bonds A These are bonds #hich are sold in one currency and
payment of interest or principal or both is done in another currency. Eg. (n Indian company
may float a '%6 bond in '% and pay the interest and principal back in ID-.
Bond Iss!e Proced!re
+. Issuing company takes the approval of the !oard of 6irectors.
2. Issuing company appoints "ead )anager.
4. In consultation #ith the issue manager, the company appoints Co@)anagers, 'nder #riters,
!rokers to the issue.
>. The "ead manager prepares the draft document for the bond issue and the bond rate is decided.
<. The draft prospectus is discussed and is given the final shape.
;. "isting formalities are completed by the company and the Issue )anager.
3. (nnouncement of the issue is made.
F. Investor response is monitored.
,. Final bond issue is made.
+1. Tombstone advertisement is published A It is in the form of Thanks advertisement detailing the
response and money collected.
External Commercial Borro&ings
There are t#o routes for raising EC!?
.a/ A!tomatic Ro!te
.i/ Corporates A up to '%6 21 million for 4 years and upto '%6 <11 million
for < years and above.
.ii/ D7:s A (llo#ed micro credit of upto '%6 < million.
.b/ Aroval Ro!te A Even though limit are same but banks and financial
institutions have to take prior approval.
Ho#ever, EC! can not be raised from 9ust any body. "ike the banks have to follo# B8C
.Bno# your customer/ norms, EC! borro#ers have to follo# B8" .Bno# your lender/ norms.
The borro#er needs to get a due diligence certificate from an approved overseas bank that the
lender has held a satisfactory account #ith it for atleast 2 years.
Forms of External commercial ,orro&ing H Follo#ing credits are deemed to be EC!
.a/ B!yers> Credit A The advances received from a buyer is deemed EC!.
.b/ S!liers> Credit A The credit period allo#ed by supplier is deemed EC!.
.c/ Short "erm Borro&ings A "oans raised for one year or less. Commercial papers, issue of
Certificates of 6eposits.
.d/ Fixed rate and Floating rate bonds @.
.e/ Aoans from International Financial Instit!tions A 5arious international financial
institutions like (sian 6evelopment !anks, The International Finance Corporation .IFC/
and the )ultilateral Investment 7uarantee (gency .)I7(/ and including &orld !ank
.!ut not I)F/ lend for various pro9ects.
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.f/ Syndicate Aoans A These are large loans for #hich no single bank #ants to take full
exposure. Thus, a group of banks 9oin together and lend as a group. Thus, the risk is
spread out. "oan to Enron Corporation for 6abhol *o#er *ro9ect is one example of
syndicated loan.
Proced!re of Syndicate Aoans
+. !orro#er prepares Information )emorandum.
2. I) carries details of the borro#er, the amount of loan needed, proposed maturity period
of the loan, purpose of the loan etc.
4. !orro#ers send invitations to the international banks along #ith the I).
>. !orro#er receives credit proposals and analyses them.
<. It enters into agreement #ith lead syndicate bank #hich deals #ith other banks in the
syndicate.
;. Information of the deal is submitted to the )inistry of Finance and to the -eserve !ank
of India.
ECuity Market
There are t#o routes for raising euity capital from foreign markets?
.a/ "isting companyGs shares in those countriesG stock exchanges
.b/ Through 6epository -eceipts .(6-s and 76-s/
The biggest problems faced in raising the euity money from foreign markets are the accounting
standards .'% 7((* and others/, disclosure norms (which are pretty tough in advanced countries), expenses
and time involved.
Ho#ever, raising money through (6- and 76- is still easier than listing on the foreign stock
exchanges. T#o popular terms for 6epository -eceipts are (6- and 76- #hich stand for (merican
6epository -eceipts and 7lobal 6epository -eceipts respectively. (6-s are 6epository -eceipts
issued in '%( #hile 76-s are the 6epository -eceipts #hich are issued in many countries.
6efinition? (n (6- is a negotiable certificate issued by a '.%. bank representing a specified
number of shares .or one share/ in a foreign stock that is traded on a '.%. exchange. (6-s are
denominated in '.%. dollars, #ith the underlying security held by a '.%. financial institution
overseas, and help to reduce administration and duty costs on each transaction that #ould
other#ise be levied.
The advantage of (6-$76-s to local investors is that they do not have to buy and sell shares through
the issuing companyJs home exchange, #hich may be difficult and expensive. In addition, the share
price and all dividends are converted into the shareholderJs home currency.
The process of (6-s and 76-s involves selling the shares .#ithout voting rights/ to a 6epository
*articipants .%ome International !ank/. This 6epository then sells those shares in its markets. !uyers
of the 6epository -eceipts have right over the shares of the company. There is rarely one to one
relationship bet#een 6- and the %hares of the company. It could be any ratio, say :ne (6- E +1
%hares.
Fungibility A Fungibility is Interchangeability. Here, it is facility to convert 6epository -eceipts in to
actual shares. T#o #ay fungibility means permission to convert 6epository -eceipts to shares and then
back to (6-s.
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