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ASSIGNMENT REFERENCE MATERIAL (2020-21)

I.B.O.-06

International Business Finance

Q-1 Define Balance of Payments. Explain the inter-relationship between Current

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Account, Capital Account and Reserve Account with examples.

Ans:- Balance of Payments: Balance of payments (BOP) accounts are an accounting record
of all monetary transactions between a country and the rest of the world. These transactions

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include payments for the country’s exports and imports of goods, services, and financial
capital, as well as financial transfers. The BOP accounts summarize international transactions
for a specific period, usually a year, and are prepared in a single currency, typically the
domestic currency for the country concerned. Sources of funds for a nation, such as exports
or the receipts of loans and investments, are recorded as positive or surplus items. Uses of

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funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit
items. a
When all components of the BOP accounts are included they must sum to zero with no
b
overall surplus or deficit. For example, if a country is importing more than it exports, its trade

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balance will be in deficit, but the shortfall will have to be counter-balanced in other ways –
such as by funds earned from its foreign investments, by running down central bank reserves
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a
or by receiving loans from other countries.
b

Current Account: It is used to mark the inflow and outflow of goods and services into a
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country. Earnings on investments, both public and private, are also put into the current
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account.
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Within the current account are credits and debits on the trade of merchandise, which includes
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goods such as raw materials and manufactured goods that are bought, sold or given away
(possibly in the form of aid). Services refer to receipts from tourism, transportation (like the
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levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering,
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business service fees (from lawyers or management consulting, for example), and royalties
from patents and copyrights. When combined, goods and services together make up a
country’s balance of trade (BOT). The BOT is typically the biggest bulk of a country’s
balance of payments as it makes up total imports and exports. If a country has a balance of
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trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports
more than it imports.

Capital Account: The capital account of the balance of payments is record of the flow of
payments between one country and other countries that result from: (1) domestic purchases of
financial and physical capital from the foreign sector and (2) foreign purchases of financial
and physical capital from the domestic sector.

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Q-2 (a) What is foreign exchange market? Explain its significance and the functions of
participants.

Ans. The Foreign Exchange Market (Forex, FX, or Currency Market) is a worldwide
decentralized over-the-counter financial market for the trading of currencies. Financial
centers around the world function as anchors of trading between a wide range of different
types of buyers and sellers around the clock, with the exception of weekends. The foreign
exchange market determines the relative values of different currencies. The primary purpose
of the foreign exchange market is to assist international trade and investment, by allowing
businesses to convert one currency to another currency. For example, it permits a US
business to import British goods and to pay Pound Sterling, even though the business’s

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income is in US dollars. It also supports speculation, and facilitates to carry trade, in which
investors borrow low-yielding currencies and lend (invest in) yielding currencies, and which
(it has been claimed) may lead to loss of competitiveness in some countries.

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In a typical foreign exchange transaction, a party purchases a quantity of one currency by
paying a quantity of another currency. The modern foreign exchange market began forming
during the 1970s when countries gradually switched to floating exchange rates from the
previous exchange rate regime, which remained fixed as per the Bretton Woods system.

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The foreign exchange market is unique because of:

(i)

(ii)
ba
its huge trading volume, leading to liquidity;

its geographical dispersion;

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(iii) its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15
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a
GMT on Sunday until 22:00 GMT Friday;
b

(iv) the variety of factors that affect exchange rates;

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(v) the low margins of relative profit compared with other markets of fixed
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income; and
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(vi) the use of leverage to enhance profit margins with respect to account size.
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The foreign exchange markets are international markets where currencies are bought and sold
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in the wholesale amounts. Significance of the foreign exchange markets are as follows:

• Liquidity: In terms of international trade, liquidity is the ease in which foreign

currency is converted into domestic currency. FX markets, such as the New York Mercantile
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Exchange, match buyers and sellers to bring about speedy, orderly transactions.

• Rates: Buyers and sellers set prices using the auction method in the FX
market. Sellers try to earn the highest “ask” price possible, and buyers try to purchase
currency at the lowest “bid.” Buyers and sellers meet at the “spot” price, the current value
and exchange rate for a particular currency against others.

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(b) What is political risk? How do international firms manage political risk arising in
the host countries?

Ans. Political risk is a type of risk faced by investors, corporations, and governments. It is a
risk that can be understood and managed with reasoned foresight and investment.

Broadly speaking, political risk refers to the complications businesses and governments may
face as a result of what are commonly referred to as political decisions—or “any political
change that alters the expected outcome and value of a given economic action by changing
the probability of achieving business objectives. Political risk faced by firms can be defined
as “the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket

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factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial,
income, labour, and developmental), or events related to political instability (terrorism, riots,
coups, civil war, and insurrection). Understanding risk as part probability and part impact
provides insight into political risk. For a business, the implication for political risk is that

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there is a measure of likelihood that political events may complicate its pursuit of earnings
through direct impacts (such as taxes or fees) or indirect impacts (such as opportunity cost
forgone). As a result, political risk is similar to an expected value such that the likelihood of a
political event occurring may reduce the desirability of that investment by reducing its
anticipated returns.

a .
Risk concerns the deviation of one or more results of one or more future events from their
expected value. Technically, the value of those results may be positive or negative. However,
general usage tends to focus only on potential harm that may arise from a future event, which
b
may accrue either from incurring a cost ‘Downside Risk’ or by failing to attain some benefit

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‘Upside Risk’.
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a
There are different definitions of risk for each of several applications. The widely
inconsistent and ambiguous use of the word is one of several current criticisms of the
b

methods to manage risk. In one definition, ‘risks’ are simply future issues that can be avoided
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or mitigated, rather than present problems that must be immediately addressed.
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The difference between political risk and political uncertainty is to do with the degree of
knowledge of the situation.
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Q-3 What is translation exposure? How is it different from transaction exposure?

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Discuss the various techniques of managing translation exposure.

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Ans. Accountants use various methods to insulate firms from these types of risks, such as
consolidation techniques for the firm’s financial statements and the use of the most effective
cost accounting evaluation procedures. In many cases, this exposure will be recorded in the
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financial statements as an exchange rate gain (or loss). The risk that a company’s equities,
assets, liabilities or income will change in value as a result of exchange rate changes. This
occurs when a firm denominates a portion of its equities, assets, liabilities or income in a
foreign currency.

Distinction between Transaction and Translation Exposure

The addition of the word ‘risk’ after ‘transaction’ or ‘translation’ tends to convey the
transaction risk and translation risk are two different risks, i.e. different external threats.

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Indeed, they may be more appropriately viewed as different ways of looking at and managing
the same (or at least largely overlapping) external threats. An accounting model of receipts
and payments is implicit when reference is made to translation risk, and a cash flow model of
receipts and payments is implicit when reference is made to transaction risk.

Translation risks are commonly restricted by experts to contractually[26] committed receipts

and payments. Uncommitted ones may never appear on financial statements at all. Clearly,
this category of contractually committed receipts and payments overlaps with a considerable
proportion of those included in transaction risks. In fact, some writers would treat transaction
and translation risks as co-terminus, whereas others would wish to extend transaction risk to
include a number of uncommitted future transactions. What is common to all of them,

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however, is that the distinction is not between different external threats, i.e. different
mismatches. Transaction and translation mismatches arise largely from the same transactions:
both threats are from the effect of adverse movements in the same nominal exchange rates on
the outcomes of largely the same transactions. The distinction is effectively between two

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models of the business used by managers, the accounting model and the future cash flows
model. The contrast concerns the values (current market or balance sheet values) and the time
horizon which the currency manager has in mind when managing the risks. The distinction is
subjective in that it turns on manager’s perceptions[27]: if he is concerned with accounting
values and with losses or gains arising in financial reporting periods, then he is managing the

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translation or accounting risk; if he is concerned with the amount of the future cash receipt or
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payment on its expected date, then he is managing transaction risk. The distinction between
translation and transaction risk is, therefore, between management perceptions, not between
external threats or risks. This is, however, important to recognize and provide for.
b
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Q-4 What are the benefits of project export? What are the risk included in project
exports? Discuss the various kinds of bonds/guarantees in project export.
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a
Ans:- The benefits of project export
b
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A Financial Benefits
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a) It is an avenue for earning considerable foreign exchange with use of minimum domestic
resources.
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b) Besides project exports, it involves export of technical services and skilled and unskilled
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manpower.
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c) Purchase of equipment for execution of the project is paid through foreign exchange from
the project.
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d) In project exports, credit facilities granted by banks are self liquidating in nature. Non-
funded bonds are guarantees for bulk of credit facilities required.

B Non-financial Benefits

a) Undertaking projects in foreign countries fosters good relationships between home and the
host countries.

b) Carrying out projects abroad enables absorption of the latest international technology and

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to appreciate the versatility of the state of art engineering and construction equipment.

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Q-5 Define yield curve. How is it constructed? How does interest rate risk influence

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yield curve. Explain.
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a
Ans: In finance, the yield curve is the relation between the interest rate (or cost of
borrowing) and the time to maturity of the debt for a given borrower in a given currency. For
b

example, the US Dollar interest rates paid on US Treasury securities for various maturities
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are closely watched by many traders, and are commonly plotted on a graph such as the one on
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the right which is informally called ‘the yield curve’. More formal mathematical descriptions
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of this relation are often called the term structure of interest rates.
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The yield of a debt instrument is the overall rate of return available on the investment. For
instance, a bank account that pays an interest rate of 4 per cent per year has a 4 per cent yield.
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In general the percentage per year that can be earned is dependent on the length of time that
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the money is invested. For example, a bank may offer a ‘savings rate’ higher than the normal
checking account rate if the customer is prepared to leave money untouched for five years.
Investing for a period of time t gives a yield Y(t).
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This function Y is called the yield curve, and it is often, but not always, an increasing
function of t. Yield curves are used by fixed income analysts, who analyze bonds and related
securities, to understand conditions in financial markets and to seek trading opportunities.
Economists use the curves to understand economic conditions.

They are usually upward sloping asymptotically: the longer the maturity, the higher the yield,
with diminishing marginal increases that is, as one moves to the right, the curve flattens out.
There are two common explanations for upward sloping yield curves. First, it may be that the
market is anticipating a rise in the risk-free rate. If investors hold off investing now, they may

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receive a better rate in the future. Therefore, under the arbitrage pricing theory, investors who
are willing to lock their money in now need to be compensated for the anticipated raise in
rates thus the higher interest rate on long-term investments. One of the key considerations in
the minds of investors who buy long-term loans in the form of bonds or Treasury notes that
will pay interest over a long stretch of years is inflation. The higher inflation runs, the less
money will be worth in the future. This means that higher interest rates must be charged on
long-term loans to make up for the deficit. If the expectation for future inflation remains low,
interest rates can run lower and still attract investment money.

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