Question Paper International Finance and Trade I

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Question Paper

International Finance and Trade I (221) – October 2004

Section A : Basic Concepts (30 Marks)

• • This section consists of questions with serial number 1 -30.

• • Answer all questions.

• • Each question carries one mark.

• • Maximum time for answering Section A is 30 Minutes.

1. A country experiencing hyper inflation should see a rapid

(a) Appreciation of its currency (b) Decrease in its nominal interest rates(c) Increase in its real asset prices (d) Devaluation of its currency(e) Both (a) and (b) above.

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2. The US economy which is undergoing a huge trade deficit is currently financing it by

(a) Selling domestic assets like bonds, stocks and real estate to foreign investors(b) Buying foreign assets like bonds, stocks and real estate(c) Retiring stocks and bonds held by foreigners(d) Foreign aid(e) IMF loan.

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3. Brazil has a comparative advantage in coffee if

(a) It produces more coffee than its trading partner (b) It has more land to grow coffee then its trading partner (c) It produces coffee at a lower opportunity cost than its trading partner (d) It produces coffee at a higher opportunity cost than its trading partner (e) It produces less coffee at a higher cost than its trading partner.

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4. An import quota is

(a) A tax on imported goods(b) A ban not to import such goods(c) A flat duty on imports(d) A limit on the number of units that can be imported(e) A tariff barrier.

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5. According to the Heckscher-Ohlin model, the source of comparative advantages is a country’s

(a) Technology (b) Human capital(c) Factor endowments (d) Ability to publicize its products(e) Both (a) and (b) above.

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6. If a country adopting a fixed exchange rate has a balance of payments deficit, then in order to maintain the exchange rate the central bank must

(a) Supply foreign exchange to the market(b) Demand foreign exchange from the market(c) Supply domestic currency to the market(d) Neither supply nor demand foreign exchange(e) Neither supply nor demand domestic currency.

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7. Trade involving financial assets and international investments is recorded in the _____ account.

(a) Current (b) Capital (c) Unilateral transfers(d) Merchandise (e) Services.

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8. Which of the following statements is true?

(a) If the current account is in surplus, then capital account must also be in surplus(b) If the capital account is in deficit, then current account must also be in deficit(c) The overall sum of all the entries in the balance of payments must be positive(d) The overall sum of all the entries in the balance of payments must be negative

(e) The overall sum of all the entries in the balance of payments must be zero.

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9. Which of the following is false under a currency board system?

(a) The interest rates are automatically set by the market mechanism(b) The Central Bank of a country cannot act as the lender of the last resort(c) Exchange rates under the currency board system are stable(d) Lending to either the Government or the domestic banks by the board is not allowed(e) When there is a higher demand for the anchor currency, the reserves with the currency board get

enhanced.

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10. Which of the following forms of purchasing power parity states that changes in spot rates over a period of time reflect the changes in the price levels over the same period in the currencies of the concernedeconomies?

(a) Absolute form (b) Expectations form(c) Relative form (d) Both (a) and (b) above(e) Both (b) and (c) above.

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11. Which of the following risks is/are classified by Export Credit Guarantee Corporation as political risk?

(a) Buyer’s failure to accept the goods(b) Insolvency of the buyer (c) Cancellation of a valid import license(d) Buyer’s failure to make the payment within the due date(e) Both (a) and (d) above.

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12. The following are the exchange rates quoted in New York:

CHF / $ 1.2552 / 54$ / CAD 0.7427 / 29

The synthetic quotes of Swiss Franc per Canadian dollar are

(a) CHF / CAD 0.9322 / 26 (b) CHF / CAD 0.9323 / 25(c) CHF / CAD 1.6898 / 00 (d) CHF / CAD 1.6896 / 03(e) C HF / CAD 0.9320 / 22.

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13. The pound sterling quote of a bank is Rs.83.79 / 84. If the banker agrees to quote a better rate by 2 paise to an Exporter, who is buying £200000, the rate quoted is

(a) Rs.83.77 (b) Rs.83.86 (c) Rs.83.81 (d) Rs.83.83 (e) Rs.83.82.

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14. According to the Monetary Approach of exchange rate forecasting, inflation is the outcome of

(a) Increase in wages in the economy(b) Increase in real output growth

(c) Increase in government spending(d) Adverse effect of political factors on the economy(e) Increase in money supply in excess of real output growth.

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15. Which of the following is/are the reason(s) for the J-Curve effect?

(a) The inelastic nature of short-run foreign demand for exported goods allows export businesses toachieve a temporary unfair advantage

(b) The elastic nature of short-run foreign demand for exported goods allows export businesses toachieve a temporary unfair advantage

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(c) The elastic nature of short-run foreign demand for exported goods delays the benefits that export businesses should realize

(d) The inelastic nature of short-run foreign demand for exported goods delays the benefits that export businesses should realize

(e) Both (a) and (b) above.

16. Which of the following serves as an evidence that the goods have actually been imported into India for

the remittance sent in foreign currency by an Authorized Dealer?

(a) Bill of Lading (b) Bill of Entry(c) Air Way Bill (d) Combined Transport bill of lading(e) House airway bill.

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17. A letter of credit which allows the Issuing bank to make payment to the beneficiary in installments is known as

(a) Red clause L/c (b) Green clause L/c (c) Revolving L/c(d) Transferable L/c (e) Deferred L/c.

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18. Which of the following conditions is/are to be satisfied, in order to ensure that there is no triangular arbitrage?

(a) (A/B) bid × (B/C) bid ≤ (A/C) ask (b) (A/B) bid × (B/C) bid ≤ (A/C) bid

(c) (A/B)ask × (B/C) ask ≤ (A/C) bid (d) Both (a) and (c) above(e) (a), (b) and (c) above.

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19. Samurai bond is a bond

(a) Denominated in yen and issued outside Japan(b) Denominated in a currency other than yen and issued to the public in Japan(c) Denominated in yen and issued under Private placement by non-Japanese borrowers in Japan(d) Denominated in yen and issued by non-Japanese borrowers to the public in Japan(e) Denominated in yen and issued by Japanese borrower in US.

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20. If probability of positive NPV is high, the discount rate used in the APV method for calculating the value of incremental borrowing capacity is

(a) The risk free interest rate in the home country(b) The risk free interest rate in the host country(c) Competitive borrowing rate in the home country(d) Competitive borrowing rate in the host country(e) Cost of capital for the parent company.

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21. Consider the following rates

Spot Rs./$46.01/04

1 month 5/4 paise

2 months 10/9 paise

3 months 15/14 paise

If an Indian importer seeks to have an option of taking dollar over third month, then the bank will quote

(a) Rs.45.95/$ (b) Rs.45.90/$ (c) Rs.45.91/$ (d) Rs.45.86/$ (e) Rs.46.00/$.

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22. Overshooting of exchange rates is explained by

(a) Fisher open condition (b) Triffin’s paradox(c) Dornbush sticky price theory (d) Marshall-Lerner condition(e) Asset approach.

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23. Compensatory financing is

(a) A form of counter trade(b) A form of transaction that involves asset transfer as a condition of purchase of goods

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(c) An IMF program to assist countries facing temporary shortfall in reserves(d) A form of overdraft in foreign exchange given by RBI to authorized dealers(e) A form of electronic funds transfer.

24. Free flow of not only goods but also factors of production is allowed among member nations in the case of

(a) Free trade area (b) Customs union(c) Common market (d) Both (a) and (b) above(e) Both (b) and (c) above.

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25. According to UCPDC, the L/C issuing bank while issuing L/C, should clearly indicate whether it is revocable or irrevocable. In the absence of such indication –

(a) The credit shall be deemed to be revocable(b) The credit shall be deemed to be irrevocable(c) The credit shall be deemed to be 50% revocable and 50% irrevocable(d) The credit shall be amended at the option of applicant(e) The credit shall be amended at the option of beneficiary.

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26. Which of the following statements is/are false?

(a) SDR transactions involve no exchange of currencies but only book entries(b) SDR is defined in terms of certain gold equivalent(c) Issue of SDRs to a member country is in proportion to its quota in IMF(d) SDR is a composite currency unit(e) Both (a) and (c) above.

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27. A loan which is arranged through public arrangement between lending banks and a borrower is known as

(a) Club loan (b) Syndicated euro credit(c) Note Issuance facility (d) Multiple component facility(e) Commercial paper.

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28. A banker who relied on the inter bank rate of Rs./$ 46.06/10 is requested by an Exporter for purchase of dollars. What is the rate to be quoted if the banker wants a margin of 0.10%?

(a) Rs.46.11 (b) Rs.46.01 (c) Rs.46.15 (d) Rs.46.05 (e) Rs.46.10.

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29. Which of the following theory(ies) of exchange rate states that the changes that are expected to occur in the value of a currency in future, gets reflected in the exchange rates immediately?

(a) Demand – supply (b) Monetary(c) Portfolio balance (d) Efficient market hypothesis approach(e) Both (a) and (d) above.

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30. If the outright forward rate of US $ for 3 months is Rs.46.10/13 and the relevant swap points are 5/6 paise, then the spot rate is

(a) 46.15/19 (b) 46.16/18 (c) 46.05/07 (d) 46.04/07 (e) 46.05/08.

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END OF SECTION A




































Section B : Problems (50 Marks)

• This section consists of questions with serial number 1 – 5.

• Answer all questions.

• Marks are indicated against each question.• Detailed workings should form part of your answer.

• Do not spend more than 110 - 120 minutes on Section B.

1. Consider the following exchange rates :

US $ Equivalent Foreign currency per US $

US MarketJapanese Yen (¥) Spot 0.009091 110

90 – day forward 0.009140 109.41Swiss Franc (CHF) Spot 0.7654 1.3065

90 – day forward 0.7710 1.2970

EquivalentYen Foreign Currency per Yen

Japanese MarketSwiss Franc 84.59 0.011822

a. You are required to verify whether there is a triangular arbitrage to exploit the difference between Yen-Franccross rates in the U.S market and the Yen – Franc rates in the Japanese market. Indicate clearly whichcurrency you would buy/sell and in which market.

If you buy $ 1 million worth of foreign currency in the US market what is the profit or loss from thetriangular arbitrage, in US dollars.

b. The risk less rate of interest in the Japanese market for a 90-day investment is 1.25% p.a. compoundedannually. What is the 90-day risk less interest rate in the U.S (expressed as effective annual rate)?

(5 + 5 = 10 marks)< Answer >

2. An institutional investor plans to increase the returns by international diversification. It is in this backdrop thefollowing information is collected.

United States United Kingdom Singapore

Expected return (%) 12 16 10

Standard deviation of return (%) 8 6 5

Correlation with the United States 1.0 0.60 0.05

a. What is the expected return and standard deviation of returns of a portfolio with 25% invested in the U.K.and 75% in the US?

b. What is the expected return and standard deviation of returns of a portfolio with 50% invested in Singaporeand 50% in the US?

c. Which country is to be considered for a better set of risk-return choices? Singapore or UK?

(5 + 5 + 2 = 12 marks)< Answer >

3. An exporter in London expects to receive Euro 5,00,000 after 3 months. He has collected the followinginformation from his banker.

Euro / £ Spot 1.4970/72

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3 months forward 1.4981/84

3 months interest rates (p.a.)

Euro 3.20% - 3.60%

£ 4.00% - 4.40%

Which of the following would be a better alternative to the exporter for covering the exposure?

(i) Forward market

(ii) Money market

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4. An Indian Company based at Chennai needs short-term funds of Rs.50 million for a period of 3 months. Thecompany collected the following information from its banker:

Rs./$ Rs./£

Spot 46.11/14 83.77/803 months forward 25/26 paise 19/20 paise

3 months Interest rates (p.a.)

Rs : 8%$ : 2%

£ : 5%

You are required to calculate the annualized effective cost of borrowing,

a. If the company borrows in USD and

(i) Covers the exchange rate risk through forward market

(ii) Keeps the position open and spot rate after 3 months turns out to be Rs/$ 46.21/24.

b. If the company borrows in pounds and

(i) Covers the exchange rate risk through forward market

(ii) Keeps the position open and spot rate after 3 months turns out to be Rs/£ 83.87/90.

(5 + 5 = 10 marks)< Answer >

5. Indira Crafts exports handicrafts to Germany. On July 01, 2004, the company requested its banker to book a

forward contract for Euro 200000 with an option to deliver in September 2004.

On July 01, 2004 the following rates prevailed in the inter bank market for US dollars in Mumbai

Rs/$ Spot : 46.10/11

July : 10/11 paise

August : 20/21 paise

September : 30/31 paise

The exchange rates in Singapore market are:

Euro/$ Spot : 0.8222/23July : 0.8215/17August : 0.8208/11

September : 0.8200/04

However, the company could not export the handicrafts due to a dispute over the price. Hence, the companyrequested its banker to cancel the contract on September 30, 2004.

On September 30, 2004 the following rates prevailed in the inter-bank market for US dollars in Mumbai.

Rs./$ Spot : 46.00/011 month forward : 7/8 paise2 months forward : 14/15 paise







The exchange rates in Singapore market are:

Euro/$ Spot : 0.8202/04

Exchange margin collected by the bank is 0.10% while quoting the rates.

You are required to compute:

a. The forward rate quoted by the bank on July 01, 2004.

b. The cancellation charges, if any, payable by or to the company.

(4 + 6 = 10 marks)< Answer >

END OF SECTION B

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 6 - 7.

• Answer all questions.

• Marks are indicated against each question.

• Do not spend more than 25 -30 minutes on section C.

6. There are various techniques of managing foreign exchange exposure so as to reduce or eliminate foreignexchange risk. These techniques can be broadly classified as internal and external hedging techniques. How doyou differentiate between internal and external hedging techniques? Also describe briefly the different internalhedging techniques.

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7. Exporters are to be provided adequate credit at competitive interest rates in order to ensure steady export growth.Explain in detail about pre-shipment finance.

(10 marks) < Answer >

END OF SECTION C

END OF QUESTION PAPER


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Suggested Answers

International Finance and Trade I (221) – October 2004

Section A : Basic Concepts

1. Answer : (d)Reason : A country experiencing from hyper inflation should see a rapid devaluation of its currency due to the

application of purchasing power party principle.

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2. Answer : (a)

Reason : The US economy is currently financing its trade deficit by selling domestic assets like bonds, stocks andreal estate to foreign investors.

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3. Answer : (c)

Reason : A country with a comparative advantage in the production of a good produces that good at a lower opportunity cost than its trading partner.

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4. Answer : (d)

Reason : An import quota is a limit on the number of units that can be imported.

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5. Answer : (c)

Reason : According to the Heckscher-Owlin model, the source of comparative advantages is a country’s factor endowments.

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6. Answer : (a)

Reason : Under a BOP deficit, the quantity demanded of foreign exchange exceeds the quantity supplied. Thisamounts to a shortage of foreign exchange. To maintain the exchange rate the central bank must supplythe extra foreign exchange demanded. Hence correct answer is (a).

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7. Answer : (b)

Reason : Trade involving financial assets and international investments is recorded in the capital account.

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8. Answer : (e)

Reason : The overall sum of all the entries in the balance of payments must be zero.

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9. Answer : (e)

Reason : Options in (a), (b), (c) and (d) are true. Option in (e) is false.

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10. Answer : (c)

Reason : Relative form of PPP states that changes in spot rates over a period of time reflect the changes in the price levels over the same period in the currencies of the concerned economies. Absolute form of PPPstates that the respective price levels in the two countries determine the exchange rate between the twocountries currencies. According to the expectations form of PPP, the expected percentage change in thespot rate is equal to the difference in the expected inflation rates in the two countries. Correct answer is(c).

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11. Answer : (c)

Reason : Cancellation of a valid import license in the buyers country is classified by ECGC as political risk.Options in (a), (b) and (d) are the examples of commercial risks.

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12. Answer : (a)

Reason : CHF/CAD bid rate = 1.2552 × 0.7427 = 0.9322

CHF/CAD ask rate = 1.2554 × 0.7429 = 0.9326.

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13. Answer : (c)

Reason : Bid rate for pound is Rs.83.79. This means banker gives Rs.83.79 to take one pound. If banker agrees to

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quote a better rate he pays still more by 2 paise to take one pound. So 2 paise is to be added to the bidrate. Correct answer is Rs.83.81.

14. Answer : (e)

Reason : According to the Monetary Approach, an increase in the money supply causes the currency todepreciate. The outcome of the increase in money supply in excess of real output growth is inflation.

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15. Answer : (d)Reason : The J-curve suggests that short run demand for domestic and foreign goods is inelastic, which means

they will not change easily. This is a result of contracts that may already be in place and the speed inwhich buyer behavior will change. In fact the current account will become more negative at first asimporters pay even higher prices for volumes they cannot reduce and exporters can’t benefit fromadditional sales until volumes can be increased.

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16. Answer : (b)

Reason : Bill of Entry serves as evidence that the goods have actually been imported into India for the remittancesent in foreign currency by the ADs. Options in (a), (c), (d) and (e) are documents of title to the goodsand these documents are issued by carrier agents.

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17. Answer : (e)

Reason : A letter of credit which allows the issuing bank to make payments in installments is known as ‘DeferredL/C’.

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18. Answer : (a)

Reason : To ensure that there is no triangular arbitrage, the following conditions are to be satisfied.

i. (A/B) bid × (B/C) bid ≤ (A/C) ask

ii. (A/B) ask × (B/C) ask ≥ (A/C) bid. Correct answer is (a).

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19. Answer : (d)

Reason : Samurai bond is a bond denominated in Yen and issued by non-Japanese borrowers to the public inJapan.

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20. Answer : (a)

Reason : The discount rate used in the APV method for calculating the value of incremental borrowing capacity,if probability of positive NPV is high, is the risk free interest rate in the home country.

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21. Answer : (a)

Reason : Forward margin is in discount. Discount is to be deducted. Discount for 2 months is to be givenassuming that the importer may deliver the foreign currency on the first day of the option period. Hence2 months discount of 9 paise is to be deducted from the ask rate of Rs.46.04. Bank will quoteRs.45.95/$.

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22. Answer : (c)

Reason : (a) Fisher Open condition says that the nominal interest rates minus the expected inflation rates i.e. thereal interest rates are equal across different countries.

(b) The total number of dollars issued by the Federal Reserve (the American Central Bank) wasfar in excess of the value of the gold held by it. As it would not have been possible for the

Fed to convert all dollars in to gold, it ran on the confidence of other countries. This createda paradox in the system known as the Triffins Paradox.

(c) Dornbush sticky price theory explains the overshooting of exchange rates.

(d) Marshall Lerner condition states that the elasticities of Export supply and import demand curveshould together be greater than one to avoid exchange market instability.

(e) Asset approach is one of the exchange rate forecasting approaches. Correct answer is (c).

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23. Answer : (c)< TOP >























Reason : Compensatory financing is an IMF programme to assist countries facing temporary shortfall in reserves.Options in (a), (b), (d) and (e) are not correct.

24. Answer : (c)

Reason : A common market allows free flow among member nations of not only goods, but also factors of production (labour and capital) and services.

a) In a free trade area, there are no barriers to trade among the member countries. But the member countries individually decide upon their trade policies as applicable to non member countries, to prevent misuse of the system/arrangement by any member country, by stipulatingdocuments/conditions such as certificate of origin.

b) Under a Customs Union, in addition to the absence of internal trade barriers, among the member nations, the external barriers for non members are also common. Hence the correct answer is (c).

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25. Answer : (b)

Reason : If the L/c issuing bank fails to indicate, whether the documentary credit is revocable or irrevocable, thenthe credit shall be deemed to be irrevocable.

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26. Answer : (b)

Reason : It is false that SDR is defined in terms of certain gold equivalent. SDR is defined in terms of theweighted average value of 5 currencies (US Dollar, yen, pound, sterling, DM and French Franc).

All the other options under (a), (c), and (d) are true. Hence the correct answer is b.

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27. Answer : (b)

Reason : Syndicated euro credit is a loan which is arranged through public arrangement between lending banksand a borrower.

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28. Answer : (b)

Reason : Profit margin of 0.10% is to be deducted from the bid rate. That is 46.06 ×

0.10

100 = Rs.0.05Spot bid rate = 46.06 – 0.05 = 46.01.

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29. Answer : (d)

Reason : Efficient market hypothesis approach also known as the asset approach states that the changes that areexpected to occur in the value of a currency in future, gets reflected in the exchange rates immediately.

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30. Answer : (c)

Reason : Outright forward rate for Rs./$

Spot rate + premium = Forward rate

Spot rate = Forward rate – premium

Forward rate46.10

/13

Less Premium 0.05 / 06

Spot rate46.05

/07

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Section B : Problems

1. a. In the U.S market the cross rate of Yen/SFR

= 0.7654 × 110

= 84.194

The spot rate of Yen / SFR in the Japanese market = 84.59

Thus the Swiss Franc is cheaper in the U.S market and worth more in Japan. Therefore we buy Swiss Francesin the U.S, sell Swiss Frances in Japan for Yen which we sell in the U.S. The triangular arbitrage isimplemented as follows.

First we buy $ 1000000 worth of Swiss Frances in the U.S

Thus we get SFR 1000000 × 1.3065

= SFR 1306500

Then sell this SFR 1306500 in the Japanese market for Yen.

Thus we get Yen = 1306500 × 84.59

= Yen 110516835

Finally, sell these Yen in the U.S. market for dollars

= 110516835 × 0.009091

= $ 1004708.547

Say $ 1004709

Profit on the transaction = 1004709 – 1000000 = $ 4709

b. 90 day risk less rate in Japan

= (1+0.0125)90/360 – 1

= 0.311%

By interest rate parity

→ F90 = S ×

us

yen

1 r

1 r +

+

0.009140 = 0.009091 ×

us1 r

1 0.00311

++

or,

us1 r

1 0.00311

++ =

0.009140

0.009091

or, 1 + r us = 1.00539 × 1.00311

= 1.008517

r us = 0.8517% for 90 days

Effective annual rate = (1+0.008517) 360/90 – 1

= 3.45%.

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2. a. Expected return and standard deviation of return of a portfolio with 25% invested in the U.K. and 75% in theU.S.

Expected return = 0.25 x 16 + 0.75 x 12 = 13%

Standard deviation of the portfolio (2

Pσ

)

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= Wus2

2

usσ

+ Wuk 2 σ

uk 2 + 2 covariance US, UK, Wus Wuk

Where Wus2 σ us

2 = The variance of US stocks return multiplied by the weight

Wuk 2 σ

uk 2 = The variance of UK stocks return multiplied by the weight

= (8) 2 (0.75) 2 + (6) 2 (0.25) 2 + 2 x 0.60 x 8 x 6 x 0.75 x 0.25

= 36 + 2.25 + 10.8

= 49.05 (%)2

σ p = 7%

b. Expected return and standard deviation of return of a portfolio with 50% invested in Singapore and 50% inthe US.

Expected return = 0.50 x 12 + 0.50 x 10 = 11%

Standard deviation of return of the portfolio

= (8) 2 (0.50) 2 + (5) 2 (0.50) 2 + 2 x 0.05 x 8 x 5 x 0.5 x 0.5

= 16 + 6.25 + 1.0

= 23.25 (%)2

σ p = 4.82%

c. Singapore offers better diversification opportunities because its fund returns are less correlated with the USmarket (r= 0.05) than UK funds ( r = 0.60).

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3. (i) Forward market

If the exporters uses the forward market, inflow after 3 months will be =

5,00,000

1.4984

= Euro 333689.27

(ii) Money market

If the exporter borrows euros, converts into pounds and invests for 3 months, the inflow will be

Amount of Euros to be borrowed =

5,00,000

0.0361

4

+

= Euro 495540.14

The loan will be closed with the receivable of euro 5,00,000

Convert Euros into Pounds at the spot rate.

Inflow of pounds =

495540.14

1.4972

= £ 330977.92

Invest this amount for 3 months and the amount with interest after 3 months

= 330977.92

0.04

1 4

+

= £ 334287.70

Money market cover is better as it maximizes the inflow.

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4. The company requires Rs.50 million

Borrow in Dollars:







Amount of dollars required to be borrowed =

50

46.11 = 1.08436 million

Amount to be repaid after 6 months = 1.08436

0.021

4

+ = $ 1.08978 million

If covered through forward market, rupee outflow= 1.08978 × 46.40

= 50.5658 million

Annualized effective cost of borrowing =

50.5658 50 12

50 3

−×

= 4.53%

If kept open position, rupee outflow

= 1.08978 × 46.24

= 50.3914.

Annualized effective cost of borrowing =

50.3914 50 12

50 3

−×

= 3.13%.

Borrow in sterling:

Amount of sterling required to be borrowed =

50

83.77 = £ 0.59687 million

Amount to be repaid after 3 months = 0.59687

0.051

4

+ = £ 0.60433 million

If covered through forward market rupee outflow

= 0.60433 × 84 = Rs.50.7640 million

Effective cost of borrowing =

50.7640 50

50

−

×

12

3 = 6.11%

If kept open position, rupee outflow

= 0.60433 × 83.90 = Rs.50.7033 million.

Effective cost of borrowing =

50.7033 50

50

−

×

12

3 = 5.63%

So, it is better to borrow in dollars and keep open position.

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5. a. US dollar is at premium. Assuming that the dollar is delivered on the first day of the option period, premiumis to be taken for August 2004 only

Rs /$ Spot bid rate 46.10

Add premium for August 0.20

46.300

Less exchange margin at 0.10% 0.046

Forward buying rate for dollar 46.254

US dollar is at discount. Since selling rate is to be considered, earlier delivery ask rate of 0.8211 is to betaken.

Forward bid rate of Euro =

46.254

0.8211





= Rs.56.33

b. On September 30, 2004 the contract is to be cancelled at the T.T. selling rate

Rs/$ spot ask rate = 46.01

Add Exchange margin at 0.10% =

0.046

46.056

Euro/$ spot buying rate 0.8202

T.T selling rate for Rs/Euro =

46.056

0.8202

= 56.152

Say Rs.56.15

Cancellation charges

Euro 200000 sold to the company at Rs.56.15 = Rs.1,12,30,000

Euro 200000 bought from the company at Rs.56.33 = Rs.1,12,66,000

Exchange difference payable to the company 36,000

The company is paid Rs.35,900 after deducting Rs.100/- towards cancellation charges.

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Section C: Applied Theory

6. These techniques can broadly be classified as internal and external hedging. Internal techniques are those, whichare a part of the day-to-day operations of a company, while external techniques are the ones, which are not a partof the day-to-day activities and are especially undertaken for the purpose of hedging exchange rate risk. Here, itneeds to be noted that the term internal does not denote that no external party is involved. It only denotes that it isa normal activity for the company.

The various internal hedging techniques are

• • Exposure netting

• • Leading and lagging

• • Choosing the currency of invoice

• • Sourcing

Exposure Netting

Exposure netting involves creating exposures in the normal course of business, which offset the existingexposures. The exposures so created may be in the same currency as the existing exposures, or in any other currency, but the effect should be that any movement in exchange rates that results in a loss on the originalexposure should result in a gain on the new exposure. This may be achieved by creating an opposite exposure inthe same currency or a currency, which moves in tandem with the currency of the original exposure. It may also be

achieved by creating a similar exposure in a currency, which moves, in the opposite direction to the currency of the original exposure.

Leading and Lagging

Leading and lagging can also be used to hedge exposures. Leading involves advancing a payment, i.e. making a payment before it is due. Lagging, on the other hand, refers to postponing a payment. A company can lead payments required to be made in a currency that is likely to appreciate, and lag the payments that it needs to makein a currency that is likely to depreciate.

Hedging by Choosing the Currency of Invoicing





One very simple way of eliminating transaction and translation exposure is to invoice all receivables and payablesin the domestic currency. However, only one of the parties involved can hedge itself in this manner. It will stillleave the other party exposed, as it will be dealing in a foreign currency. Also, as the other party needs to cover itsexposure, it is likely to build in the cost of doing so in the price it quotes/it is willing to accept.

Another way of using the choice of invoicing currency as a hedging tool relates to the outlook of a firm aboutvarious currencies. This involves invoicing exports in a hard currency and imports in a soft currency. The currency

so chosen may not be the domestic currency for either of the parties involved, and may be selected because of itsstability (like the dollar, which serves as an international currency).

Another way the parties involved in international transactions may hedge exposures is by sharing the risk. Thismay be achieved by denominating the transaction partly in each of the domestic currencies of the parties involved.This way, the exposure for both the parties gets reduced.

Hedging through Sourcing

Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials in the same currency inwhich it sells its products. This results in netting of the exposure, at least to some extent. This technique has itsown disadvantages. A company may have to buy raw material, which is costlier or of lower quality than it canotherwise buy, if it restricts the possible sources in this manner. Due to this, firms do not use this technique veryextensively.

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7. Pre-shipment finance is basically a short-term finance (inventory finance) extended to exporters in anticipation of export of goods. This finance enables exporters to procure raw materials, process, manufacture, and warehouses,ship the goods meant for export.

Pre-shipment finance can be classified as

a. Packing credit

b. Advance against incentives receivable from Government covered by ECGC Guarantee

c. Advance against cheques/drafts received as advance payment.

Packing Credit

It is a loan or advance granted to the exporter for purchase of raw materials/processing/packing based on Letter of Credit (LC) opened in his favor by the importer. The LC/Confirmed order will be retained by the bank and will beendorsed accordingly indicating that the exporter has availed of packing credit.

Eligibility

An exporter who wants to avail of pre-shipment finance should obtain an importer-exporter code number from theDGFT. In addition, the exporter should not be under the caution list/special approval list of RBI/ECGC.

Usually, packing credit is extended to exporters who have the export order/letter of credit in their name. It can also be extended where the contract is concluded by exchange of messages between the two parties, with the openingof LC to be followed later on provided the track record of the exporter is good. In such instances banks may grant packing credit based on the communication, provided the following information is made available:

a. Name of the overseas buyer

b. Particulars of goods to be exported

c. Quantity and unit prices or value of order

d. Dates of shipment

e. Terms of sales and payments.

Packing credit is also extended to supporting manufacturers/suppliers of goods who do not have LCs in their ownname but an LC holder has placed orders on them for supply of goods.

Type of Finance

Packing credit is normally a funded advance. It takes the form of an unsecured/clean loan in the initial stages of disbursement of funds (i.e. when raw materials are yet to be procured). It is called extended packing credit. Whenthe exporter gets a title to the goods it becomes a secured advance.

At times pre-shipment finance will be extended in a non-fund form, like issuing LCs favoring the suppliers of raw

http://www.icfai.org/suggested/221-1004.htm#QC1%23QC1




materials, opening guarantees for credit purchases, etc.

Quantum of Finance

Quantum of loan will not normally exceed FOB value of goods or domestic market value of goods whichever islower. However, there are certain exceptions to this. Packing credit may be granted up to the domestic cost of goods even if it is higher than the FOB value, provided the goods are covered by export incentives of theGovernment of India and availability of Export Production Finance Guarantee offered by ECGC. The excess of

advance over FOB value should be adjusted from the cash incentives/duty drawback received.

Margin Requirements

Pre-shipment finance being a need based finance; banks have the freedom to determine the margin that is to be brought in by the exporters.

The percentage of margin will depend on the nature of the order, commodity, capability of the exporter, etc.Disbursement of funds under packing credit takes place in phases depending on the length of the operating cycle.

Period of Finance

Packing credit can be extended at a concessional rate of interest for a maximum period of 180 days or for theoperating cycle of the particular activity whichever is lower. Banks may further extend this period to an additional90 days (i.e. 180 + 90 = 270 days). Alternately, banks may extend packing credit for a maximum period of 270days from the beginning itself. If the packing credit is outstanding after the due date it is called overdue packingcredit. Overdue packing credit is not eligible for concessional rate of interest.

It should be noted that concessional rates of interest will be applicable only if export of goods takes place withinthe time stipulated. This period has been fixed as 360 days from the date of availing the finance. In case export of goods does not take place within the stipulated period, banks are eligible to charge interest from the very first dayof advance at a rate prescribed for ‘Export credit not otherwise specified’.

Liquidation of Packing Credit

All packing credit advances should be liquidated from funds received by the exporter from either one or acombination of any of the following sources:

a. Proceeds of export bills negotiated, purchased, or discounted

b. Proceeds of payments receivable from the Government of India, in the form of duty drawback or a paymentfrom the Market Development Fund (MDF) of the Central Government or from any other relevant source.

If a packing credit advance is not liquidated by export proceeds, that particular advance will not be entitled for

concessional rate of interest.

Advances against Incentives Receivable from Government of India

These advances are generally granted at post-shipment stage. However, in exceptional cases, where the value of material to be procured for export is more than the FOB value of the contract and considering the availability of receivables from Government of India, advances are granted for a maximum period of 90 days for more than theFOB value. These advances are liquidated by negotiation of export bills and out of proceeds of receivables fromGovernment of India.

Advance against Duty Drawback

Pre-shipment finance can also be extended against duty drawback entitlements provisionally certified by theCustoms. The loans so extended will be adjusted when the final assessment is made by customs and they refundduties. Banks normally grant duty drawback loans at the post-shipment stage for a period not exceeding 90 days atlower interest rate as specified.

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Question Paper International Finance and Trade I

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