Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 1 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
Date: 20 Jul 2006
Mrs Smita Shukla
Recommended Books –
1. International Finance – PG Apte (Best book but for higher level. Students who have finance
background may opt for this. Can be referred by novices like me for Forex Arithmetic)
2. Multinational Finance – Madhu Viz (Most Recommended for all. But not the best book for
Forex Arithmetic)
3. International Finance – Jain & Others (A balanced book for theory and numericals). 4. International Finance – Levi
5. Global Finance Markets – Giddy
6. Foreign Exchange and Derivative – Jain and Others
7. International Finance – Bhalla.
Students should build their knowledge by regularly going through business journals,
magazines and newspapers.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 2 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
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 of another currency. Here, currency does not
necessarily mean bank notes and coins but includes Travellers Cheques, Bills of Exchange,
Letters of Credit, any drafts, etc as well. 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/Sydney in the morning and closing in West Coast of USA shortly before it is time
for opening of next day market in Tokyo (effect of changing time zones).
Indian Forex Market
Indian Forex Market is still in nascent stage of development. Prior to 1991, we had FERA
which made possession of Foreign currency a criminal offence. Exchange rate was decided
by the RBI and Forex market virtually did not exist. Post 1991, after replacement of FERA
with FEMA, and current account convertibility, Indian forex market has begun to develop.
With exports volume growing steadily at good pace, forex market is becoming important.
The Foreign Exchange Management Act (1999) popularly known as FEMA came into
force from June 01, 2000. FEMA replaced the Foreign Exchange Regulation Act of 1973
(FERA). While FERA was aimed at conserving foreign exchange by restricting
expenditure, FEMA is aimed at facilitating external trade and payments for promoting
orderly development and maintenance of foreign exchange market in India. Violations
under FEMA are considered civil offence and not criminal offence as was the case under
FERA.
In India, most of the trade happens in USD. Besides US Dollar, Euro, Great British Pound,
and Japanese Yen are other major currencies that are traded. Other currencies are also dealt
but in small volume. SBI deals in 16 currencies in all.
Exchange rates are not constant and keep changing on minute to minute basis like stocks in
stock market. Unlike “Stock Exchange”, there is no “Forex Exchange” where there is a
central intermediary available for every transaction and hence single quote for any currency
is not available. It is more like a vegetable market where there are so many shops and each
is quoting its own rate for each vegetable and willing to bargain with you. Or, in the market
language, it is Over the Counter (OTC) trade.
Foreign Currency Exchange Rate
The primary basis for exchange rate movement on day to day basis is Demand and Supply
of foreign currency. Demand can spurt due to various reasons like large companies with
considerable import requirements (like Maruti requiring import from Suzuki, Japan) stocking forex
for future requirement. Similarly, 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.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 3 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
Although the exchange rate is affected by market forces of demand and supply, we do not
have a fully flexible exchange rate, or as it is called Floating Exchange Rate, as yet. What
we actually have is a Managed Exchange Rate.
What it means is that exchange rate is being macro managed by the Govt through RBI. RBI
keeps a hawk eye on the forex market and keeps manipulating exchange rate by either
buying excess forex or injecting liquidity by selling forex from its own holding of 165
Billion US Dollars.
Like, SEBI is the controller of the Securities market, RBI is the controller of Forex market
in India. It authorises certain entities like banks and even other companies like Thomas
Cook to deal in Forex. It has a dealing room of its own which keeps track of exchange rate
movement in the market on continuous basis. If the exchange rate starts moving wildly in
either direction, it intervenes by either buying or selling forex in the market to control it.
Factors Affecting the Exchange Rate
(a) Balance of Payment position of the country
(b) Strength of economy
(c) Fiscal and Monetary policy
(d) Interest rates
(e) Political Factors
(f) Exchange control
(g) Central Bank Intervention
(h) Speculation
(i) Technical Factors
(j) Other factors.
Balance of Payment - Balance of Payment is the measure of demand and supply
of foreign currency. If the balance of payment is positive and high (Exports higher
than imports), it will lead to excess supply of foreign currencies and therefore local
currency will appreciate. In the reverse case, domestic currency will depreciate.
Strength of the Economy - If the economy is strong and growing, foreign
investment/capital will 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 will 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 weakening of local currency.
Interest Rates - Higher interest rates attract foreign currency deposits provided
local currency is not depreciating faster than interest rate induced growth. Thus,
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Page 4 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
higher interest rates coupled with relatively stable local currency acts like a self
sustaining process. More inflow of foreign currency leads to further stability of
exchange rates.
Political Factors - If a govt is considered to be unstable, or change of govt with
socialistic inclination is expected, local currency will weaken. Currency will
strengthen if the new govt is expected to take capitalistic policy decisions.
Exchange Control - Exchange control is generally aimed at free movement of
capital flows and therefore foreign nationals will be wary of investing in the
country.
Central Bank Intervention - Already explained as to how central bank can affect
exchange rate in the short term.
Speculation - 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 upward movement in price leads even smaller
player to start buying aggressively and foreign currency appreciates.
Technical Factors - Technical factors work best in free market. Indian forex
market is still not as free and therefore they do not have much effect.
Other Factors - These are general factors which are hard to define. It could be
world political and economic situation, prices of major import constituent like crude
oil, etc. Fear of war with Pakistan can send the Rupee down overnight.
Reference Rate
What we have discussed above is mechanics of day to day changes in exchange rate. But
how is the basic exchange rate of one currency set against the other currency? How is it
determined that a dollar should cost approximately Rs 45 and not Rs 25?
Current mean of Rs 45 or so is called Reference Rate. This reference rate is decided using
various different methods: -
(a) Mint Parity System – Simply stated this system is based on amount of
currency printed by any country for each ounce or Kg of gold. If India prints
Rs 30,000 for each ounce of gold held with govt and US prints US$ 600 for
each ounce of gold held with USA, exchange rate between US$ and INR
would be – 30,000/600 = Rs 50 per dollar.
(b) Gold Standard System – This system started in mid 1870s and lasted till
1914 ie till start of World War I. In this system, the coins had a fixed gold
content and ratio of gold content in coins of any two countries denominated
their exchange rate. In case of paper currency, amount of gold freely
payable by Govt/Central Banks of two countries for each unit of paper
currency determined the exchange ratio. The countries were committed not
to print currency in excess of their gold holding or dilute the gold content in
coins. However, during the World War I, countries began to renege on this
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
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Jamnalal Bajaj Institute of Mgmt Studies
commitment to meet the funding requirement of the war and the gold
standard collapsed.
Many countries tried to revive the Gold Standard after the war ended
in 1919 but failed. In the economic depression that followed the WW-I,
when they tried to withdraw additional money they had pumped into the
economy during the war, it led to Deflation (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 wait for the economies to recover. But by the time they began their next
attempt a couple of decades later, World War II started in 1939 and lasted
till 1944. Thus, this standard was abandoned.
(c) Bretton Woods System – Post World War II, in 1946, the newly-created
Economic and Social Council of the United Nations called a conference at
the Bretton Woods where in the troika of post-War economic agencies ie
International Monetary Fund (IMF), World Bank and International Trade
Organisation (ITO – which later came in avatar of GATT) were born.
Countries were allowed to declare their currency value in gold or dollars and
USA promised to freely exchange an ounce of gold for US$ 35 or vice
versa. Since this system was born during Bretton Woods conference, this
standard came to be known as Bretton Woods system.
The system worked very well till 1969. However, when USA got
embroiled in the long and costly Vietnam war, its economy suffered. The
U.S. trade balance on goods and services shifted to a surprising deficit in
1971. These deficits supported speculations that the dollar was overvalued.
France realised that it was beneficial to exchange its forex holding into gold
and began to convert it. Because of massive gold outflows from the United
States, President Nixon suspended convertibility of the dollar in August
1971. This ended the Bretton Woods System.
(d) Smithsonian Agreement - IMF’s attempts in the subsequent period to revive
Bretton Woods system were unsuccessful as USA did not agree to make
dollar convertible to gold. In the following period, there was complete
chaos. In an attempt to restore order to the exchange market, 10 leading
nations met at the Smithsonian on December 16 and 17, 1971. The
“Smithsonian Agreement” was a new system of exchange-parity values.
Although this new system was still a dollar-standard exchange-rate system,
the dollar, was still not convertible to gold. Smithsonian Agreement
collapsed within 15 months and a de facto system of floating rates emerged.
(e) Now we have following systems of Exchange Rate being followed by
different countries as per their convenience:
(i) Fixed Exchange Rate Systems
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
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Jamnalal Bajaj Institute of Mgmt Studies
(aa) Currency Board
(ab) Fixed Peg
(ac) Flexible Peg
(ii) Floating Exchange Rate Systems
(aa) Managed Float System
(ab) Independent Float System
Scientific Way of Deciding Exchange Rate Between Currencies
1. Purchasing Power Parity System - This theory is based on the law of one price, the
idea that, in an efficient market, identical goods must have only one price. This is
thus Real Effective Exchange Rate (REER). A basket of representative goods and
services has been identified and its cost in each country in its domestic currency is
calculated. The ratio between its costs in any two 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 US. While the average price of a hair cut in India is
Rs 15, it costs US$ 3 in US. If this was to represent average ratio of costs for all the
goods in the basket, purchasing power parity of US$ would be 5 against INR.
The differences between PPP and market exchange rates can be significant.
For example, on plain conversion of Yuan to dollar basis, per capita GDP in China
is about USD 1,500, while on a PPP basis, it is about USD 6,200. Same is the case
of India. Per Capita GDP by PPP in 2000 = USD 2686) At the other extreme,
Japan's nominal per capita GDP is around USD 37,600, but its PPP figure is only
USD 31,400.
Exchange Rate = Price in domestic market for basket of goods = Pd
Price in foreign market for basket of goods Pf
This is called absolute version of PPP.
These special exchange rates are often used to compare the standards of living of
two or more countries. The adjustments are meant to give a better picture than
comparing gross domestic products (GDP) using market exchange rates.
2. Relative Purchasing Power Parity – This is a related theory, which predicts the
relation between the two countries' relative inflation rates and the change in the
exchange rate of their currencies. This is the economist’s definition. In business
terms, it helps in deciding Forward Rate of Forex from Spot Rate by taking inflation
into account.
Suppose, present Exchange Rate of dollar in India is Rs 47 and inflation in
India is 5% and in US 1%. Thus, cost of same product after one year in India =
PD (1+ 0.05) and in US = PF (1+ 0.01).
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 7 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
Thus, exchange rate after one year = PD (1+ 0.05)
PF (1+ 0.01)
= Rs 48.86
But 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, Interest rates is pegged to covered
the depreciation of money through inflation and a little as incentive. Thus, if inflation is low, interest
rates would automatically be correspondingly low).
3. Interest Parity Theory – Effect of interest on exchange rate is called Interest Parity
theory. Let us see how a smart operator can benefit by playing currency of two
countries having differential interest rates and gain from it.
Suppose, current exchange for US$ is INR 46. RBI bond interest rate is 7%
and US treasury interest rate is 2%. A smart American investor instead of investing
in US treasury bill would invest in RBI bonds. (this is what NRIs do with NRE and other
accounts). However, whole thing is not as simple as it appears. When 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 US.
Therefore, on maturity of deposit, reverse conversion of Rupee deposit to dollars is
going to be at higher cost than the original conversion rate Thus, losing of some
gains.
Sterilisation of Forex
While every country is bending over backwards to earn as much forex as possible, there is
limit of each economy to absorb forex inflow. Uncontrolled influx of forex can be harmful,
especially the hot money which can be withdrawn at short or nil notice, like portfolio and
stock market investment with capital account convertibility. (This is what was the prime cause of
South Asian Economic crisis of 1997). Also, influx of huge funds leads to inflation. Therefore,
there are times when forex inflows have to be checked or controlled. Technically such a
process is called Sterilisation of Forex. Recently, India adopted this approach by reducing
interest rates on NRE deposits which made parking of funds in India less attractive.
Another way of sterilisation is to liberalise Imports. Surge in imports takes away excess
supply of dollars in the market. Yet another method is to repay the old debts.
The methods we discussed above are the planned and controlled method of
Sterilisation of Forex. In addition, there could be host of uncontrollable and unpredictable
reasons leading to sterilisation, like –
(a) Threat of War
(b) Increase in oil prices
(c) Political Instability
(d) Govt Policies
(e) Social Disturbance
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 8 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
Fixed Exchange Rate Systems
1. Currency Board – Currency Board arrangement is one where a country declares
value of its domestic currency against some other strong currency. In this system,
currency notes issued by the country depend upon the declared exchange rate and
the amount of foreign currency reserves. If India gets into US currency Board and
has a forex reserve of US$ 150 Billion and exchange rate is Rs 40, India can issue
150 x 40 = 6000 Billion Rupees worth of currency notes. Thereafter, Indian
currency will move in tandem (same ratio) with USD. Domestic currency is also
fully convertible into foreign currency and vice versa. However, in this case,
monetary policies have to be in consonance with other country. Thus, it kills the
economic sovereignty of the nation and therefore difficult to follow.
Examples are Argentina, Hong Kong, Estonia, and Bulgaria
2. Fixed Peg – In this system, exchange rate is declared by the country and ratified by
the IMF. Thereafter, exchange rate does not change till it is revised by the Govt.
Reluctance by the govt to revise the rate due to political or other compulsions can
lead to long term consequences. South East Asian crisis was partly result of this
system.
Reasons for South East Asian Crisis (1997)
(a) Countries had adopted complete convertibility on Current as well as Capital
account. This made flight of capital very easy. There was no way to control
outward flight of capital at the time of crisis.
(b) They adopted Fixed Peg system against dollar. There was massive influx of
foreign currency through hot investments, foreign currency loans by banks,
etc. This money was invested in assets like real estate and stocks. There was
massive rise in asset prices and an asset bubble was created.
(c) There was massive current account deficit. Imports far exceeded exports.
(d) High inflation rates due to increased money supply. Inflation was not
reflected in exchange rate; firstly, due to Fixed Peg system and secondly,
due to govts’ reluctance to revise the rate downwards which would have
affected investors’ sentiments. Speculators suddenly realized that due to
overvalued currencies, it was beneficial to convert local currency into
dollars and they went for it hammer and tongs. Due to relatively small size
of economies (a few tens of billion dollars each), and therefore small forex
reserves, in three trading sessions, Forex reserves became nil.
3. Flexible Peg System – This system provides a “Parity band” which allows limited
flexibility for movement of exchange rate on either side of the parity rate. Bands
can be very narrow or very wide. Examples are Bangladesh, China, and Egypt.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 9 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
Floating Exchange Rate Systems
1. Managed Float – This is the system that we are currently following in India.
Exchange rate is free to float but under constant watch of Central Bank (RBI). It
generally intervenes only on occasions when there are wild movements. It basically
acts as stabiliser.
2. Independent Float – In this system Govt is just not bothered which way its
currency is moving. This is the system followed by rich and advanced countries like
USA, Kuwait, Saudi Arabia, etc.
India followed Fixed Peg System since independence. Indian rupee was pegged against UK
₤. In 1966, rupee was devalued. In 1975, India moved away from ₤ parity and pegged its
rupee against an unknown basket of 5 currencies. It devalued rupee once again during the
Balance of Payment Crisis in 1991. From 1993, we started following floating rate exchange
system.
Impossible Trinity (The three events that can not occur together)
(a) Having Fixed Peg system of Exchange Rate.
(b) Having complete convertibility on current and capital account.
(c) Having complete independence in deciding monetary policy.
No country to date has ever been able to achieve all the three conditions together at
any point of time. That is why it is called impossible trinity.
Why did economies of Argentina, Chile and Mexico crash?
Argentina Economic Crash – 2001
Argentina had been having a see saw economy ever since the beginning of 20th
century. It
was the 4th
largest economy in early 1915, fell down drastically in late 70s & 80s and then
again recovered to become 56th
economy in 1996. It suffered its first crash in 1929 during
American Stock Market Crash. It recovered from there to become 15th
largest economy
only to suffer yet another crash in 1970s and 1980s. In 1980, the inflation was as high as
5000%. In a matter 22 years, ie between 1970 and 1992, money got devalued by 10 billion
times. Yes! 10 billion pesos were reduced to a single peso.
Economic reforms launched in 1991 reduced inflation from 2300% in 1991 to just 1% in
next few years. However, the recovery was short lived. Some wrong currency policies of
Govt and economic crisis in countries like Mexico, Brazil and Russia, triggered another
economic crisis in 2001.
In 1991, a currency stabilization regime established a currency board, which pegged the
Argentine peso to the dollar on a 1-to-1 basis. Inflation was virtually eliminated. Foreign
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
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investment returned. GDP growth was strong in the early 1990s, but unemployment
increased as a result of extensive structural reforms. Argentina finally seemed to have a
handle on its chronic economic problems. However, external events in the late 1990s
buffeted the Argentine economy:
1995: Mexico
1997: East Asia
1998: Russia
1999: Brazil
Because of its long history of economic instability, every economic crisis in the Third
World, particularly in Latin America, caused investors to pull out of Argentina, creating a
self-fulfilling prophesy. It was investors’ hair-trigger reaction to crises elsewhere that
caused Argentina’s instability, Thus, the adverse effects of these crises were greater in
Argentina than in most other new-growth economies. Another reason for this enhanced
vulnerability is that Argentina stood alone with its fixed-exchange-rate policy, whereas the
floating currencies of its neighbours depreciated. By 2001, the peso was significantly
overvalued, in no small part due to the dollar itself having become overvalued. The
devaluation of the Brazilian real had a particularly large effect. It reduced demand from
Argentina’s largest trading partner, and businesses began to move from Argentina to Brazil
in search of lower production costs. As the credibility of the peso at its pegged value
declined, and the government had to expend huge sums to support the currency, which in
turn necessitated more borrowing. Under these conditions, interest rates that were 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. Argentina continued to keep the peso
pegged to the dollar by external borrowings.
The buzzards came home to roost in December 2001. The nation rapidly descended into an
unprecedented chaos. As economic activity shuddered to a virtual halt, governments
resigned and were hastily replaced amid sporadic rioting. The following month, when
Eduardo Duhalde (the fifth person to hold the presidency in two weeks) unpegged the peso
in January 2002, the peso crashed hard, losing more than 70% of its value and inflation
rising to 41% though it was still far far better than the expectations of four digit hyper
inflation experienced in late 80s decades. But inflation had fallen back to 3.2% by 2003.
So, we know now what agony was the country saved from by the much maligned and ever
pouting Mr PV Narsimha Rao, who displayed the rare courage to stand up against the
economically blind political class of the country (including his own party men) in
appointing Mr Man Mohan Singh as Finance Minister; and the practical economist Mr Man
Mohan Singh himself, whose economic prescriptions to cure the ills of the economy were
as effective as any measures ever were any where in the world in its modern history.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 11 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
Mexican Economic Crisis
Mexican Economic trouble of 1994 was not a ‘Crash’ but a Crisis as it lasted just 10
months and the melt down was not as spectacular as in Argentina. This crisis was also
triggered by wrong currency policies of the govt. In Dec 1994, Mexican Peso fell from the
pegged rate of 3.3 peso to a dollar to 7.7 peso.
Though the crisis was triggered by; first: the devaluation of currency in December 1994
and second: floatation of currency soon after; the seeds were sown earlier.
Mexico had a fixed exchange rate of 3.3 peso to a dollar. In 1994, as the general election
drew near, the incumbent govt went into a spending blitz (politicians are same every where). As
a result, current account deficit ballooned to a record of 7%. 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 Peso by approximately 20%. Some investors were alarmed;
other smelled the opportunity; and together they quickly encashed the bonds in dollars.
Foreign exchange reserves fell drastically. Declining reserves necessitated devaluation of
currency. However, political compulsions did not allow this simple but hard prescription
till the incumbent govt lasted.
Next Govt which took over power in Dec 1994, devalued the currency to 4 pesos to dollar.
That did not prove adequate and within days peso was allowed full float which led to
crashing of peso to 7.2 pesos to a dollar.
Mexico’s immediate neighbour, USA, intervened immediately by first buying pesos from
open market and then arranging a loan of US$ 50 billion. The currency then stabilized first
at 6 pesos to a dollar and thereafter gradually declining over next two years to 7.7 dollars
before beginning a regular recovery. Mexico repaid all loans by 1997.
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27 Jul 2006
FOREX MARKET AND FOREX ARITHMETIC
Forex market is open almost 24 hrs a day. It starts in Tokyo and ends in West Coast of
USA. By the time it closes in USA West Coast, it is within 2.5 hrs of opening of Tokyo
market for the next day.
Total trade in the Forex market is to the tune of over US$ 5 trillion per day. The Indian
Forex Market turnover itself averages US$ 5-10 billions/day.
Communication System – Forex Market has a dedicated worldwide telecommunication
network called SWIFT (Society for Worldwide Interbank Financial Telecommunications).
Forex Dealers
There are two kinds of forex dealers in the market:
(a) Full Fledged Money Changers – Mostly designated banks and Thomas
Cook (an exception). These are the authorized dealers who are permitted to
take positions. An authorized dealer deals in millions of dollars each day.
They can go long or short (overbought or oversold positions). They are also
allowed to appoint their franchisees.
(b) Restricted Money Changers – These are the kind of money changers who
line up the streets in tourist centres. They can only buy forex. They are not
allowed to sell. They are essentially convenience centres for tourists for
currency exchange.
One peculiarity of Forex Market is that it is mostly unregulated and completely driven by
the Demand-Supply principal. There are few benchmarks. Rates fluctuate minute by
minute, dealer by dealer, and customer by customer. There is nothing fixed. Two people
doing a sell deal with the same dealer at the same time in the same place and of same
currency may end up with vastly different rates. Money changers are free to quote their
own rate for buying and selling any currency (technically called Bid and Ask rates
respectively) based on customer, size of deal, their own current positions, etc.
How to make a Quote?
All money changers are connected to Reuters through SWIFT. The Reuters screen
continuously flashes current going rate for various currencies at different centres. However,
the rates are only indicative. They are representative rates for market as a whole. Individual
rates with various dealers vary.
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Exchange Rates are quoted in following format: -
USD/INR = )(
)( 9000.46/8000.46 AskRate
BidRate
Above represents amount of currency in denominator (here INR) to be paid for each unit of
currency in numerator (here USD). Quotation is always in double numbers with minor
difference between the two. First number is called the Bid Rate and second number is
called Ask Rate. Bid rate is always lower than the Ask Rate.
Bid Rate is the rate at which the money changer is willing to buy a particular currency.
Ask Rate is the rate at which the money changer is willing to sell same currency.
Spread – As stated earlier, there is always a positive difference between Ask Rate and Bid
rate. This difference is called Spread and it is the profit margin that the dealer earns by
trade.
Spread = Ask Rate – Bid Rate
Spread % = 100
BR
BRAR
Forex market behaves like any other commodity market. Here too, there is whole sale and
retail market.
Whole sale market consists of Authorised Dealers and Big Corporate Houses like TCS,
Infosys and Wipro who have high forex exposures. But spreads in whole sale market are
lower.
Retail Market is populated by money changers, ordinary citizens, small exporters and
importers and small corporates.
Positions
In any financial market, two positions can be taken
(a) Long or overbought position and
(b) Short or oversold position.
Why are positions created?
Positions 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 liquidated by manipulating the
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Page 14 of 58 - International Finance (Ver 1.3)
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Bid and Ask rates. Example - If it is a long/overbought position, both Ask and Bid rates
will be lowered. Similarly, if there is an oversold position, both Ask rate and Bid Rate will
be hiked.
The quotations are normally in four decimal places. If a dollar is being quoted against
Rupee, it will be quoted as follows: -
46.5230/46.5250
First figure of quote is Bid Rate and second figure is Ask Rate. Third and fourth decimal
places are called PIPS. Thus, in the above case, 30 and 50 are pips.
In most cases, quotations are abbreviated to give only two or three digit pips in place of
Ask Rate. Thus, above quote could also be represented as: -
46.5230/50
Inter dealer quotes 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
known.
Arbitrage
As in any other trade, arbitrage opportunities exist in Forex trade also. Arbitrage is
basically taking advantage of rate differential at two locations or markets or sources. For
instance, Bid (Buying) Rate of one dealer may be higher than Ask (Selling) Rate of another
dealer. A smart operator can buy from second dealer and sell to first dealer and earn some
money. This transaction is called Arbitrage. Let us see the above process in numbers.
Dealer A Dealer B
46.5030/46.5080 46.5090/46.5095
In the above case, Bid Rate of Dealer B (46.5090) is higher than Ask Rate of Dealer A
(46.5080). If a person Buys one million dollars from Dealer A and sells to Dealer B, he
earns - 0.0010 x 1,000,000 = Rs 1000
This is also called Single Point Arbitrage since there is only one Buying and Selling
operation involved. It normally happens when the deal is in single market involving two
dealers
Inverse Quote – Also called “Indirect Quote”. Normally, value of other currency is quoted
in local currency, ie, amount of local currency to be paid for each unit of foreign currency.
In India, all currencies are quoted using INR as the base, ie, value of other currency is
quoted in Indian Rupees. Similar practice is adopted by all other countries, using their local
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currency as base and indicating number of local currency to be paid for each unit of other
currency.
Thus, a person will obtain USD/INR quote = 46.3020/46.3090 from a dealer in India and
INR/USD quote = 0.0213/0.0224 from another dealer in USA (US currency is used as base in
USA. So, the quotation will be number of USD to be paid for each INR). If the bases of quotes are
different, how do we compare the quotes? Comparison of two quotes becomes difficult.
Therefore, there is a need to INVERSE one of the quotes so that the base is common.
USD/INR = 46.3020
Inverse the quote
INR/USD = 0216.0 46.3020
1
)/(
1
INRUSD
That was a simple case when only mean rate is given. Now let us see what happens
when bid and ask rates are quoted.
USD/INR = 46.3020/46.3090
021597.046.3020
1
)/(
1
BIDASK INRUSDUSD
INR
021594.03090.46
1
)/(
1
ASKBID INRUSDUSD
INR
(Please note that for finding BID rate, we have to inverse ASK rate and for finding ASK rate we have
to inverse BID rate. What is the logic for this?
Currency trade is basically a BARTER trade. In any other trade, commodity is traded against a
currency. However, in currency trade, both sides have currencies but of different type. It is like one
side having wheat and the other side having rice and both ready to exchange their commodity for the
other’s for a negotiated exchange rate. In such a situation there is no seller and no buyer. Saying it
other way round, both are sellers and both are buyers. When one buys other’s commodity, he
simultaneously sells his commodity. So, when one trader says – I am willing to sell one dollar for
Rs 47, it can also be interpreted as - he is willing to buy Rupee for 1/47 dollar. Thus, his ASK rate
of Rs 47 for a dollar has become his BID rate for a Rupee in inverse quote at 1/47 dollar. Therefore,
when currency quotes (exchange rates) are inversed, Bid and Ask rates also have to be inversed).
Two Point Arbitrage – When two 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 US market for Rupee.
This is called Two Point Arbitrage.
Three Point Arbitrage – Some times Arbitrage opportunity is available by currency
exchange operations across two 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
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currency is then sold in third or first market for original currency.
Suppose, there are three currencies A, B and C. Quotes are available for A/B, B/C and C/A
(C/A)BID = (B/A)BID X (C/B)BID
ASKASK
BIDCBBA
AC)/(
1
)/(
1)/(
AND
(C/A)ASK =(C/B)ASK X (B/A)ASK
BIDBID
ASKBACB
AC)/(
1
)/(
1)/(
Forward Quotes
Forward quotes are one where a dealer quotes for purchase and selling of forex at a future
date. These quotes are mainly useful for exporters and importers who commit to sell their
ware or import goods based on exchange rate prevailing on that date. However, money is
received or paid in foreign currency at a much later date. Any 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 forward quotes. Various terminologies associated
with forward quotes are as follows:
Spot Deal – Settlement on T+2 days (‘T’ refers to Transaction Date. Thus, delivery of
forex and payment of cash for a transaction done on Monday has to be completed (settled)
by Wednesday)
Spotcash Deal – Settlement on T + 0 days (Same day payment and delivery)
SpotTom Deal – Settlement on T + 1 Day (Next Day Payment)
Forward deals could be T+10, T + 30, T + 90, etc. (Add 2 working days for each settlement).
Inter Dealer Forward Quotes are not elaborate. Only differential amount to spot deal rates
are quoted. Thus, if
If GBP/INRspot = 85.8680/85.8950
Then, 30 days FP (Forward Premium) is quoted as 30/40, which means
30 days FP for GBP/INRspot = (85.8680 + 0.0030) / (85.8950 + 0.0040)
= 85.8710/85.8990
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It is possible that Bid FP for a Forward Quote is higher than Ask FP. 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 would be paid. Thus, in
such a situation, the quoted differential amount is decreased rather than added to Spot
quotes.
In the above example, if dealer quotes were 40/30, then 30 days FP would be:
30 days FP for GBP/INRspot = 85.8680 - 0.0040 /85.8950 - 0.0030
= 85.8640/85.8920
In the Forward Deals there are more variations –
Out Right Forward Deal – A deal where there is only one transaction of sell or buy at a
future date. So, you decide to buy one million dollars after 60 days.
Spot Forward Deal – A deal where there is a Spot Deal and a covering deal on a future
date. So, you buy one million dollars today and strike a forward deal for selling one million
dollars after 60 days.
Forward Forward Deal – There is a Buy and a covering Sell deal on a future date (future
dates of buy and sell deals are different). So, you do a forward deal to buy one million
dollars after 30 days and do another forward deal to sell one million dollars after 45 days.
Broken Date/Forward Rate Calculation
Quotes are available for one month, three months or six months. There may be requirement
to calculate for a date in between these quoted dates, say for 1½ months or 3 months and 25
days. Such calculations are done by intrapolation of quotes for available dates
(extrapolation is never done for dates beyond max quote). Let us take an example for
conceptual clarity:
Spot USD/INRSpot = 46.8000/46.9000
1 month FP = 50/80
3 months FP = 100/200
6 months FP = 200/300
Find forward rates for 1 month 15 days and also for 3 months 25 days.
Ans. For 1 month 15 days =
daysdays
daysdays
1560
80200
1560
50100
(“60” because 3 months minus 1 month = 60 days)
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= 30
13
= 46.8050 + .0013 / 46.9080 + 0.0030
= 46.8063 / 46.9110
For 3 month 25 days =
daysdays
daysdays
2590
200300
2590
100200
= 70.27
7.27
28
28
= 46.8100 + .0028 / 46.9200 + 0.0028
= 46.8128 / 46.9228
Forward Premium/Discount Computation
FP = 10012
nSR
SRFR
MR
MRMR (MR means Mid Rate which is average of Bid and Ask Rates)
If FP is (+)ve, then foreign currency is appreciating
If FP is (–)ve then forward deal is at a discount which means that local currency is
expected to appreciate.
Spot USD/INR = 46.8030/46.8500 Mid Rate = 46.8265
3M FR = 46.9030/46.9500 Mid Rate = 46.9265
n = 3 months
Forward Premium = 1003
12
46.8265
46.8265- 46.9265
= 0.8542 Thus, there is a 0.85% premium on forward quotes.
In case the result was in negative, then there was a discount, which means that foreign
currency is going to depreciate and local currency is expected to appreciate.
Factors Affecting the Forex Forward Quote
1. Inflation – The currency of the country experiencing higher inflation rate will
depreciate in value
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2. Interest Rate – Capital will move from low interest rate country to higher interest
country. Thus, currency of country with higher interest rate will appreciate due to
higher demand.
Forward Rate =
RF
RD
I
ISpotRate
1
1
Where
IRD = Interest Rate in Domestic Market
IRF = Interest Rate in Foreign Market
Interest Arbitrage
Interest Arbitrage refers to the international flow of short term liquid capital (Fixed
Deposits denominated in Foreign Currencies or Convertible local currency) to earn a higher
interest abroad. In India, we have NRIs investing in fixed deposits to earn higher interest
rates. Interest arbitrage can be uncovered or covered.
Uncovered Interest Arbitrage
In order to be able to take benefit of higher interest opportunity in foreign country, it is
often necessary to convert the domestic currency to foreign currency while investing in
foreign country and then reconverting principal and interest earned to local currency at the
time of maturity.
In countries where interest rates are higher, inflation is also higher. (nominal interest rate is
mostly equal to real interest rate + inflation). When inflation is higher, the currency mostly
depreciates over time. Thus, there is a risk of depreciation of investment due to lower
exchange rate during the re-conversion after maturity. If such a foreign exchange risk is
covered through forward, we have covered interest arbitrage, else, we have uncovered
interest arbitrage.
Suppose, interest rate in India is 11% where as it is 5% in US. A US investor will earn 6%
extra per year or 3% every 6 months if he invests in India. However, since inflation rate is
also high in India at 5% compared to just 2% in US, INR is likely to depreciate. If INR
depreciates by 3% over one year, net return on investment by US investor falls to barely
3%. However, in case INR depreciates by more than 6%, the US investor will end up as net
loser (and we have not even considered the transaction costs in conversion and reconversion processes).
Covered Interest Arbitrage
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
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same time sells forward the amount of foreign currency he is investing plus the interest he
would earn to coincide with maturity date of investment. Though, he would be paying
some premium for forward cover, he is insured against depreciation of currency. His return
on investment will reduce by the amount of premium paid for forward deal compared to
uncovered interest arbitrage, but that is the price to be paid for insurance.
But such opportunities do not last long due to two reasons.
(a) As funds move out of the home country, the interest rates rise there due to
resultant paucity of funds. Vice versa, as additional funds flow in to foreign
country, excess liquidity of capital causes interest rates to soften there.
(b) As demand for forward deals on currency of other country rise, premium on
forward deals increases. Thus, the cost of transaction (conversion and
reconversion of currency) increases and eats into profits to be earned from
interest rate arbitrage.
Thus, the interest rate differential keeps reducing and forward premium keeps
increasing till it comes to a level where it is no more advantageous to invest in foreign
country.
Problem 01
Exchange rate for USD in India is
Spot: 45.0020
6 month forward: 45.9010
Interest rate (annual) in the money market is as follows:
USA: 7%
India: 12%
Work out the arbitrage opportunity.
Solution
Given Spot USD/INR = 45.0020
6 Months Forward = 45.9010
Interest Rate USA = 7% and India = 12%
Forward Rate =
RF
RD
I
ISpotRate
1
1
=
12
6
100
71
12
6
100
121
0020.45
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= 45.0020 x (1.0241)
= 46.0890
& the Forward Market Rate = 45.9010. Thus, there is an opportunity for arbitrage.
Annualised Forward Premium = 10012
nSR
SRFR
MR
MRMR
= 1006
12
0020.45
0020.459010.45
= 3.995%
USD is going at a premium of 3.995%.
As per the interest rate differential, USD should be quoted at INR 46.0890. Also, Interest
Rate Differential between two countries = 12 – 7 = 5%, where as, USD is being quoted at a
forward premium of only 3.995%. Thus, there is an opportunity to borrow USD from USA
@ 7%, convert to INR and invest in treasury bond at 12% while simultaneously buying
USD 6 months Forward @ 45.9010 and earn an arbitrage of 1.005% on investment.
Scenario II
If forward rate was 46.9010
Then premium = 1006
12
0020.45
0020.459010.46
= 8.44%
Thus, if you invest in INR, you would make a loss of 8.44% in forward deal where as your
earning from interest would be 12 – 7 = 5%. Thus, you be in net loss of 8.44 – 5 = 3.44%.
This kind of transaction is possible only when Govt gives freedom to buy and sell INR or
USD in both countries.
Now in this case, borrow INR 45.0020 in India @ 12% and convert to 1 USD at spot rate.
Invest this USD in money market in USD at 7% for six months. Simultaneously, sell USD
1.035 in 6 months forward for INR 48.5425. Your liability against borrowing in India =
12
6
100
12110020.45
= 47.702
Thus, there would be gain of INR 48.5425 - 47.702 = INR 0.8405 per INR 45.0020
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invested or 3.44%.
Problem 02
In April 2005, USD/ INR quotes were 43.70/44.05.
6 months Swap points were 40/70
Annual Interest Rate in USA and Indian were 2% and 8% respectively.
Work out the scope for arbitrage, if any.
Solution.
Spot Rate USD/INR : 43.70/44.05
Fwd Rate (Six Months) : 43.70+0.40/44.05+0.70
= 44.10/44.75
Annual Interest Rates in USA and India are 2% and 8%.
For buying USDfwd, Premium = 1006
12
Rate Bid
Rate Bid - RateAsk
Spot
SpotFwd
= 1006
12
43.70
43.70 - 44.75
= 4.80%
(Method for deriving above formula : Proceed as per following logic. Start with buying forward for currency
of country where interest rate is low. You want to buy forward because you need to pay in future in that
currency. You need to pay in future in that currency because you borrowed today in that currency. Once you
have borrowed that currency, you will sell that currency in spot market and buy other currency. That gives
the base, either Bid Ratespot or Ask Ratespot. Put this at denominator. Put same figure as “value to be
subtracted” in numerator. Put complementary value of subtracted value as first figure, like, for Bid RateFwd
Ask RateFwd and for Ask RateFwd Bid RateFwd. That completes the formula. In case you want to work out
formula for forward of other currency, simply inverse all the Ask for Bid and Bid for Ask).
So, Formula for buying INRFwd, Premium = 1006
12
Spot
SpotFwd
RateAsk
RateAskRateBid
Interest Rate Differential = 8 – 2 = 6%
Thus, while we lose 4.8% in forward market, we earn 6% in money market. Thus, net gain
is 6 – 4.8 = 1.2%.
Start with USD 100 borrowed from US market @ 2% and convert to INR @ 43.70 to INR
4370. Invest this money in Indian market @ 8% and get 4370 x 1.04 = INR 4544.80. Buy
USD forward @ 44.7 for INR 4544.80 and get USD 101.56. Pay USD 101 to US market
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and keep USD 0.56 as covered interest arbitrage profit.
Interest Rate Differential, Covered Interest Arbitrage and Interest Parity Theory
3
2
Arbitrage
1
0
-1 .
.
-2
-3
-3 -2 -1 0 1 2 3 Forward Exchange Rate – Discount or premium in percent per annum
Explanation of the above figure
Arbitrage Outflow will take place
1. If (+)ve interest rate differential is > Forward Discount like at Point A, Interest Rate
Differential = 2, and Fwd Discount = 0.5
2. If Forward Premium > (–)ve Interest Rate Differential like at Point A’,
Fwd Premium = 2.2, and Interest Rate Differential = - 1.05
Arbitrage Inflow
3. If Forward Discount > (+)ve Interest Rate Differential, like at Point B,
Fwd Discount = 2.7, and (+)ve Interest Differential = 1.2
4. If (–)ve interest Rate Differential > Forward Premium, like at Point B’,
–ve Interest Rate Differential = 2.2, and Forward Premium = 0.7
Arbitrage
Outflow
Arbitrage
inflow
.A’
.B
A
Inte
rees
t D
iffe
ren
tial
in
fav
our
of
fore
ign
co
un
try
in
per
cen
t p
er a
nnu
m
Interest
Parity
B’
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Sample Practice Questions on Exch Rate (Forex Arithmetic)
Q1. The Spot Rate of two banks in US Market for GBP is as follows:
GBP/USD: Bank A: 1.4550/1.4560
Bank B: 1.4380/1.4548
Find Whether Arbitrage is possible.
Ans. Bank B 1.4380 1.4548
Bank A 1.4550 1.4560
The Ask Rate of bank B for selling a GBP is USD 1.4548 which is less than Bid Rate of
bank A at 1.4550. Thus, it is possible to buy GBP from bank B and sell to bank A and earn
an arbitrage of USD 0.0002 for each GBP traded. In the above diagram, the triple line in
green indicates the arbitrage opportunity. If the two lines, double line and solid thick line
had overlapped, then there was no arbitrage opportunity.
Q2. Rate for USD in Indian Market is as follows:
USD/INR: 46.2000/3000
Inverse the quotes.
Ans. 2000.46
1
/
1/
BID
ASKINRUSD
USDINR
= 0.021645
3000.46
1
/
1/
ASK
BIDINRUSD
USDINR
= 0.021598
Q3. In the Forex Market, following are the rates:
USD/JPY: 110.25/111.10
USD/AUD: 1.6520/1.6530
AUD/JPY: 68.30/69.00
Find Whether Arbitrage is possible in terms of AUD/JPY.
Ans. In this case, if we inverse the rate of USD/AUD and get AUD/USD, our job will
become easy.
6050.06530.1
1
/
1/
ASK
BIDAUDUSD
USDAUD
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6053.06520.1
1
/
1/
BID
ASKAUDUSD
USDAUD
AUD/JPY = AUD/USD X USD/JPY
(AUD/JPY)BID = (AUD/USD)BID X (USD/JPY)BID
2533.6710.1116520.1
1/
6969.6625.1106530.1
1/
ASK
BID
JPYAUD
JPYAUD
By Three Point Arbitrage - AUD/JPY = 66.6969/67.2533
Forex Market Rate for AUD/JPY = 68.30/69.00
Thus, there is a difference of almost one JPY for each AUD in two situations.
So, to earn arbitrage, Sell JPY and buy USD @ 111.10.
Then sell USD and buy AUD @ 1.6520. Now sell 1.6520 AUD and buy JPY @
JPY 68.3 for AUD 1.
83.11230.686520.1
Thus, for every JPY 111.10 put into market, there is a return of JPY 112.83.
Q4. Following are the quotes in New York:
GBP/USD: 1.5275/85
USD/CHF: 1.5530/39
(a) What rate do you expect for GBP in Basle?
(b) If Basle quote is 1GBP = 2.3320/30 CHF, then find whether Arbitrage is
possible?
Ans GBP/USD: 1.5275/85, USD/CHF: 1.5530/39
CHF
GBPCHF
USDUSD
GBP
3751.2
3722.2
5539.1
5530.1
5285.1
5275.1
3751.23722.2
CHFGBP
Basle Quote = 1GBP = 2.3320/30 CHF
GBP is cheaper to buy in Basle at 2.3330 CHF. Therefore, buy one GBP in Basle
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and sell in New York for USD 1.5275. Then sell USD 1.5275 for 2.3722 CHF and earn an
arbitrage of (2.3722 - 2.3330) = 0.0398 CHF per GBP or
2.3722 CHF = 3722.23330.2
1
= 1.0168 GBP
So, the Arbitrageur will make GBP 0.0168 for every GBP traded.
Q5. Following are the EUR/INR quotes:
Spot: 49.9525/80
1 Month Forward: 100/120
3 Month Forward: 225/255
6 Month Forward: 300/275
Find absolute forward quotes.
Ans. 1 Month Forward: 49.9625/700
3 Month Forward: 49.9750/835
6 Month Forward: 49.9225/305
Q6. A bank is quoting following rates:
EUR/USD: 1.5975/80
2 Month Forward Points :20/10
3 Month Forward Points: 25/10
Further,
AED/USD rate is 3.7550/60
2 month forwards points: 20/40
3 month Forward points: 30/50
A firm wishes to buy AED against EUR 3 month forward. Find the rate to be quoted by
the bank.
Ans. AED/USD = 3.7550/60
3 months Forward Rate = 3.7580/610
EUR/USD: 1.5975/80
3 months Forward Rate = 1.5950/70
BID
ASKUSDEUR
EURUSD/
1/
5950.1
1/ ASKEURUSD
62696.0
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ASK
BIDUSDEUR
EURUSD/
1/
62617.0
5970.1
1/
ASKEURUSD
EUR
USD
USD
AED
EURAED
3532.2
62617.07580.3
BIDBID
BID EUR
USD
USD
AED
EURAED
3572.2
62696.07610.3
ASKASK
ASK EUR
USD
USD
AED
EURAED
So, AED/EUR = 2.3532/80
Money Market Hedging
Q1. An American Exporter will be receiving ₤ 1,000,000 three months from now. Spot
Rate for GBP/USD = 1.6 Rate of interest in USA and London Money market is
10% and 5% respectively. Suggest hedging strategies for the exporter.
Ans: Exporter should borrow ₤ 987,654 from London Money Market @ 5%, convert to
USD 1,580,247 and invest in US for 3 months @ 10%. After 3 months he will get
USD 1,580,247 + 39,506 = USD 1,619,753 and will need to pay ₤ 1,000,000 which
he can when he receives his payment 3 months later. Thus, he earns USD 19,753 as
arbitrage. There is no need to hedge the position for his borrowing with a forward
cover since he has natural hedge in terms of earning.
Q2. An American importer has to pay ₤ 1,000,000 to a party in London 3 months from
now for the denim import it has made. The Spot rate for GBP is 1.6 USD. It is
expected that USD may depreciate further in future. Rate of Interest in USA is 5%
and in UK it is 10%. Suggest hedging strategies for importer.
Ans: This is a slightly peculiar case. Normally, the currency of country where interest
rate is high, depreciates. But in this case USD is expected to depreciate despite US
interest rates being lower. But that makes the job of importer much easier.
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The American importer needs to pay 1.6 x 1,000,000 = USD 1,600,000 at
current rates. Since he needs to pay 3 months later, and USD is expected to
depreciate in the meanwhile, he can convert USD to GBP now and invest in UK @
10% per annum. He will earn 2.5% interest in 3 months. To be able to have GBP
1,000,000 three months from now, he should invest GBP 1,000,000/1.025 = GBP
975,610 now. GBP 975,610 = USD 1,560,976.
So, he should borrow USD 1,560,976 and convert to GBP and invest in UK
market @ 10%. Three months later, he will get GBP 1,000,000 (principal + interest)
and pay his liability. In US, he will have to pay only USD 1,580,488 to bank
instead of USD 1,600,000 and thus save USD19,152 as arbitrage. His position has
been also hedged simultaneously.
Interest Rate Arbitrage
Q3. A Customer obtains following quote-
EUR/USD: 1.2930/1.3270
Annual USIBBR/US IBOR: 4/5.5%
Annual LIBBR/LIBOR: 6/9%
Calculate the likely limits for the Forward Rate between the two countries.
Ans: Suppose you borrow USD 1.3270 @ 5.5% for one year. Your liability after one
year = 1.3270 + 5.5% = USD 1.4000. Convert this USD 1.3270 to EUR 1.0000 and
invest in bank @ 6%. You will earn EUR 1.0600
Sell EUR 1.0600 in Forward market. Bid Rate should be such that your money does
not fetch you more than your liability for payment (USD 1.4000 in this case)
So, 1.06 x ForwardBid ≤ 1.4000 Thus, Forward EUR/USDBid ≤ 1.3208
Now take the Reverse Arbitrage
Borrow EUR 1 @ 9% for one year. Your liability after one year = EUR1.0900
Convert (sell EUR) this EUR 1 to get USD 1.2930 and invest in bank @ 4%.
You will earn USD 1.34472. Using this USD 1.34472, buy EUR in forward market.
Forward EUR/USDAsk rates should be such that it yields you less than your liability
(EUR 1.0900 in this case).
1.34472 / FR ≤ EUR1.0900, or FR ≥ 1.34472 / 1.0900
Forward EUR/USDAsk ≥ 1.2337
Ask rate should always be higher than Bid Rate and forward spread should be more
than spot spread. Spot spread is 0.0340. If we increase the spread by another 10
points, ie, 0.0350 and add to Bid Rate. We get the range as
Forward EUR/USDAsk = 1.3208/1.3558
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FOREX RISK MANAGEMENT THROUGH FUTURES
A future is an exchange-traded derivative which is similar to a forward. Both futures and
forwards represent agreements to buy/sell some underlying asset in the future for a
specified price. Both can be for physical settlement or cash settlement. Both offer a
convenient tool for hedging or speculation. For little or no initial cash outlay, both
instruments provide price exposure without a need to immediately pay for, hold or
warehouse the underlying asset. In this sense, both instruments are leveraged. Futures and
forwards trade on a variety of underliers: wheat, oil, live beef, Eurodollar deposits, gold,
foreign exchange, the S&P 500 stock index, etc.
The fundamental difference between futures and forwards is the fact that futures are traded
on Exchanges. Forwards trade over the counter. This has three practical implications.
1. Futures are standardized instruments. You can only trade in the specific contracts
supported by the exchange. Forwards are entirely flexible. Because they are
privately negotiated between parties, they can be for any conceivable underlier
(currency) and for any settlement date. Parties to the contract decide on the notional
amount and whether physical or cash settlement will be used. If the underlier is for
a physically settled commodity or energy, parties agree on issues such as delivery
point and quality.
2. Forwards entail both market risk and credit risk. A counterparty may fail to perform
on a forward. With futures, there is only market risk. This is because exchanges
employ a system whereby counterparties settle profits or losses on daily basis.
Through these margin payments, a futures contract's market value is effectively
reset to zero at the end of each trading day. This all but eliminates credit risk.
3. The daily cash flows associated with margining can skew futures prices, causing
them to diverge from corresponding forward prices.
A future is transacted through an authorised brokerage firm. Working through their
respective brokers, two parties will transact a trade. Legally, that trade is structured as two
trades, both with a clearinghouse owned by or closely affiliated with the exchange. For
example, suppose Party A and Party B trade. Party A is long and Party B is short. This
would be legally structured as
Party A being long on One million USD futures at Rs 47 with the
exchange's clearinghouse being the counterparty; and
The exchange's clearinghouse being long on One million USD futures at
Rs 47 with Party B being the counterparty.
Party A and B then have no legal obligation to each other. Their respective legal
obligations are to the exchange's clearinghouse. The clearinghouse never takes market risk
because it always has offsetting positions with different counterparties.
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Before 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 account. The amount of initial margin is determined according
to a formula set by the exchange. For a single futures contract, it will be a small fraction of
the market value of the futures' underlier. For futures spreads, or if you are using futures to
hedge a physical position in the underlier, initial margin may be even lower. Generally,
initial margin is intended to represent the maximum one-day net loss you could reasonably
be expected to incur on a position.
Through the margining process, futures settle every day. Unlike a Forward, where 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 realized.
This essentially eliminates credit risk for futures.
Maintenance Margin is some fraction - perhaps 75% - of initial margin for a position.
Should the balance in your margin account fall below the maintenance margin, your broker
will require that you deposit funds or securities sufficient to restore the balance to the initial
margin level. Such a demand is called a Margin Call. The additional deposit is called
Variation Margin. Should you fail to make a variation margin payment, your broker will
immediately liquidate some or all of your positions.
Mechanism of Futures Trading
Components of Futures Trade
1. Futures Players
(a) Hedgers – These are the importers and exporters who mitigate their risk of
unfavourable movement of exchange rate when they need to buy or sell the
foreign currency at a future date.
(b) Speculators – These are investors who buy or sell foreign currency with the
sole aim of earning money through correct anticipation of movement of
exchange rate. Even though they are essentially gamblers, they are an
important component of market as they provide the liquidity and stability in
the market.
(c) Arbitrageurs – These are people who 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 Houses – Futures trade is an organised trade. Futures are traded through
exchanges akin to Securities Exchanges which provide performance guarantee for
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.
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3. Margin Requirement – The risk of default of any player is insured by imposing the
requirement of depositing the margin money which is adequate to cover the adverse
movement of currency in the short term. Thus, margins are not uniform and vary
across markets, contracts, currencies and duration of contract. Since the currency
movement is not as wild as stocks, the margin requirement is also relatively small. (Usually in the range of 5% of contract value).
4. Daily Settlement – Notional losses or gains incurred due to fall in the value of the
currency are required to be settled between the party and the broker on daily basis
to ensure maintenance of original level of margin (security) money. This is
technically called “Mark to Market”.
5. Delivery Date – There are two types of contracts – European Contract, which are
delivered/encashed only on the last day of the contract period and American
Contracts, which can be delivered/encashed on any day during the contract period.
6. Manner of Delivery – The contract settlement, technically called “Delivery”, can be
done by either of the following three modes:
(a) Physical exchange of underlying assets ie Exchange of currencies.
(b) Cash Settlement as in the case of Stock Index Futures. There is no exchange
of currencies and only differential amount is paid.
(c) Reversing Trade - It is the process of offsetting a long position by acquiring
a short position or vice versa. The two positions square at the end of the day.
7. Types of Orders –
(a) Market Order – Order placed with broker to Buy or sell at prevailing market
price.
(b) Limit Order – Buy or sell order at a specific price or better.
(c) Fill-or-Kill Order – It instructs broker to fill an order immediately at a
specified price.
(d) All or none Order – It allows broker to fill part of the order at specified
price and remaining at other price/s.
(e) On the Open or Close Order – This represents order to trade within a few
minutes of opening or closing of the exchange.
(f) Stop Order – It triggers a reversing trade when prices hit a prescribed limit.
Functions of Futures Markets
Futures Markets function as –
1. Price Discovery Agent
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2. Speculation Tool
3. Hedging Tool
Price Discovery
“Futures” prices are generally treated as a consensus forecast by the market of 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. More often than not,
they provide a reasonably good hint in case of currencies and commodities but not equally
accurately in case of stocks.
Speculation
Futures provide excellent tool for speculation since it is highly leveraged (only margin amount
of approximately 5% needs to be paid upfront). Also, the transaction costs are lower than in case of
delivery. Thus, percentage returns are higher.
Speculators are categorised based on the length of positions they hold.
(a) Scalpers – They have the shortest holding horizons, typically closing a
position within minutes of initiation.
(b) Day Traders – They hold futures positions for a few hours but never longer
than one trading session. They open and close positions within the same
day. Their net holding at the end of any day is always zero. They play on the
scheduled announcements and news related to money supply, trade deficit
etc.
(c) Position Traders – They have longer holding horizons, often a few months.
There are two types of position traders:
(i) Outright Position Holders – He takes position based on his belief
on the underlying potential. He stands to make large gains or losses.
(ii) Spread Position Holders – He does not have belief on a particular
currency or commodity, but he speculates on relative movement of
two commodities. So he holds simultaneous position in two
commodities, long in commodity which is likely to appreciate and
short in commodity which is likely to depreciate. The two
commodities could be from same basket, like wheat and rice or
could be from different baskets like wheat and Steel. If the spread
between them widens, he gains else he loses. Such positions are less
risky than Outright Positions.
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Hedging
Hedging is process of engaging in a futures or forward contract by paying a small premium
to eliminate risk associated with large unfavourable movement in exchange rate by the time
payment or receipt is due. There are three types of hedges:
(a) Long Hedge/Anticipatory Hedge – Investor does not own the asset but
wants 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 Hedge – An investor already owns an asset which he wants to sell in
future. He wants protection against steep fall in its prices. He hedges the risk
by selling its future.
(c) Cross Hedge – The act of hedging ones position by taking an offsetting
position in another good with similar price movements. Although the two
goods are not identical, they are correlated enough to create a hedged
position. A good example is cross hedging a long position in crude oil
futures contract with a short position in natural gas. Even though these two
products are not identical, their price movements are similar enough to use
for hedging purposes. In currency matters, USD and Canadian Dollars can
be used for cross hedging.
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FOREX RISK MANAGEMENT THROUGH OPTIONS
An Option is a contract which gives its buyer the right either to buy (Call Option) or to sell
(Put Option) a specified amount of a currency within/after a specified period at a
predetermined price called Strike Price. An Option that gives the right to buy is called a
Call Option and an Option that gives the right to sell is called a Put Option.
An option gives the buyer right to buy or sell but there is no obligation to do so. A buyer is
at liberty not to exercise his option. But the seller is under obligation to honour the call or
put option if the buyer decides to exercise it. And the buyer will do it only when it is
profitable to him. He will exercise his Call Option (right to buy) when market rate of that
currency is higher than the strike price. Similarly, he will exercise his put Option, only
when market price has fallen below the strike price.
Suppose, Mr Yashwant buys a Call Option from Mr Joseph @ INR 46 for USD 1,000,000
on 01 Sep 2006 with the expiry date of 30 Sep 2006. Now, Mr Yashwant can demand from
Mr Joseph to sell USD 1,000,000 on any day during this period. Mr Yashwant will want to
buy these USD from Joseph only if rate of USD in the open market is higher than strike
price of INR 46, say INR 47. In case, open market rate is lower than INR 46, say INR 45,
Mr Yashwant will be better off buying the USD from open market.
If USD rate goes up to INR 47 and Mr Yashwant demands to exercise his Call Option, Mr
Joseph will have to sell him those USD at strike price of Rs 46 which is now at a discount
of INR 1/- to the market price. However, if the market price had fallen below the strike
price to INR 45, Mr Yashwant is under no obligation to buy USD from Mr Joseph at Rs 46.
But why should Option Seller (also called Writer) take this risk? He sells the options for a
price called Premium which is non refundable. He hopes that option would not be
exercised and he would 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.
Speciality of Options contracts is that while max loss for the buyer of Option is limited to
the premium he paid for purchasing the contract, his profits have no limits. The situation is
just the reverse for the seller. His max profit is equal to the premium he has received but his
losses have no cap.
Option Contracts also follow the American and European systems. An option which can be
exercised at any time during the currency of the contract is called “American Style”
Option. Another type of Option which can be exercised only at the end of the contract
period is called the European Style. The probability of exercise of option is higher in case
of American Options and therefore the premium is also higher. Similarly, if the contract
period is longer, probability of exercise of option increases and the premium goes up again.
Another factor which 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.
An option can be “In the Money”, “At the money” or “Out of the money” depending upon
Strike Price vis a vis market price of asset.
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An option is called “In the Money” if the exercise of option at that market price would
fetch him profit. So, in a Call Option, if the dollar’s spot price is INR 46, and strike price is
INR 44, exercise of option will fetch a profit of INR 2.00 per dollar.
An option is called “At the Money” if the spot price and strike price are equal and therefore
no gain or loss would accrue to either side (premium is not considered). Therefore, such
options are not exercised.
An option is called “Out of Money” if its exercise would lead to loss to the buyer, ie, in a
call option, the spot price of the USD falls below the strike price. Suppose, a dollar Call
Option was purchased for INR 44. If the spot price of dollar falls to Rs 43, it would be
cheaper to buy dollars from market than exercise of option. Therefore, “Out of Money”
options are never exercised.
Premiums are also influenced by following factors:
(a) Volatility – Higher the volatility, higher the chances of asset prices
breaching the strike price. So, higher the premiums.
(b) Interest Rate – Relative interest rate between two currencies affect
premiums.
(c) Political uncertainty, inflation, etc, again pose risk of sharp movement in
currency exchange rates and therefore premium.
Option Strategies
This flexibility and variability in pricing of options and premium give a multitude of
opportunities to the players in the market. By buying or selling a combination of options,
profit opportunities are created. Some of the strategies adopted by people are listed below: -
Naked Option – An option for which the buyer or seller has no underlying security
position. A writer of a naked Call Option, therefore, does not own the asset or even a Long
Position in the asset on which the call has been written. Similarly, the writer of a naked Put
Option does not have a Short Position in the asset on which the Put has been written.
Naked options are very risky-although potentially very rewarding. If the underlying asset
moves in the direction anticipated by the writer/seller, profits can be enormous, because the
investor would only have had to put down a small amount of money to reap a large return.
On the other hand, if the asset moved in the opposite direction, the writer of the naked
option could be subject to huge losses. It is also called uncovered option.
Straddle – An options strategy in which the investor holds position in both, a call and a put
with the same strike price and expiration date. Straddles are a good strategy to pursue as a
buyer if an investor believes that a stock's price will move significantly, but is unsure as to
which direction (volatile market). Since the buyer has invested two premiums (one each for
call and put), the stock price must move significantly if the buyer of option is to make a
profit. As shown in the diagram below, should only a small movement in price occur in
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either direction, the buyer will experience a loss (due to premium he has paid for two contracts).
As a result, a straddle is extremely risky to perform. Additionally, on assets that are
expected to jump, the market tends to price options at a higher premium, which ultimately
reduces the expected payoff even when the stock moves significantly.
There is a Long Straddle in which 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 will collect two premiums and may have to pay back
only a small portion of that amount if the asset price moves in a narrow band. This is called
a Short Straddle because he is selling without owning the asset.
Strangle –It involves buying a call and a put option at two different rates but of equal value
and of same maturity date.
In a Long Strangle, Call is bought at a lower rate and Put is bought at higher rate. Long
Strangle is again a strategy for a volatile markets.
In the short Strangle, Call is sold at higher rate and Put is sold at lower rate. Short Strangle
is used for stable markets.
In case of straddle, if the market is not volatile, purchaser loses the premium on both the
Selling a Put Selling a Call
46
45.50 46.50 Pro
fit
Loss
A Put Option Short Straddle
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sides. But this is not the case in Strangle.
Take a hypothetical case where a Long straddle has been entered into with Put Option
purchased at Strike Price of INR 47 and a Call Option at Strike Price of INR 45, both with
a premium of INR 1 each (Graph as shown by dotted lines). Theoretically, profit will start
in the call option the moment price goes above Rs 45. However, when we consider that
besides strike price of Rs 45, we have also paid a premium of Re 1, our net cost of option
becomes Rs 46 and therefore, the profit will actually start only after market price exceeds
Rs 46. Similarly, in the put the option, theoretically profit will start the moment price falls
below Rs 47. However, in order to recover the premium that we paid, price should fall to
minimum Rs 46. Thus, when we account for premiums also, the lines shift and new graph
will look like as shown by firm lines. Now we see that at any exchange rate, the person
does not suffer any loss. In the worst case scenario, at the spot rate of INR 46, he would
break even. In any other situation, he would make some profit. There could be some loss at
times in case the premium is too high and spread between the call and put rate being
relatively small (situation represented in graph with light blue lines. Loss is shown in such case as orange
shaded area which is comparatively small).
Exotic Options
What have been discussed so far were Vanilla Options Contracts as practiced in India.
These were the contracts where there were no conditions attached to the contracts. In many
countries, options contracts are available with additional conditions. Such contracts are
called Exotic Options Contracts. While these options contracts are not available in India
through official channels, there is no bar in entering into them on OTC (Over the counter)
basis.
1. Tunnel Option Contract - This contract is also called Cylinder Options Contract. In
this case, the upper limits of exercise price for Call Option is specified. Even if the
spot price of asset exceeds the limit price, deal would be done at limit price only.
Put Option
profit Line
Call Option
profit Line
Put Option Net
Profit line Call Option Net
Profit line
Long Strangle Graph
46
45 47
Pro
fit
Loss
Premium
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Thus, max loss to the Call Seller has been limited. Similarly, limit price for exercise
of Put option is also specified, thus limiting the max loss of the Put option writer.
Since the loss of writer has been capped, and the possible gain of the buyer has
been capped, the premium is very low.
Eg. Put Option sold at Strike Price of INR 46.25 with the exercise price
capped at INR 46. Now, even if the spot rate falls to INR 44, the exercise price will
be considered to be INR 46 only and the seller will pay only INR 0.25 per dollar to
the buyer.
2. Knock Out Options – This is a further amendment to the Tunnel Option. In this
case, if the spot price moves beyond the limit price, the contract is knocked out
which means that contract becomes null and void and no settlement takes place.
Such kind of contract is not possible under American Contracts method. This
happens only in European contracts where the contract expiry date is fixed. The
premium for such contract is even lower than tunnel option because seller’s
position is well protected.
3. Look Back Option – This is one option which has very high premium because it is
heavily loaded in favour of buyer. Under this option, the settlement is done at most
favourable price for the buyer in the period preceding the settlement date. It allows
the buyer to look back and select the most favourable rate in the past for settlement.
So, if the rates in the past were 46.11, 46.31, 46.55, 46,72, 46.95, 46.45, 46.39,
46.20 on the days from contract to the settlement date, Call option buyer can look
back into the past and select 46.95, which is the highest in the period, as the
settlement/exercise price. At the same time a put option buyer will be allowed to
select 46.11 as the exercise price because that is most favourable to him.
4. Average Rate Option Contract – This is also called Asian Contract. Under this
contract, the exercise price is the average of closing prices since contract date.
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SWAPS
Unlike Futures and Options, Swap is not a risk management strategy. It is a strategy to take
advantage of differential opportunities for different people.
Swap, as the name suggests, is the exchange of liabilities. Two people having liabilities of
different types exchange their liabilities for some perceived advantage. For example, a
French company wanting dollar loan might be getting better rates in French Francs.
Another company in US might want French Francs but it is advantageous for it to borrow
dollars. The two can borrow what is advantageous to them and then mutually exchange
their currencies along with their payment liabilities without involving their lenders.
It could also be a swap between current and future liabilities of same person. A person may
purchase spot currency X by selling currency Y and simultaneously selling forward
currency X buying back currency Y. Thus, there is one spot deal and one forward deal.
Suppose, you are due to receive USD 1000 three months from now and have some
excellent investment opportunity in USD. So, you spot buy the USD 1000 against INR and
forward sell (three months) USD 1000. Once you receive USD 1000 three months later,
you square up the forward position and get back the rupees that you had invested.
Swap comes in many forms, like interest rate swaps, currency swaps, positions swap, etc.
(a) Spot Forward Swap – As explained above.
(b) Forward Forward Swap – Both transactions are in future but executable on
different dates.
(c) Interest Swap
(d) Currency Swap
Interest Swaps
(a) Fixed to Fixed Interest rate Swaps (Generally involves two countries)
(b) Fixed to Floating Interest rate Swaps (Mostly in same country but can be in
different countries also)
(c) Floating to Floating Interest Rate Swaps (Again, often involves two
different countries).
Example –
Company A is offered fixed rate loan in the market @ 11%; floating rate loan @ LIBOR +
0.5%. Company A prefers to take fixed rate loan. Company B enjoys better credit ratings
and therefore has been offered loan @ 9.50 % fixed and LIBOR floating. Company B
prefers floating rate. Find the Swap possibility.
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Solution –
Fixed Rate Floating Rate
Company A 11% LIBOR + 0.50%
Company B 9.50% LIBOR
Difference 1.50 0.50
It is clear from above data that company B has lower rate in both the cases. However,
company B enjoys more benefit compared to A in case of fixed rate where the differential
is 1.50% as against floating rate where differential is barely 0.5%. However, company B
wants floating rate where its relative advantage is less.
In order to derive full advantage of this situation, Company B should take Fixed rate loan
even though it wants a floating rate loan and consequently, Company A should take
Floating Rate loan even though it wants fixed rate loan. After taking the loans they can
mutually swap their liabilities. If both of them had gone independently, they would have
taken loans at 11% fixed and Libor (total interest liability = 11%+Libor). But now they
have taken at 9.5% and Libor + 0.5% (Total interest liability = 9.5% + Libor + 0.5% = 10%
+ Libor) Thus, they have together saved 1% on interest cost. Now let us draw the table and
see how both companies can benefit from such a transaction.
Co Pay to
Market
Receive fm
other co
Differential Pay to
other co
Net Rate
of Interest
Old
Rate
Gain
A Libor+0.50 Libor 0.5% loss 10% 10.5% 11% 0.5%
B 9.5% 10% 0.5% gain Libor Libor-.5% Libor 0.5%
To understand this problem, look at it from another angle. Let us take company A and
forget about company B for the time being. Company A has taken loan from the market
and lent to Company B. So, it will earn interest from company B but has to pay interest to
the market. There will be some differential between the two interest rates which will be
gain or loss (gain at this stage is not mandatory). Now company A has also taken a second loan
from company B and has to pay interest for it. This interest plus the differential is the net
interest cost to the company A. Compare it with what company A would have paid had it
taken the desired loan directly from the market and you know the gain. Repeat same
exercise for company B. What is very important to note here is that while gains to both the
companies may not be equal, neither company should be in loss, else, it will not enter into
this swap transaction.
International Financial Institutions (Banks) are ever eager to swap their loans. These banks
have their assets at Floating rate where as liabilities are at fixed rate. To cover this
mismatch between assets and liability, they use swap.
Similarly, long gestation period projects like infrastructure projects prefer fixed rate
whereas banks are often reluctant to give fixed rate loans due to long maturity period.
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Currency Swaps
Cross Currency Swaps Along With Swap of Interest Rate Liability.
First ever such deal was between IBM and the World Bank. IBM had CHF loan and wanted
to convert into USD loan. On the other hand World Bank wanted CHF loan but interest
rates in Switzerland had already risen quite a bit. The two agreed to swap the loan and
World Bank floated USD bonds in US market for equivalent amount to CHF loan of IBM.
Once the money was collected, they swapped their loans. IBM began to service US lenders
on behalf of World Bank while World Bank began to service IBM lenders in Switzerland.
Now suppose, World Bank issued bonds @ 3% in US market for USD 100,000,000 and
IBM loan was CHF 300,000,000 with exchange rate being CHF 3 per USD.
Company Pay to Market Other Party
pays to Co
Pay to other
Party
Net Rate of
Interest
Gain
World Bank 3% 3.10% 8.10 8%
IBM 8% 8.10% 3.10 3%
Biggest Challenge in case of swap transaction is to find another party which has
corresponding requirements where 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 with banks acting as mediator, it is not always possible to find a company with
corresponding requirements. So, a trend is emerging where in the banks have started acting
as the counter party. (Is it not the same as basic function of banks? In case of direct lending and deposits,
they do not match the tenure and amount. Same is the condition in this case).
A normal deposit and lending function carries two risks:
(a) Credit Risk – The borrower may default in payment.
(b) Interest Rate Risk – In case of interest rates movement, the customer at
disadvantage may foreclose his account but the one who gains will not. The
loss will then have to be borne by the bank.
In case of swap functions, there could be another risk, ie.
(c) Exchange Rate Risk – The two 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 with counter swap.
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Problem –
Company Fixed Floating Preference
A 10 % Libor + 0.5% Fixed
B 9.5% Libor + 0.25% Floating
Differential 0.5% 0.25 % 0.25 % (net)
Company Pay to
Market
Receive
from other
Co
Differential
(Interest
loss/gain)
Pay to
Other
Co
Net Rate of
Interest
Gain
A Libor +
0.5%
Libor +
0.375%
0.125% loss 9.75% 9.875% 0.125%
B 9.5% 9.75% 0.25% gain Libor +
0.375%
Libor +
0.125%
0.125%
Valuation of Swap
Valuation of swap is done by finding out present value of future earnings. Valuation of
Fixed rate swap is easy since earnings every year are known. In case of Floating rate
swaps, the interest is reset every six months. Thus, calculating long term valuation beyond
one or two periods is not possible.
PV of earning of Rs 100/year over 5 years = 5432 )10.1(
100
)10.1(
100
)10.1(
100
)10.1(
100
)10.1(
100
MINI CASE: THE CENTRALIA CORPORATION’S CURRENCY SWAP
The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It
has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to
manufacture microwave ovens for sale to the European Union market. The plant is
expected to cost € 4,920,000 and to take about one year to complete. The plant is to be
financed over its economic life of eight years. The borrowing capacity created by this
capital expenditure is $1,700,000; the remainder of the plant will be equity financed.
Centralia is not well known in the Spanish or international bond market; consequently, it
would have to pay 9 percent per annum to borrow euros, whereas the normal borrowing
rate in the euro zone for well-known firms of equivalent risk is 7 percent. Centralia could
borrow dollars in the United States at a rate of 8 percent.
Study Questions:
1. Suppose a Spanish MNC has a mirror-image situation and needs $1,700,000 to
finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay
a 9 percent fixed rate in the United States for dollars, whereas it can borrow euros at
7 percent. The exchange rate has been forecast to be $0.90/€1.00 in one year. Set up
a currency swap that will benefit each counterparty.
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2. Suppose that one year after the inception of the currency swap between Centralia
and the Spanish MNC, the U.S. dollar fixed rate falls from 8 to 6 percent and the
euro zone fixed rate for euros has fallen from 7 to 5.5 percent. In both dollars and
euros, determine the market value of the swap if the exchange rate is $0.9043/€1.00.
Company Pay to
Market
Receive
fm other
Co
Differential Pay to
other Co
Net Rate of
Interest
Gain
Centralia 8% 8.5% 0.5 % gain 8 % 7.5 % 1.5 %
Spanish
MNC
7% 8 % 1.0 % gain 8.5 % 7.5 % 1.5 %
Solution
Since both the companies have relative advantage in borrowing from their respective
countries, Centralia will borrow from USA $1,700,000 @ 8% and Spanish MNC will
borrow € 18,888,889 @ 7% from Spain. It is assumed that the two companies will go for
plain currency swap without any bargaining on interest rate. Thus, Centralia will take over
loan of € 18,888,889 ($1700000/0.9) and hand over $ 1,700,000 loan to Spanish MNC
along with liability for payment of interest and principal.
Payments that needs to be paid/received by each party: -
(Centralia will receive payment @ 8% per annum (ie USD 1,36,000) from Spanish MNC for 7 years and then
a lump sum payment of USD 1,700,000 at the end of 7 years. Spanish MNC will receive payment @ 7 %
annum (ie Euro 1,32,222) from Centralia over the same period and then Euro 1888889 at the end of the 7
years).
Loan Y 1 Y 2 Y 3 Y 4 Y 5 Y 6 Y 7 Y 8 Y 8 Centralia 1700000 136000 136000 136000 136000 136000 136000 136000 1700000
Spain
MNC 1888889 132222 132222 132222 132222 132222 132222 132222 1888889
Calculating Present Value of above payments:
(Please note that above are ANNUITIES (where a fixed amount is paid every year for a number of years) of 7
year each at different rates of interests. There are three methods to calculate the Present Value of an annuity
and can be calculated by any of the three methods. First method is explained on previous page).
Second Method : PV of an annuity =
nrrr
C1
11
Third Method: - Tables are available at the end of every FM book which give value of
annuity factor for any given combination of interest rate and duration. The annuity factor
can be used to multiply with principal amount to arrive at the present value of any annuity.
(The problem with first method is that it is too long and cumbersome, where as third method requires
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availability of tables. It also does not give value for fraction of interest rates like 5.5. Thus, second method is
by far the best method).
So, PV of Centralia Income = 136000
706.0106.0
1
06.0
1
= 136000 x 5.582 (You will find same value against column 6% and
line 7 years in FM tables)
= $ 759,152
Present Value of lump sum payment of USD 1,700,000 =
7
06.01
1700000
=
5036.1
1700000 = $ 1,130,597
Total Present Value of Centralia Loan = 759,152 +1,130,597 = $1,889,749
PV of Spanish MNC Income = 132222
7055.01055.0
1
055.0
1
= 132222 x 5.683 (You can take average value of 5 and 6% from the
table)
= € 751,413
Similarly, Present Value of lump sum payment of Euro 1,888,889 =
7
055.01
1888889
=
4547.1
188889 = € 1,298,492
Total Present Value of Spanish MNC Loan = 751,413 + 1,298,492 = € 2,049,905
Converting the Euro into dollar amount € 2,049,905 x 0.9043 = $1,853,729
Net Loss to Spanish MNC = 1,889,749 - 1,853,729 = $ 36020
Forward Rate Agreement (Possibly a short note)
A Forward Rate Agreement (FRA) is a forward contract where the parties agree that a
certain interest rate will apply to a certain notional loan or deposit during a specified future
period of time. A FRA is similar to a Forex forward contract where 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
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between agreed rate of interest and the market rate of interest. Thus, suppose, a company
negotiates with a bank on 14 Sep 2006 a loan of USD 500 million for 5 years @ 6%
interest starting on 01 Jan 2007. If the interest rate in the market at the start of the loan
period, ie on 01 Jan 2007, increases to 7 %, bank will pay the company interest @ 1% for
5 year period on USD 500 million. However, if the interest rate falls to 5%, company will
be obliged to pay to the bank same amount. There is no option to back out of contract.
Interest Rate Options – In case of interest rate options, often there is a floor and a cap. In
case of wild movement of interest rates, these floor and cap come into play. They restrict
the upside and the down side for both the parties. The settlement is done within the band of
floor and cap even if the interest rates move beyond these limits.
For quite a few years Japan had a ‘0’ interest rate regime. The interest rates have begun to
harden a bit now. However, they are still abysmally low. Libor for Yen is currently at 0.15
– 0.18%. Yen loans are available at Libor plus 4 to 5 % where as Rupee loans cost as
much as 8 to 10%. Thus, there is still margin of 3 to 5 % available for an Indian Company.
When an Indian company or bank takes a Yen loan, it is hoping that the Yen won’t
appreciate compared to Indian currency, nor will the interest rate in Japan fluctuate wildly
during the loan period. But, lenders’ expectations are just the opposite. They are hoping
that Yen will appreciate and even the interest rates in Japan will harden. The deal takes
place because of contrary expectations of two parties.
Similarly, Swiss Frank Libor rate is currently at 2%. Add a few percent margin and it is
still cheaper to borrow ; but with the risk of Libor increasing as also appreciation in value
of Swiss Frank which may wipe out all the gains of lower interest rate prevailing now.
While there is a cap placed on ECB, there is no cap on Swap deals.
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Balance of Payment Concept/Accounting
Balance of Payment Account is accounting record of economic transactions of the country
with the world. Any transaction which can be converted into money terms is recorded.
Balance of Payment account has three main heads: -
(a) Current Account (Revenue Transactions)
(b) Capital Account
(c) Reserve Account (Liability of Central Bank)
The rules for accounting are –
(a) Cr all transactions which lead to receipt of Forex from rest of the world but
Dr the receipt of forex itself.
(b) Dr all transactions which lead to payment of forex to Rest of World (RoW).
Cr the payment of forex itself.
This account also follows the typical double entry book keeping system. There is a
debit entry for every credit entry and vice versa. (It is the same principle which we studied
in Financial Accounting. Credit the account which generates the income (so Cr sales account for
sales) but debit the account which receives the payment or goods (so Dr cash account).
Reserve Bank Bulletin for Balance of Payment status (Sep 2006) is available at
http://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/72537.pdf (internet) or Balance of
Payment.pdf file separately.
Clarifications regarding some terminology:
Merchandise – Physical goods which can be seen and felt.
Invisibles – Which have no physical existence, like services, software, BPO, etc.
Travel – Money spent by tourists in India or by Indians tourists else where. Includes
inland travelling ticket expenses.
Transport – Fares paid for international movement of men and material. Ticket
fares paid for international travel are accounted under this head but not the
travel fares within the country.
G.n.i.e. – Government Not Included Elsewhere
Some Typical Transactions:
1. An Indian Company exporting goods worth Rs 100 million to rest of the world and
receiving payment in bank.
By Merchandise Cr 100 million
To Banking Dr 100 million
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2. Indian Co. exporting to RoW USD 500 million worth of goods of which it receives
50% payment immediately and rest in instalment over next 3 years
By Merchandise Cr 500 million
To Banking Dr 250 million
To Commercial Loan Dr 250 million
Suppose after one year USD 50 million is received.
By Commercial Loan Cr 50 million
To Banking Dr 50 million
3. Indian Govt receives a grant of goods worth USD 500 million after Gujarat Earth
Quake from Govt of US
By Transfer Payment Ac (official) Cr 500 million
To Merchandise Ac Dr 500 million (for accounting purpose, cases of goods grant are treated as import)
4. BHEL floats out ECB deal to RoW worth 500 million and uses the money for
buying plant and machinery for use:
By Commercial Borrowing Cr 500 million
To Merchandise Dr 500 million
5. Infosys receiving part of profit USD 500 million which is outcome of investment in
software entities in Singapore, USA and UK
By Foreign Investment A/c Cr 500 million
To Banking A/c Dr 500 million
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CAPITAL ACCOUNT CONVERTIBILITY The govt has allowed De-Jure Current Account Convertibility but not De-Facto
convertibility. What it means is that current account convertibility is only in the name.
While 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, Studies, Maintenance, etc.
Convertibility on Capital Account, also called full float of rupee, is still far way off.
Even though Tarapore Committee (Salient Recommendations listed below) had recommended
Capital Account Convertibility, Govt and RBI are treading a cautious approach. The
repercussions of Capital Account Convertibility can be disastrous if things go wrong. The
world learnt it through East Asian Economic Crisis in 1997. Booming Economies suddenly
collapsed in a matter of days.
Once Capital Account convertibility is allowed, every one is allowed a free hand to
invest in and dis-invest from the country as much as and whenever he wants. At the first
sign of trouble, investors rush to dis-invest and the cascading effect on economy is
crippling. Currently, there are caps on how much Indians can invest abroad or how much
can a foreign company invest in which company/sector. In addition, before investing,
companies have to register themselves. There are caps on ECB as well.
For further details on Capital account, read last semester notes on FEMA compiled
and forwarded by Mr Parab.
RECOMMENDATIONS OF TARAPORE COMMITTEE ON
CAPITAL ACCOUNT CONVERTIBILITY
A committee on Capital Account Convertibility, was setup by the Reserve Bank of India
(RBI) under the chairmanship of former RBI deputy governor S.S. Tarapore in ----- to "lay
the road map" for capital account convertibility. The committee submitted its report in
1997. At 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 1999-2000. The highlights of the report including the preconditions to be
achieved for the full float of money are as follows:-
Pre-Conditions
1. Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in
1997-98 to 3.5% in 1999-2000. (Yet to be achieved).
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2. A consolidated sinking fund has to be set up to meet government's debt repayment
needs; to be financed by increase in RBI's profit transfer to the govt. and
disinvestment proceeds.
3. Inflation rate should remain between an average 3-5 per cent for the 3-year period
1997-2000. (had come down but inched up again over last two years).
4. Gross NPAs of the public sector banking system needs to be brought down from the
present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be
brought down from the current 9.3% to 3%. (We are almost there).
5. RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a
neutral Real Effective Exchange Rate. RBI should be transparent about the changes
in REER
6. External sector policies should be designed to increase current receipts to GDP ratio
and bring down the debt servicing ratio from 25% to 20%
7. Four indicators should be used for evaluating adequacy of foreign exchange
reserves to safeguard against any contingency. Plus, a minimum net foreign asset to
currency ratio of 40 per cent should be prescribed by law in the RBI Act.
8. Phased Liberalisation of Capital Controls - The Committee's recommendations for
a phased liberalisation of controls on capital outflows over the three year period
which have been set out in detail in a tabular form in Chapter 4 of the Report, inter
alia, include:-
(a) Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be
allowed to invest up to US $ 50 million in ventures abroad at the level of the
Authorised Dealers (ADs) in phase 1 with transparent and comprehensive
guidelines set out by the RBI. The existing requirement of repatriation of the
amount of investment by way of dividend etc., within a period of 5 years
may be removed. Furthermore, JVs/WOSs could be allowed to be set up by
any party and not be restricted to only exporters/exchange earners.
(b) Exporters/exchange earners may be allowed 100 per cent retention of
earnings in Exchange Earners Foreign Currency (EEFC) accounts with
complete flexibility in operation of these accounts including cheque writing
facility in Phase I.
(c) Individual residents may be allowed to invest in assets in financial market
abroad up to $ 25,000 in Phase I with progressive increase to US $ 50,000 in
Phase II and US$ 100,000 in Phase III. Similar limits may be allowed for
non-residents out of their non-repatriable assets in India. (Phase I limits
allowed)
(d) SEBI registered Indian investors may be allowed to set funds for
investments abroad subject to overall limits of $ 500 million in Phase I, $ 1
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billion in Phase II and $ 2 billion in Phase III.
(e) Banks may be allowed much more liberal limits in regard to borrowings
from abroad and deployment of funds outside India. Borrowings (short and
long term) may be subject to an overall limit of 50 per cent of unimpaired
Tier 1 capital in Phase 1, 75 per cent in Phase II and 100 per cent in Phase
III with a sub-limit for short term borrowing. in case of deployment of funds
abroad, the requirement of section 25 of Banking Regulation Act and the
prudential norms for open position and gap limits would apply.
(f) Foreign direct and portfolio investment and disinvestment should be
governed by comprehensive and transparent guidelines, and prior RBI
approval at various stages may be dispensed with subject to reporting by
ADs. All non-residents may be treated on par 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 forward markets; FIIs, non-residents and non-resident banks may be
allowed forward cover to the extent of their assets in India; all India
Financial Institutions (FIs) fulfilling requisite criteria should be allowed to
become full-fledged ADs; currency futures may be introduced with screen
based trading and efficient settlement system; participation in money
markets may be widened, market segmentation removed and interest rates
deregulated; the RBI should withdraw from the primary market in
Government securities; the role of primary and satellite dealers should be
increased; fiscal incentives should be provided for individuals investing in
Government securities; the Government should set up its own office of
public debt.
(h) There is a strong case for liberalising the overall policy regime on gold;
Banks and FIs fulfilling well defined criteria may be allowed to participate
in gold markets in India and abroad and deal in gold products.
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INTERNATIONAL FINANCIAL MARKETS
International Financial Market can be divided as follows:
(a) Euro Currency Market
(b) International forex and bond market
(c) International equity market
Euro Currency Markets
What is Euro Currency?
Euro currency is not to be confused with currency of European Union. It has no relation to
Euro or for that matter with any currency in particular.
Eurocurrency is the term used to describe deposits residing in banks that are located
outside the borders/legal jurisdiction of the country of currency the deposits are
denominated in. For example, a deposit denominated in US dollars residing in a Japanese
bank is a Eurocurrency deposit, or more specifically a Eurodollar deposit.
As 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 with the Euro. The use of this
idiosyncratic term arose from the fact that Eurocurrency markets first developed in Europe
during the 1950s when the former Soviet Union asked London banks to hold US dollar
denominated deposits in the fear that deposits in US banks would be frozen or even seized
in the event of escalation of tension between USA and USSR.
Today, the Eurocurrency markets are active for the reason that they avoid domestic interest
rate regulations, reserve requirements and other barriers to the free flow of capital.
Thus, Euro currency is not any currency in particular. A Eurocurrency is any currency that
is deposited in a bank outside its country of origin. So, 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 Bonds
(c) Euro Commercial Papers
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What is Euro Currency Market?
Euro currency market is the foreign currency market which specializes in the facilitation of
borrowing and deposits of currencies outside their country of origin. For example USD
deposits or USD loans made available by a bank in London.
Reasons for Rise of Euro Currency Markets
Euro currency markets emerged in the decade of 1950s and 1960s on account of
following –
1. Cold War between USA and USSR – The dollars earned by USSR through
weapons sale and other exports needed to be invested outside USSR.
2. Oil crisis which benefited gulf countries. Petro dollars earned by middle east
countries needed to be invested. America has been having a love hate relationship
with Middle East for a long time and therefore they did not want to park all their
petro dollars in USA. In addition, deposit rates on external deposits were
comparatively low in USA.
3. Relaxation of banking norms in the European region.
Main centers of Euro Currency markets are London, Frankfurt, Singapore, Hong Kong, etc.
Categorization of Euro Currency Market
1. Euro Deposit Market / Euro Credit Market – This refers to simple deposit and
lending function of a third country currency in Euro Bank.
2. Euro commercial paper market.
3. Euro Bond Market – E.g. An Indian Corporate house floating bond denominated in
terms of Yen or dollars in London.
Advantages of Euro Deposit / Credit Market
Euro Banks are normally beyond the tight controls of Central Banks of the country and do
not need to follow the stringent SLR and CRR ratios, interest rate regulations, etc. This
lowers their cost of operation and thus, they are able to offer better deposit and lending
rates than normal domestic banks.
Offshore Financial Centre
OFC are certain specific locations on the world map –
1. Which are tax heavens
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2. Enjoy scenario of low or no government regulations and
3. Offer the advantage of banking secrecy and anonymity. Like erstwhile Swiss Banks
which were notorious for being repository of black money of the world, Offshore
Financial Centres provide similar secrecy and anonymity though they do not enjoy
same kind of confidence as Swiss Banks.
There are some 55-60 OFCs in the world. Some well known financial centers are –
Bahamas, British Virgin Island, Cayman Island, Hong Kong, Maldives etc.
Use of Offshore Financial Centers
1. For establishment of offshore banks.
2. For establishment of international business corporations.
3. For tax evasion and money laundering.
SEZs, which are mushrooming in India and China, are mini versions of Offshore Financial
Centres.
What is an Offshore bank?
(a) A bank which carries deposits of such depositors who are either non-
residents or are residents but maintain the foreign currency accounts.
(b) Offshore banking entities do not bank in terms of the currency of the
country where they are located but deal in forex deposits and loans only.
Thus, an Indian Offshore bank can not deal in INR. All its transaction will
be in any currency but INR.
Advantages of Offshore Banking
(a) Secrecy of accounts.
(b) Tax advantage
(c) Offshore banks do not need to follow the reserve requirement guidelines and
have lower regulatory expenses Thus, their lending rates are lower and
deposits rates more attractive.
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International Bond Market
Categorization of International bond market –
(a) Euro Bonds
(b) Foreign Bonds
(c) Global Bonds
Euro Bonds
Bonds in the currency other than the currency of the country in which they are floated by a
company of the third country called Euro Bonds. Thus, if an Indian company floats USD
denominated bonds in UK, they will be called Euro Bonds.
Foreign Bonds
Bonds which are floated in the local currency of the country of floatation by a foreign
company are called Foreign Bonds. Thus, if an Indian company floats USD denominated
bonds in USA, they will be called Foreign Bonds.
Types of Foreign Bonds
(a) Yankee Bonds – These are foreign bonds floated in USA
(b) Bulldog Bonds – These are foreign bonds floated in UK
(c) Samurai and Shibosai Bonds –
(i) Samurai – These are Yen bonds floated in Japan in open market.
(ii) Shibosai – Yen bonds floated on Pvt Placement basis in Japan.
(d) Dragon Bonds – These are foreign bonds issued in local currencies of the
South Asian countries.
Other Types of Bonds
1. Straight Bonds – These are plain vanilla bonds with fixed rate of interest and fixed
date of maturity.
2. Floating Rate Bonds – These are LIBOR linked variable interest rate bonds
wherein interest rate is adjusted every 6 months.
3. Convertible Bonds – These bonds convert into equity share after the specified
period of time. In this category, there could be fully convertible or partly
convertible bonds.
4. Floating Rate Bond with Collars – These floating rate bonds have upper and
lower limits of interest rate variation. Thus, the max and min interest payable are
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capped irrespective of movement of interest rate in the market.
5. Bonds with Warrants – These are the bonds which are accompanied by an option
to the buyer to buy specified number of equity 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
at the time of buy. He may even sell this option to some one else at a premium.
These are not same as Convertible Bonds. There is a minor variation from
convertible bonds. In case of convertible bonds, the money which was paid as bond
price is not paid back and shares are issued in lieu. In case of warrants, additional
money is paid for exercise of option while bond money is paid back on maturity.
Warrant option is used as a sweetener to float bonds with lower interest rate.
In case the probability of share price appreciation is very high, they could be even
at Zero interest rate.
6. Zero Coupon Bonds – These are also called Deep Discount Bonds. These bonds
are issued as zero percent interest rate bonds but at a discount to the face value.
Bonds are paid back at face value on maturity. Thus, the discount on the face value
actually represents the interest component. However, this trick is played to beat the
tax system of the countries where interest income is charged to tax.
7. Callable Bonds – These are the bonds wherein the company reserves the option to
call back the bonds prior to maturity but after the lock-in period. Such bonds are
issued when
(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.
8. Puttable Bonds – These are bonds wherein the buyer has option to sell back to
company any time after the lock-in period. Such bonds are issued if the company
does not enjoy very good credit rating in the market to give some confidence to the
investors.
9. Dual Currency Bonds or Hybrid Bonds – These are bonds which are sold in one
currency and payment of interest or principal or both is done in another currency.
Eg. An Indian company may float a USD bond in US and pay the interest and
principal back in INR.
Bond Issue Procedure
1. Issuing company takes the approval of the Board of Directors.
2. Issuing company appoints Lead Manager.
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3. In consultation with the issue manager, the company appoints Co-Managers, Under
writers, Brokers to the issue.
4. The Lead manager prepares the draft document for the bond issue and the bond rate
is decided.
5. The draft prospectus is discussed and is given the final shape.
6. Listing formalities are completed by the company and the Issue Manager.
7. Announcement of the issue is made.
8. Investor response is monitored.
9. Final bond issue is made.
10. Tombstone advertisement is published – It is in the form of Thanks advertisement
detailing the response and money collected.
External Commercial Borrowings
There are two routes for raising ECB:
(a) Automatic Route
(i) Corporates – up to USD 20 million for 3 years and upto USD 750
million for 5 years and above.
(ii) NGOs – Allowed micro credit of upto USD 5 million.
(b) Approval Route – Even though limit are same but banks and financial
institutions have to take prior approval.
However, ECB can not be raised from just any body. Like the banks have to follow KYC
(Know your customer) norms, ECB borrowers have to follow KYL (Know your lender)
norms. The borrower needs to get a due diligence certificate from an approved overseas
bank that the lender has held a satisfactory account with it for at least 2 years.
Forms of External commercial borrowing – Following credits are deemed to be
ECB
(a) Buyers’ Credit – The advances received from a buyer are deemed ECB.
(b) Suppliers’ Credit – The credit period allowed by supplier is deemed ECB.
(c) Short Term Borrowings – Loans raised for one year or less. Commercial
papers, issue of Certificates of Deposits.
(d) Fixed rate and Floating rate bonds -.
(e) Loans from International Financial Institutions – Various international
financial institutions like Asian Development Bank, The International
Finance Corporation (IFC) and the Multilateral Investment Guarantee
Agency (MIGA) and including World Bank (But not IMF) lend for various
projects.
(f) Syndicate Loans – These are large loans for which no single bank wants to
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take full exposure. Thus, a group of banks join together and lend as a group.
Thus, the risk is spread out. Loan to Enron Corporation for Dabhol Power
Project is one example of syndicated loan.
Procedure of Syndicate Loans
1. Borrower prepares Information Memorandum (IM).
2. IM carries details of the borrower, the amount of loan needed, proposed maturity
period of the loan, purpose of the loan etc.
3. Borrowers send invitations to the international banks along with the IM.
4. Borrower receives credit proposals and analyses them.
5. It enters into agreement with lead syndicate bank which deals with other banks in
the syndicate.
6. Information of the deal is submitted to the Ministry of Finance and to the Reserve
Bank of India.
Equity Market
There are two routes for raising equity capital from foreign markets:
(a) Listing company’s shares in those countries’ stock exchanges
(b) Through Depository Receipts (ADRs and GDRs)
The biggest problems faced in raising the equity money from foreign markets are the
accounting standards (US GAAP and others), disclosure norms (which are pretty tough in
advanced countries), expenses and time involved.
However, raising money through ADR and GDR is still easier than listing on the foreign
stock exchanges. Two popular terms for Depository Receipts are ADR and GDR which
stand for American Depository Receipts and Global Depository Receipts respectively.
ADRs are Depository Receipts issued in USA while GDRs are the Depository Receipts
which are issued in many countries.
Definition: An ADR is a negotiable certificate issued by a U.S. bank representing a
specified number of shares (or one share) in a foreign stock that is traded on a U.S.
exchange. ADRs are denominated in U.S. dollars, with the underlying security held
by a U.S. financial institution overseas, and help to reduce administration and duty
costs on each transaction that would otherwise be levied.
The advantage of ADR/GDRs to local investors is that they do not have to buy and sell
shares through the issuing company's home exchange, which may be difficult and
expensive. In addition, the share price and all dividends are converted into the shareholder's
home currency.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 58 of 58 - International Finance (Ver 1.3)
Jamnalal Bajaj Institute of Mgmt Studies
The process of ADRs and GDRs involves selling the shares (without voting rights) to a
Depository Participants (Some International Bank). This Depository then sells those shares
in its markets. Buyers of the Depository Receipts have right over the shares of the
company. There is rarely one to one relationship between DR and the Shares of the
company. It could be any ratio, say One ADR = 10 Shares.
Fungibility – Fungibility is Interchangeability. Here, it is facility to convert Depository
Receipts in to actual shares. Two way fungibility means permission to convert Depository
Receipts to shares and then back to ADRs.
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