international finance question & answers

7/30/2019 International Finance Question & Answers

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International Finance Question Bank with

Answers.

Q1. What is Indias export promotion policy?

Answer:

The Export Promotion Councils are non-profit organizations registered under theIndian Companies Act or the Societies Registration Act, as the case may be. Theyare supported by financial assistance from the Government of India.

Role

The main role of the EPCs is to project India's image abroad as a reliable supplierof high quality goods and services. In particular, the EPCs encourage and monitorthe observance of international standards and specifications by exporters. TheEPCs keep abreast of the trends and opportunities in international markets forgoods and services and assist their members in taking advantage of suchopportunities in order to expand and diversify exports.

Functions

The major functions of the EPCs are as follows:

1. To provide commercially useful information and assistance to their membersin developing and increasing their exports

2. To offer professional advice to their members in areas such as technologyupgradation, quality and design improvement, standards and specifications,product development and innovation etc.

3. To organize visits of delegations of its members abroad to explore overseasmarket opportunities.

4. To organize participation in trade fairs, exhibitions and buyer-seller meets inIndia and abroad.

5. To promote interaction between the exporting community and theGovernment both at the Central and State levels

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6. To build a statistical base and provide data on the exports and imports of thecountry, exports and imports of their members, as well as other relevantinternational trade data.

Q2. Whatre the objectives of the international monetary system?

(a) What challenges are faced by the countries in the present situation?

(b) Whatre the possible remedies?

Answer:

The International Monetary Fund (IMF) is the intergovernmental organization that

oversees the global financial system by following the macroeconomic policies of its

member countries; in particular those with an impact on exchange rate and thebalance of payments. Its objectives are to stabilize international exchange rates

and facilitate development through the encouragement of liberalizing economic

policiesin other countries as a condition of loans, debt relief, and aid. It also offers

loans with varying levels of conditionality, mainly to poorer countries.

The International Monetary Fund was conceived in July 1944 originally with 45

members and came into existence in December 1945 when 29 countries signed

the agreement,with a goal to stabilize exchange rates and assist the reconstruction

of the world's international payment system. Countries contributed to a pool which

could be borrowed from, on a temporary basis, by countries with paymentimbalances. The IMF was important when it was first created because it helped the

world stabilize the economic system.

(a) What challenges are faced by the countries in the present situation?

Two criticisms from economists have been that financial aid is always bound to so-called "Conditionalities", including Structural Adjustment Programs (SAP). It isclaimed that conditionalities retard social stability and hence inhibit the stated goalsof the IMF, while Structural Adjustment Programs lead to an increase in poverty inrecipient countries.

The IMF sometimes advocates "austerity programmes," increasing taxes evenwhen the economy is weak, in order to generate government revenue and bringbudgets closer to a balance, thus reducing budget deficits. Countries are oftenadvised to lower their corporate tax rate.

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Argentina, which had been considered by the IMF to be a model country in itscompliance to policy proposals by the Bretton Woods institutions, experienced acatastrophic economic crisis in 2001,which some believe to have been caused byIMF-induced budget restrictions

Impact on peoples access to food in developing countries.

Impact on Public Health

Impact on Environment

(b) Whatre the possible remedies?

The delay in the IMF's response to any crisis, and the fact that it tends to only

respond to them (or even create them) rather than prevent them, has led many

economists to argue for reform. In 2006, an IMF reform agenda called the Medium

Term Strategy was widely endorsed by the institution's member countries. The

agenda includes changes in IMF governance to enhance the role of developing

countries in the institution's decision-making process and steps to deepen the

effectiveness of its core mandate, which is known as economic surveillance or

helping member countries adopt macroeconomic policies that will sustain global

growth and reduce poverty. On June 15, 2007, the Executive Board of the IMF

adopted the 2007 Decision on Bilateral Surveillance, a landmark measure that

replaced a 30-year-old decision of the Fund's member countries on how the IMF

should analyze economic outcomes at the country level.

Q3. Whatre the different exchange rate systems in the world?

Highlight its advantages & disadvantages.

Answer:

Exchange rates are determined by demand and supply. But governments caninfluence those exchange rates in various ways. The extent and nature of

government involvement in currency markets define alternative systems ofexchange rates. In this section we will examine some common systems andexplore some of their macroeconomic implications.

There are three broad categories of exchange rate systems. In one system,exchange rates are set purely by private market forces with no government

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involvement. Values change constantly as the demand for and supply of currenciesfluctuate. In another system, currency values are allowed to change, butgovernments participate in currency markets in an effort to influence those values.Finally, governments may seek to fix the values of their currencies, either throughparticipation in the market or through regulatory policy.

Free-Floating Systems

In a free-floating exchange rate system, governments and central banks do notparticipate in the market for foreign exchange. The relationship betweengovernments and central banks on the one hand and currency markets on theother is much the same as the typical relationship between these institutions and

stock markets. Governments may regulate stock markets to prevent fraud, butstock values themselves are left to float in the market. The U.S. government, forexample, does not intervene in the stock market to influence stock prices.

The concept of a completely free-floating exchange rate system is a theoreticalone. In practice, all governments or central banks intervene in currency markets inan effort to influence exchange rates. Some countries, such as the United States,intervene to only a small degree, so that the notion of a free-floating exchange ratesystem comes close to what actually exists in the United States.

A free-floating system has the advantage of being self-regulating. There is no need

for government intervention if the exchange rate is left to the market. Market forcesalso restrain large swings in demand or supply. Suppose, for example, that adramatic shift in world preferences led to a sharply increased demand for goodsand services produced in Canada. This would increase the demand for Canadiandollars, raise Canadas exchange rate, and make Canadian goods and servicesmore expensive for foreigners to buy. Some of the impact of the swing in foreigndemand would thus be absorbed in a rising exchange rate. In effect, a free-floatingexchange rate acts as a buffer to insulate an economy from the impact ofinternational events.

The primary difficulty with free-floating exchange rates lies in their unpredictability.

Contracts between buyers and sellers in different countries must not only reckonwith possible changes in prices and other factors during the lives of thosecontracts, they must also consider the possibility of exchange rate changes. Anagreement by a U.S. distributor to purchase a certain quantity of Canadian lumbereach year, for example, will be affected by the possibility that the exchange ratebetween the Canadian dollar and the U.S. dollar will change while the contract is in

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effect. Fluctuating exchange rates make international transactions riskier and thusincrease the cost of doing business with other countries.

Managed Float Systems

Governments and central banks often seek to increase or decrease their exchangerates by buying or selling their own currencies. Exchange rates are still free to float,but governments try to influence their values. Government or central bankparticipation in a floating exchange rate system is called a managed float.

Countries that have a floating exchange rate system intervene from time to time inthe currency market in an effort to raise or lower the price of their own currency.Typically, the purpose of such intervention is to prevent sudden large swings in thevalue of a nations currency. Such intervention is likely to have only a small impact,if any, on exchange rates. Roughly $1.5 trillion worth of currencies changes handsevery day in the world market; it is difficult for any one agencyeven an agency

the size of the U.S. government or the Fedto force significant changes inexchange rates.

Still, governments or central banks can sometimes influence their exchange rates.

Suppose the price of a countrys currency is rising very rapidly. The countrys

government or central bank might seek to hold off further increases in order to

prevent a major reduction in net exports. An announcement that a further increase

in its exchange rate is unacceptable, followed by sales of that countrys currency by

the central bank in order to bring its exchange rate down, can sometimes convince

other participants in the currency market that the exchange rate will not rise further.

That change in expectations could reduce demand for and increase supply of thecurrency, thus achieving the goal of holding the exchange rate down.

Fixed Exchange Rates

In a fixed exchange rate system, the exchange rate between two currencies is setby government policy. There are several mechanisms through which fixedexchange rates may be maintained. Whatever the system for maintaining theserates, however, all fixed exchange rate systems share some important features.

A Commodity Standard

In a commodity standard system, countries fix the value of their respectivecurrencies relative to a certain commodity or group of commodities. With eachcurrencys value fixed in terms of the commodity, currencies are fixed relative toone another.

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For centuries, the values of many currencies were fixed relative to gold. Suppose,for example, that the price of gold were fixed at $20 per ounce in the United States.This would mean that the government of the United States was committed toexchanging 1 ounce of gold to anyone who handed over $20. (That was the case inthe United Statesand $20 was roughly the priceup to 1933.) Now suppose that

the exchange rate between the British pound and gold was 5 per ounce of gold.With 5 and $20 both trading for 1 ounce of gold, 1 would exchange for $4. Noone would pay more than $4 for 1, because $4 could always be exchanged for 1/5ounce of gold, and that gold could be exchanged for 1. And no one would sell 1for less than $4, because the owner of 1 could always exchange it for 1/5 ounceof gold, which could be exchanged for $4. In practice, actual currency values couldvary slightly from the levels implied by their commodity values because of the costsinvolved in exchanging currencies for gold, but these variations are slight.

Under the gold standard, the quantity of money was regulated by the quantity ofgold in a country. If, for example, the United States guaranteed to exchange dollars

for gold at the rate of $20 per ounce, it could not issue more money than it couldback up with the gold it owned.

The gold standard was a self-regulating system. Suppose that at the fixed

exchange rate implied by the gold standard, the supply of a countrys currency

exceeded the demand. That would imply that spending flowing out of the country

exceeded spending flowing in. As residents supplied their currency to make foreign

purchases, foreigners acquiring that currency could redeem it for gold, since

countries guaranteed to exchange gold for their currencies at a fixed rate. Gold

would thus flow out of the country running a deficit. Given an obligation to

exchange the countrys currency for gold, a reduction in a countrys gold holdingswould force it to reduce its money supply. That would reduce aggregate demand in

the country, lowering income and the price level. But both of those events would

increase net exports in the country, eliminating the deficit in the balance of

payments. Balance would be achieved, but at the cost of a recession. A country

with a surplus in its balance of payments would experience an inflow of gold. That

would boost its money supply and increase aggregate demand. That, in turn, would

generate higher prices and higher real GDP. Those events would reduce net

exports and correct the surplus in the balance of payments, but again at the cost of

changes in the domestic economy.

Because of this tendency for imbalances in a countrys balance of payments to be

corrected only through changes in the entire economy, nations began abandoning

the gold standard in the 1930s. That was the period of the Great Depression,

during which world trade virtually was ground to a halt. World War II made the

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during the war. As the war was coming to an end, representatives of the United

States and its allies met in 1944 at Bretton Woods, New Hampshire, to fashion a

new mechanism through which international trade could be financed after the war.

The system was to be one of fixed exchange rates, but with much less emphasis

on gold as a backing for the system.

Q4. Discuss the evolution of Indias rupee exchange rate system

Answer:

The rupee was historically linked i.e. pegged to the pound sterling. Earlier, during

British regime and till late sixties, most of Indias trade transactions were dominated

to pound sterling. Under Bretton Woods system, as a member of IMF Indian

declared its par value of rupee in terms of gold. The corresponding rupee sterling

rate was fixed 1 GBP = RS 18.

When Bretton Woods system bore down in August 1971, the rupee was de-linkedfrom US $ and the exchange rate was fixed at 1 US $ = Rs 7.50. Reserve bank ofIndia, however, remained pound sterling as the currency of intervention. The US $and rupee pegging was used to arrive at rupee-sterling parity. After Smithsonian

Agreement in December 1971, the rupee was de-linked from US $ and again linkedto pound sterling. This parity was maintained with a band of 2.25%. Due to poorfundamental pound got depreciated by 20%, which cause rupee to depreciate.

To be not dependent on the single currency, pound sterling on September 25, 1975rupee was de-linked from pound sterling and was linked to basket of currencies,the currencies includes as well as their relative weights were kept secret so thatspeculators dont get a wind of the direction of the movement of exchange rate ofrupee.

From January 1, 1984 the sterling rate schedule was abolished. The interestelement, which was hitherto in built the exchange rate, was also de-linked. Theinterest was to be recovered from the customers separately. This not only allowedtransparency in the exchange rate quotations but also was in tune withinternational practice in this regard. FEDAI issued guidelines for calculation ofmerchant rates.

The liquidity crunch in 1990 and 1991 on forex front only hastened the process. OnMarch 1, 1992 Reserve Bank of India announced a new system of exchange ratesknown as Liberalized Exchange Rate Management System.

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LERMS was to make balance of payment sustainable on ongoing basis allowingmarket force to play a greater role in determining exchange rate of rupee. UnderLERMS, the rupee become convertible for all approved external transactions. Theexporters of goods and services and those who received remittances from abroadwere allowed to sell bulk of their forex receipts. Similarly, those who need foreign

exchange to import and travel abroad were to buy foreign exchange from market-determined rate.

Q7. FDI vs. FII

Both FDI and FII are related to investment in a foreign country. FDI or ForeignDirect Investment is an investment that a parent company makes in a foreigncountry. On the contrary, FII or Foreign Institutional Investor is an investment madeby an investor in the markets of a foreign nation.

In FII, the companies only need to get registered in the stock exchange to makeinvestments. But FDI is quite different from it as they invest in a foreign nation.

The Foreign Institutional Investor is also known as hot money as the investors havethe liberty to sell it and take it back. But in Foreign Direct Investment, this is notpossible. In simple words, FII can enter the stock market easily and also withdrawfrom it easily. But FDI cannot enter and exit that easily. This difference is whatmakes nations to choose FDI more than then FIIs.

FDI is more preferred to the FII as they are considered to be the most beneficial

kind of foreign investment for the whole economy.

Foreign Direct Investment only targets a specific enterprise. It aims to increase theenterprises capacity or productivity or change its management control. In an FDI,the capital inflow is translated into additional production. The FII investment flowsonly into the secondary market. It helps in increasing capital availability in generalrather than enhancing the capital of a specific enterprise.

The Foreign Direct Investment is considered to be more stable than ForeignInstitutional Investor. FDI not only brings in capital but also helps in goodgovernance practices and better management skills and even technology transfer.

Though the Foreign Institutional Investor helps in promoting good governance andimproving accounting, it does not come out with any other benefits of the FDI.

While the FDI flows into the primary market, the FII flows into secondary market.While FIIs are short-term investments, the FDI's are long term.

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Summary

1. FDI is an investment that a parent company makes in a foreign country. On thecontrary, FII is an investment made by an investor in the markets of a foreign

nation.

2. FII can enter the stock market easily and also withdraw from it easily. But FDIcannot enter and exit that easily.

3. Foreign Direct Investment targets a specific enterprise. The FII increasing capitalavailability in general.

4. The Foreign Direct Investment is considered to be more stable than ForeignInstitutional Investor

Q8. International Free Trade Agreement (FTA)

Answer:

Free trade agreements (FTAs) are generally made between two countries. Manygovernments, throughout the world have either signed FTA, or are negotiating orcontemplating new bilateral free trade and investment agreements.

The agreements are like stepping stones towards international integration into aglobal free market economy. There is another way to ensure that governmentsimplement the liberalization, privatization and deregulation measures of thecorporate globalization agenda.

It is assumed that free trade and the removal of regulations on investment will headto economic growth reducing poverty and increasing standards of living andgenerating employment opportunity.

Past evidences show that these kinds of agreements allow transnationalcorporations (TNCs) more freedom to exploit workers shaping the national and

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global economy to suit their interests. In simple terms it removes all restrictions onbusinesses.

FTAs severely constrain future governments in their policy options and help to lockin existing economic reforms which may have been imposed by the IMF, World

Bank or Asean Development Bank, or pursued by national governments of theirown volition. It works towards removing all restrictions on businesses as other freetrade and investment agreements perform.

FTAs are sometimes of narrow range in their dealing of traded goods. You cannote the US-Cambodia bilateral textile trade agreement which was extended inJanuary 2002 for a further 3 years.

India and Sri Lanka signed a free trade agreement in December 1998 with Indiaagreeing to a phase out of tariffs on a wide range of Sri Lankan goods within 3years, while Sri Lanka agreed to remove tariffs on Indian goods over eight years.

One of its objectives which were stated was to contribute, by the removal ofbarriers to bilateral trade "to the harmonious development and expansion of worldtrade".

Other FTAs are much more comprehensive and cover other issues includingservices and investment. These agreements generally take existing WTOagreements as their benchmark. They often strive to even go further than what isset out in the WTO rules.

Q.10 Functions of IMF

With its near-global membership of 187 countries, the IMF is uniquely placed tohelp member governments take advantage of the opportunitiesand manage thechallengesposed by globalization and economic development more generally.The IMF tracks global economic trends and performance, alerts its membercountries when it sees problems on the horizon, provides a forum for policydialogue, and passes on know-how to governments on how to tackle economicdifficulties.

The IMF provides policy advice and financing to members in economic difficultiesand also works with developing nations to help them achieve macroeconomicstability and reduce poverty.

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Marked by massive movements of capital and abrupt shifts in comparativeadvantage, globalization affects countries' policy choices in many areas, includinglabor, trade, and tax policies. Helping a country benefit from globalization whileavoiding potential downsides is an important task for the IMF. The global economiccrisis has highlighted just how interconnected countries have become in todays

world economy.

Key IMF activities

The IMF supports its membership by providing

policy advice to governments and central banks based on analysis ofeconomic trends and cross-country experiences;

research, statistics, forecasts, and analysis based on tracking of global,regional, and individual economies and markets;

loans to help countries overcome economic difficulties;

concessional loans to help fight poverty in developing countries; and

Technical assistance and training to help countries improve themanagement of their economies.

International monetary systems are sets of internationally agreed rules,conventions and supporting institutions that facilitate international trade, crossborder investment and generally the reallocation of capital between nation states.

They provide means of payment acceptable between buyers and sellers of differentnationality, including deferred payment. To operate successfully, they need toinspire confidence, to provide sufficient liquidity for fluctuating levels of trade and toprovide means by which global imbalances can be corrected. The systems cangrow organically as the collective result of numerous individual agreementsbetween international economic actors spread over several decades.

Role of IMF in IMS

1. Combating poverty in low income countries

2. Providing a forum for discussion and consultation among member countries

3. Increase global supply of international reserves.

4. Supervising the adjustable peg system.

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Q11. Main Functions of World Bank

The World Bank is an international financial institution that provides loans to

developing countries for capital programmes. The World Bank proclaims a goal ofreducing poverty. By law, all of its decisions must be guided by a commitment topromote foreign investment, international trade and facilitate capital investment.

World Bank- its Objectives and Functions The International Bank forReconstruction and Development (IBRD), commonly known as World Bank, wasresult of the Bretton Woods Conference. The main objectives behind setting up thisinternational organization were to aid the task of reconstruction of the war-affectedeconomies of Europe and assist in the development of the underdeveloped nationsof the world. For the first few years, the World Bank remained preoccupied with thetask of restoring war-torn nations in Europe. Having achieved success in

accomplishing this task by late 1950s, the World Bank turned its attention to thedevelopment of underdeveloped nations. Over the time, additional organizationshave been set up under the umbrella of the World Bank.

As of today, the World Bank is a group of five international organizationsresponsible for providing finance to different countries. As mentioned earlier, theWorld Bank is entrusted with the task of economic growth and widening of thescope of international trade. During its initial years of inception, it placed moreemphasis on developing infrastructure facilities like energy, transportation andothers. No doubt all this has benefited the under-developed nations too, but theresults were not found to be very satisfactory due to poor administrative structure,

lack of institutional framework and non-availability of skilled labor in thesecountries. Realizing these problems, the World Bank later decided to divertresources to bring about industrial and agricultural development in these countries.

Assistance is extended to different countries for raising cash crops so that theirincomes rise and they may export the same for earning foreign exchange. Thebank has also been providing resources for education, sanitation, health care andsmall scale enterprises. Today, the services provided by the World Bank haveincreased manifold. The World Bank is no longer confined to simply providingfinancial assistance for infrastructure development, agriculture, industry, health andsanitation. It is rather significantly involved in areas like removal of rural poverty

through raising productivity, increasing income of the rural poor, providing technicalsupport, and initiating research and cooperative ventures. The group and itsaffiliates headquartered in Washington DC catering to various financial needs arelisted below on World Bank and its affiliates. World Bank and its Affiliates

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InstitutionInternational Bank for Reconstruction and Development (IBRD) 1945International Financial Corporation (IFC) 1956International Development Association (IDA) 1960Multilateral Investment Guarantee Agency (MIGA) 1988

International Centre for Settlement of Investment Disputes (ICSID) 1966

Q.12 Explain how India has benefitted from World banks lendingprogramme.

The World Bank Program in India

To support India in achieving its long-term vision of a country free of poverty andexclusion, the World Bank Groups Country Strategy for India for FY 2009-2012

(CAS) is closely aligned with the objectives outlined in the country's Eleventh Plan.

World Bank lending to India has diverged from initial plans spelt out in the CountryStrategy due to the impact of the global financial crisis, the World Banks efforts torefocus, realign and consolidate the India program, and the increased demandfrom the Government for more financing.

In FY10, the World Bank lent a record $9.2 billion to India, compared to $2.3 billionin FY09. Fourteen new projects were added in FY10, and the project pipeline hasgrown in light of increased demand from the Government of India. The averagesize of requested projects has increased. And, the volume of Bank lending has

shifted further towards infrastructure, the delivery of essential social services, andincreasing engagement on urban issues and agriculture.

World Bank lending to India is organized around the following key challenges:

1. Achieving Rapid and Inclusive Growth

Indias integration into the global economy has been accompanied by impressiveeconomic growth that has brought significant economic and social benefits to thecountry. Nevertheless, disparities in income and human development are on therise. A large section of the population - especially the poor, Scheduled Castes,

Scheduled Tribes, Other Backward Classes, minorities and women - lack access tothe resources and opportunities needed to reap the benefits of economic growth.To assist the government in achieving rapid inclusive growth, the World Bank issupporting activities which address both cyclical and structural impediments togrowth, as well as the constraints to making growth inclusive:

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2. Ensuring Development is Sustainable

Indias remarkable economic growth has been clouded by a degradingenvironment. The country is also very vulnerable to climate change on account ofits high levels of population density, poverty, stressed ecological systems, and a

substantial dependence on natural resources of much of Indias population. Thefollowing areas will thus require long-term vision and urgent action:

Protecting Indias fragile environment - air, water, forests and bio-diversity -in the face of the rising pressures created by economic success

Adapting to climate change and the growing scarcity of water

Coping with accelerating urbanization through strengthened urbangovernance and environmental management

Improving energy efficiency and ensuring adequate energy supplies

The World Bank is in the process of articulating a vision for an environmentallysustainable future for India (India 2030), and has projects in the pipeline to supportthe National Ganga River Basin Authority and industrial pollution management.

3. Increasing the Effectiveness of Service Delivery

Most public programs suffer from varying degrees of ineffectiveness, poortargeting, and wastage of resources. In the current economic climate, India willhave to dramatically improve the impact of every rupee spent. The World Bank isworking with the Government of India to improve the delivery of key public servicesthrough systemic governance and institutional reforms of public sector service

providers, decentralization of responsibilities, promoting effective systems oftransparency and accountability, effective monitoring of service delivery, andexpanding the role of non-state service providers.

Q.14 Whatre the ways in which India can reduce BOP

A balance of payments (BOP) sheet is an accounting record of all monetarytransactions between a country and the rest of the world. These transactionsinclude payments for the country's exports and imports of goods, services, and14 | P a g e


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financial capital, as well as financial transfers. The BOP summarizes internationaltransactions for a specific period, usually a year, and is prepared in a singlecurrency, typically the domestic currency for the country concerned. Sources offunds for a nation, such as exports or the receipts of loans and investments, arerecorded as positive or surplus items. Uses of funds, such as for imports or to

invest in foreign countries, are recorded as negative or deficit items.

When all components of the BOP sheet are included it must sum to zero with nooverall surplus or deficit. For example, if a country is importing more than it exports,its trade balance will be in deficit, but the shortfall will have to be counter balancedin other ways such as by funds earned from its foreign investments, by runningdown reserves or by receiving loans from other countries.

Expressed with the IMF definition, the BOP identity can be written:

Measures to improve balance of payments in India

Reduce domestic Consumption. Domestic consumption in India is provingresilient as rest of world slips into recession. This is causing imports to rise fasterthan exports. Reducing consumer spending would reduce imports, but, it may bedeemed inappropriate as economic growth may be more important than balance ofpayments.

Encourage depreciation of Rupee. Depreciation in the Rupee would make Indianexports more competitive and imports more expensive. The problem is that with a

global recession many other countries will want to help their exporters throughencouraging a weaker currency.

Structural improvements. Long term supply side policies aimed at increasing thecompetitiveness of exports should help improve the balance of payments for India.However, they will take a long time to work.

Q16. Why is US-$ a Global Currency?

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In the foreign exchange market and international finance, a world currency,supranational currency, orglobal currency refers to a currency in which the vastmajority of international transactions take place and which serves as the world'sprimary reserve currency. In March 2009, as a result of the global economic crisis,China and Russia have pressed for urgent consideration of a global currency. A

UN panel of expert economists has proposed replacing the current US dollar-basedsystem by greatly expanding the IMF's SDRs or Special Drawing Rights.

Currencies have many forms depending on several properties: type of issuance,type of issuer and type of backing. The particular configuration of those propertiesleads to different types of money. The pros and cons of a currency are stronglyinfluenced by the type proposed. Consider, for example, the properties of acomplementary currency.

U. S. Dollar

In the period following the Bretton Woods Conference of 1944, exchange ratesaround the world were pegged against the United States dollar, which could beexchanged for a fixed amount of gold. This reinforced the dominance of the USdollar as a global currency.

Since the collapse of the fixed exchange rate regime and the gold standard and theinstitution of floating exchange rates following the Smithsonian Agreement in 1971,most currencies around the world have no longer been pegged against the UnitedStates dollar. However, as the United States remained the world's preeminenteconomic superpower, most international transactions continued to be conductedwith the United States dollar and it has remained the de facto world currency.

Only two serious challengers to the status of the United States dollar as a worldcurrency have arisen. During the 1980s, the Japanese yen became increasinglyused as an international currency, but that usage diminished with the Japaneserecession in the 1990s. More recently, the euro has increasingly competed with theUnited States dollar in international finance.

Since the mid-20th century, the de facto world currency has been the United Statesdollar. According to Robert Gilpin in Global Political Economy: Understanding theInternational Economic Order (2001): "Somewhere between 40 and 60 percent ofinternational financial transactions are denominated in dollars. For decades the

dollar has also been the world's principal reserve currency; in 1996, the dollaraccounted for approximately two-thirds of the world's foreign exchange reserves"(255).

Many of the world's currencies are pegged against the dollar. Some countries,such as Ecuador, El Salvador, and Panama, have gone even further and

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eliminated their own currency in favor of the United States dollar. The dollarcontinues to dominate global currency reserves, with 63.9% held in dollars, ascompared to 26.5% held in Euros

Q19. What is forward market rate?

The forward exchange market is a market for contracts that ensure the future

delivery of a foreign currency at a specified exchange rate. The price of a forward

contract is known as the forward rate.

Forward rates

Forward rates are usually negotiated for delivery one month, three months, or one

year after the date of the contract's creation. They usually differ from the spot rate

and from each other.

What determines the forward rate?

If there is no government intervention on the value of a currency, the forward

market will be governed by supply and demand. In such a case it is possible that

the forward rate provides information on the future spot rate, but ultimately

uncertain. What is certain is that the forward rates reflect the expectations forward

market participants have on the changes of the spot rate during the specified

interval. If the forward rate and the spot rate are the same, forward market

participants do not expect much change in the price of a currency over the givenperiod of time.

Q20. Describe Letter of Credit Mechanism

Letters of credit accomplish their purpose by substituting the credit of the bank forthat of the customer, for the purpose of facilitating trade. There are basically twotypes: commercial and standby. The commercial letter of credit is the primarypayment mechanism for a transaction, whereas the standby letter of credit is a

secondary payment mechanism.

Commercial Letter of Credit

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Commercial letters of credit have been used for centuries to facilitate payment ininternational trade. Their use will continue to increase as the global economyevolves.

Letters of credit used in international transactions are governed by the International

Chamber of Commerce Uniform Customs and Practice for Documentary Credits.The general provisions and definitions of the International Chamber of Commerceare binding on all parties. Domestic collections in the United States are governedby the Uniform Commercial Code.

A commercial letter of credit is a contractual agreement between banks, known asthe issuing bank, on behalf of one of its customers, authorizing another bank,known as the advising or confirming bank, to make payment to the beneficiary. Theissuing bank, on the request of its customer, opens the letter of credit. The issuingbank makes a commitment to honor drawings made under the credit. Thebeneficiary is normally the provider of goods and/or services. Essentially, the

issuing bank replaces the bank's customer as the payee.

Elements of a Letter of Credit

A payment undertaking given by a bank (issuing bank) On behalf of a buyer (applicant)

To pay a seller (beneficiary) for a given amount of money

On presentation of specified documents representing the supply of goods

Within specified time limits

Documents must conform to terms and conditions set out in the letter ofcredit

Documents to be presented at a specified place

Step-by-step process:

Buyer and seller agree to conduct business. The seller wants a letter ofcredit to guarantee payment.

Buyer applies to his bank for a letter of credit in favor of the seller.

Buyer's bank approves the credit risk of the buyer, issues and forwards thecredit to its correspondent bank (advising or confirming). The correspondentbank is usually located in the same geographical location as the seller(beneficiary).

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Advising bank will authenticate the credit and forward the original credit tothe seller (beneficiary).

Seller (beneficiary) ships the goods, then verifies and develops thedocumentary requirements to support the letter of credit. Documentaryrequirements may vary greatly depending on the perceived risk involved indealing with a particular company.

Seller presents the required documents to the advising or confirming bank tobe processed for payment.

Advising or confirming bank examines the documents for compliance withthe terms and conditions of the letter of credit.

If the documents are correct, the advising or confirming bank will claim thefunds by:

o Debiting the account of the issuing bank.

o Waiting until the issuing bank remits, after receiving the documents.

o Reimburse on another bank as required in the credit.

Advising or confirming bank will forward the documents to the issuing bank.

Issuing bank will examine the documents for compliance. If they are inorder, the issuing bank will debit the buyer's account.

Issuing bank then forwards the documents to the buyer.

Q.21 Describe the features of Forex Market

The foreign exchange market (forex, FX, or currency market) is a global,worldwide decentralized over-the-counter financial market for trading currencies.Financial centers around the world function as anchors of trading between a widerange of different types of buyers and sellers around the clock, with the exceptionof weekends. The foreign exchange market determines the relative values ofdifferent currencies.

The primary purpose of the foreign exchange is to assist international trade andinvestment, by allowing businesses to convert one currency to another currency.For example, it permits a US business to import British goods and pay PoundSterling, even though the business's income is in US dollars. It also supportsspeculation, and facilitates the carry trade, in which investors borrow low-yielding

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currencies and lend (invest in) high-yielding currencies, and which (it has beenclaimed) may lead to loss of competitiveness in some countries.

In a typical foreign exchange transaction, a party purchases a quantity of onecurrency by paying a quantity of another currency. The modern foreign exchange

market began forming during the 1970s when countries gradually switched tofloating exchange rates from the previous exchange rate regime, which remainedfixed as per the Bretton Woods system.

The foreign exchange market is unique because of

its huge trading volume, leading to high liquidity; its geographical dispersion;

its continuous operation: 24 hours a day except weekends, i.e. trading from20:15 GMT on Sunday until 22:00 GMT Friday;

the variety of factors that affect exchange rates;

the low margins of relative profit compared with other markets of fixedincome; and

The use ofleverage to enhance profit margins with respect to account size.

Q22. Rupee Dollar Option

The Indian derivative market has seen the rupee-dollar forward contracts for quitesome time now. But the market was introduced to a new currency derivative on 7thJuly, 2003 the rupee-dollar option contract. Options are relatively newinstruments in the local financial market. Though cross-currency options have beenavailable to corporate since January 1994, they have not yet become popular. Foryears, corporate have been accessing the foreign exchange market for dollar-rupee forwards in order to hedge their exposures on exports, imports and loans.Forwards, therefore, have better understanding and acceptability with thecorporate. As a result, the risk management decision for rupee-dollar exposures forall these years was mostly about whether to cover the risk by way of a forwardcontract or to leave it open.

Now the corporate manager has the alternative to forward contracts in the form ofrupee-options. But an option is a different animal altogether, and a novelty not onlyfor the corporate, but also for Indian banks. In a forward contract, if a corporatehedges say, an import payment and the dollar depreciates by the payment date,the corporate cannot benefit from the dollar depreciation and has to pay at the

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agreed exchange rate under the forward contract. Even though the rate paid maybe close to the budgeted rate and, therefore, need not be viewed as a loss, anopportunity has nevertheless been lost. In contrast, if an option contract is used forthe same payment, the importer will pay a premium upfront and secure the right tobuy the dollars at say, the forward rate. An option contract with an exercise price

equal to the forward rate is called an at the money forward (ATMF). Now if thedollar depreciates, the importer is under no obligation to buy the dollars at theoption contract rate. The importer will buy the cheaper dollars from the spot market.

Does it mean that one is always better off hedging by way of options? Notnecessarily so, because derivatives (forwards, options - the two basic families) arerisk management tools and appropriate use of derivatives is the key to managingrisks. For example, in the case of the importer discussed above, if the dollar hadappreciated by the payment date instead of falling against the rupee, the importerwould have felt better off (in retrospect though) with a forward contract. This is sobecause the option contract involved the payment of option premium. An option

contract is like an insurance policy.

In case of an insurance contract, the policyholder gets compensated in case of aneventuality like death, accident etc. However, no policyholder would want such aneventuality to happen. Be it car insurance or life insurance. One does not want todie just because one has an insurance policy on ones life; instead, the benefits ofliving longer are greater income inflows, besides the joys of living.

An option contract is not much different. For the buyer of the option, the benefit ismost when the need to exercise the option does not arise. Take for example, theimporter discussed earlier, whose payout would be minimized if the dollar

depreciates, rather than on the dollar does appreciation and the importer have touse the call option on the dollar.

When and how to use option contracts is a matter of risk management practice andcorporate treasurers need to bear this in mind. They would need to see thepremium paid upfront as an insurance against unfavorable currency movement andnot as a cost. There is a general lack of understanding on how the currency optionsshould be used. This results in the option premium being seen as a cost andtherefore the demand for zero cost option structures in the Indian market. It needsto be understood that zero cost option structures do not come free. It comes at thecost of limiting the possible gain - the very reason for which one would like to useoptions.

While the interbank market in rupee: dollar options is thin, a number of banksactively quote prices to their customers. The relatively low volatility in the rupee-dollar exchange rate, compared to say the dollar-euro or dollar-yen, makes therupee-dollar option prices attractive. In time, as more and more corporate

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understand the use of options better; it has the potential as a risk management toolto emerge as a formidable alternative to forward contracts. Exchange rates keepadjusting to reflect the changes in economic environment for most developingcountries, even though undue volatility in the exchange rates is not a comfortablescenario for the businesses.

A two-way movement of the currency, which is a prerequisite for an efficient marketin options, is already taking place, albeit in a limited way. After all, which exporterwould have believed even a year back that the rupee would appreciate sodramatically? This helps in two ways. One, the pricing of options becomes viable.

Option pricing is based on two way movement of the underlying - the rupee-dollarexchange rate. The writer/seller of the option will not find the business worthwhile ifthe market moves consistently only in one direction.

In the absence of two-way movement of the underlying; is it a stock or a bond or a

currency pair, the market liquidity suffers. Secondly, two-way movement of thecurrency will improve their understanding of the difference between forwards andoptions, and the need to use both derivatives at different times. While the banksoffer a number of derivative structures based on options for the corporate, it isimportant that the user is conversant with such structures.

Currency options, and in particular the rupee dollar options, are a new riskmanagement tool for the Indian corporate treasury manager and therefore notmany are expected to be familiar with options-based structure. It may therefore beuseful to use plain vanilla options to begin with, for those who are new. This will bein the interest of the market that the participants understand the product that they

are looking at.

Treasury professionals, advisors and banks have an important role to play byexplaining to corporate users and their management, the appropriate alternativestrategies for using forward and option contracts, and the multitude of variantsbeing sold by the banks. Unless options are used properly for risk managementpurposes by the corporate, the gains will not be seen and the market for optionswill not deepen.

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