lecture notes international finance printed

8/12/2019 Lecture Notes International Finance Printed

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INTERNATIONAL FINANCE

What is Foreign Exchange?

Foreign Exchange loosely refers to any foreign currency. In deeper sense, it is purchase and sale of onecurrency against sale and purchase for another currency. Here, currency does not necessarily meanbank notes and coins but includes Travellers Cheues, !ills of Exchange, "etters of Credit, any drafts,etc as #ell. In essence any financial instrument that entitles you to get another currency in lieu of onecurrency is treated as currency for this definition.

International Foreign Currency market is almost round the clock market starting in Tokyo$%ydney inthe morning and closing in &est Coast of '%( shortly before it is time for opening of next day marketin Tokyo (effect of changing time zones).

Indian Forex Market

Indian Forex )arket is still in nascent stage of development. *rior to ++, #e had FE-( #hich madepossession of Foreign currency a criminal offence. Exchange rate #as decided by the -!I and Forex

market virtually did not exist. *ost ++, after replacement of FE-( #ith FE)(, and current accountconvertibility, Indian forex market has begun to develop. &ith exports volume gro#ing steadily atgood pace, forex market is becoming important.

The Foreign Exchange )anagement (ct +/ popularly kno#n as FE)( came into force from 0une1+, 2111. FE)( replaced the Foreign Exchange -egulation (ct of +34 FE-(/. &hile FE-( #asaimed at conserving foreign exchange by restricting expenditure, FE)( is aimed at facilitatingexternal trade and payments for promoting orderly development and maintenance of foreign exchangemarket in India. 5iolations under FE)( are considered civil offence and not criminal offence as #asthe case under FE-(.

In India most of the trade happens in '%6. !esides '%6, Euro, 7reat !ritish *ound, and 0apanese 8enare other ma9or currencies that are traded. :ther currencies are also dealt but in small volume. %!Ideals in +; currencies in all.

Exchange rates are not constant and keep changing on minute to minute basis like stocks in stockmarket. 'nlike stock exchange, there is no Forex Exchange #here there is a central intermediaryavailable for every transaction and hence single uote for any currency is not available. It is more like avegetable market #here there are so many shops and each is uoting its o#n rate and #illing to bargain#ith you. :r, in the market language, it is :ver the Counter :TC/ trade.

Foreign Currency Exchange Rate

The primary basis for exchange rate movement on day to day basis is 6emand and %upply of foreigncurrency. 6emand can spurt due to various reasons like large companies #ith considerable importreuirements (like Maruti requiring import from Suzuki, Japan) of foreign currencies stocking forex for futurereuirement. %imilarly, exporters may dump their forex holding if they perceive that rupee is going toappreciate leading to sudden excess availability of foreign currency in the market.

(lthough the exchange rate is affected by market forces of demand and supply, #e do not have a fullyflexible exchange rate, or as it is called Floating Exchange -ate, as yet. &hat #e actually have is a)anaged Exchange -ate.

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&hat it means is that exchange rate is being macro managed by the 7ovt through -!I. -!I keeps aha#k eye on the forex market and keeps manipulating exchange rate by either buying excess forex orin9ecting liuidity by selling forex from its o#n holding of +;< !illion '% 6ollars. "ike, %E!I is thecontroller of the %ecurities market, -!I is the controller of Forex market. It authorises certain entitieslike banks and even other companies like Thomas Cook to deal in Forex. It has a dealing room #hichkeeps a track on exchange rate movement in the market on continuous basis. If the exchange rate startsmoving #ildly in either direction, it intervenes by either buying or selling forex in the market to controlit.

Factors Affecting the Exchange Rate

a/ !alance of *ayment position of the country

b/ %trength of economy

c/ Fiscal and )onetary policy

d/ Interest rates

e/ *olitical Factors

f/ Exchange control

g/ Central !ank Intervention

h/ %peculation

i/ Technical Factors

9/ :ther factors.

Balance of Payment - !alance of *ayment is the measure of demand and supply of foreigncurrency. If the balance of payment is high and positive Exports higher than imports/, it #illlead to excess supply of foreign currencies and therefore local currency #ill appreciate. In thereverse case, domestic currency #ill depreciate.

Strength of the Economy - If the economy is strong and gro#ing, foreign investment$capital#ill pour into the country again causing excess supply of foreign currencies leading toappreciation of local currency.

Fiscal and Monetary Policy -If fiscal policy leads to high deficit, it #ill result in inflationand therefore excess supply of local currency. High inflation rate leads to high interest rates(interest rates are mostly maintained a few percent higher than inflation rate so that real effective interest rate is

positive)leading to #eakening of local currency.

InterestRates - Higher interest rates attract foreign currency deposits provided local currencyis not depreciating faster than interest rate induced gro#th. Thus, higher interest rates coupled#ith relatively stable local currency acts like a self sustaining process. )ore inflo# of foreign

currency leads to further stability of exchange rates.PoliticalFactors - If a govt is considered to be unstable, or change of govt #ith socialisticinclination is expected, local currency #ill #eaken. Currency #ill strengthen if the ne# govt isexpected to take capitalistic policy decisions.

Exchange Control - Exchange control is generally aimed at free movement of capital flo#s andtherefore foreign nationals #ill be vary of investing in the country.

CentralBankIntervention - (lready explained as to ho# central bank can affect exchange ratein the short term.

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Sec!lation- This is again a short run effect if some big players suddenly start accumulatingforeign currency or vice versa for speculative reasons. Constant buying by big players andresultant up#ard movement in price leads even smaller player to start buying aggressively andforeign currency appreciates.

"echnicalFactors - Technical factors #ork best in regulated market. Indian forex market arestill not as free and therefore they do not have much effect.

#ther Factors - These are general factors #hich are hard to define. It could be #orld politicaland economic situation, prices of ma9or import constituent like crude oil, etc. Fear of #ar #ith*akistan can send the -upee do#n overnight.

Reference Rate

&hat #e have discussed above is mechanics of day to day changes in exchange rate. !ut ho# is thebasic exchange rate of one currency set against the other currency= Ho# is it determined that a dollarshould cost approximately -s >< and not -s 2< or so is called Reference Rate. This reference rate is decided using variousdifferent methods? @

a/ Mint Parity SystemA %imply stated this system is based on amount of currency printedby any country for each ounce or Bg of gold. If India prints -s 41,111 for each ounce ofgold held #ith govt and '% prints '% ;11 for each ounce of gold held #ith '%(,exchange rate bet#een '% and ID- #ould be A 41,111$;11 -s ie tillstart of &orld &ar I. In this system, the coins had a fixed gold content and ratio of goldcontent in coins of any t#o countries denominated their exchange rate. In case of papercurrency, amount of gold freely payable by 7ovt$Central !anks of t#o countries foreach unit of paper currency determined the exchange ratio. The countries #ere

committed not to print currency in excess of their gold holding or dilute the gold contentin coins. Ho#ever, during the &orld &ar II, countries began to renege on thiscommitment to meet the funding reuirement of the #ar and the gold standard collapsed.

)any countries tried to revive the 7old %tandard after the #ar ended in ++ butfailed. In the economic depression that follo#ed the &&@I, #hen they tried to #ithdra#additional money they had pumped into the economy during the #ar, it led to 6eflation(reverse of inflation where commodity prices start falling due to low demand (because people do not have

money to buy goods) which deters the entrepreneurs and is therefore bad for economy) They,therefore had to #ait for the economies to recover. !ut by the time they began their nextattempt a couple of decades later, &orld &ar II started in +4 and lasted till +>>.Thus, this standard #as abandoned.

c/ Bretton %oods SystemA *ost &orld &ar II, in +>;, the ne#ly@created Economic and%ocial Council of the 'nited Dations called a conference at the !retton &oods #here inthe troika of post@&ar economic agencies ie International )onetary Fund I)F/, &orld!ank and International Trade :rganisation IT: A #hich later came in avatar of 7(TT/#ere born. Countries #ere allo#ed to declare their currency value in gold or dollars and'%( promised to freely exchange an ounce of gold for '% 4< or vice versa. %ince thissystem #as born during !retton &oods conference, this standard came to be kno#n as!retton &oods system.



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The system #orked very #ell till +;. Ho#ever, #hen '%( got embroiled inthe long and costly 5ietnam #ar, its economy suffered. The '.%. balance on goods andservices shifted to a surprising deficit in +3+. These deficits supported speculationsthat the dollar #as overvalued. France realised that it #as beneficial to exchange itsforex holding into gold and began to convert it. !ecause of massive gold outflo#s fromthe 'nited %tates, *resident Dixon suspended convertibility of the dollar in (ugust+3+. This ended the !retton &oods %ystem.

d/ Smithsonian Agreement@ I)FGs attempts in the subseuent period to revive !retton&oods system #ere unsuccessful as '%( did not agree to make dollar convertible togold. In the follo#ing period, there #as complete chaos. In an attempt to restore order tothe exchange market, +1 leading nations met at the %mithsonian on 6ecember +; and +3,+3+. The %mithsonian (greement #as a ne# system of exchange@parity values.(lthough this ne# system #as still a dollar@standard exchange@rate system, the dollar,#as still not convertible to gold. %mithsonian (greement collapsed #ithin +< monthsand a de factosystem of floating rates emerged.

e/ Do# #e have follo#ing systems of Exchange -ate being follo#ed by differentcountries as per their convenience?

i/ Fixed Exchange Rate Systems

aa/ Currency !oard

ab/ Fixed *eg

ac/ Flexible *eg

ii/ Floating Exchange Rate Systems

aa/ )anaged Float %ystem

ab/ Independent Float %ystem

Scientific Way of Deciding Exchange Rate Beteen Currencies

+. P!rchasing Po&er Parity System@ This theory is based on the la# of one price, the ideathat, in an efficient market, identical goods must have only one price. This is thus RealEffective Exchange Rate-EE-/. ( basket of representative goods and services has beenidentified and its cost in each country in its domestic currency is calculated. The ratio bet#eenits cost in any t#o countries in their respective domestic currencies is their exchange rate. Tounderstand it better, let us take a case of cost of hair cut in India and '%. &hile the averageprice of a hair cut in India is -s +


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This is called absolute version of ***.

These special exchange rates are often used to compare the standards of living of t#o or morecountries. The ad9ustments are meant to give a better picture than comparing gross domesticproducts 76*/ using market exchange rates.

2. Relative P!rchasing Po&er ParityA This is a related theory, #hich predicts the relationbet#een the t#o countriesJ relative inflation rates and the change in the exchange rate of their

currencies. This is the economists definition. In business terms, it helps in deciding For#ard-ate of Forex from %pot -ate by taking inflation into account.

%uppose, present Exchange -ate of dollar in India is -s >3 and inflation in India is


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The methods #e discussed above are the planned and controlled method of %terilisation ofForex. In addition there could be host of uncontrollable and unpredictable reasons leading tosterilisation, like A

a/ Threat of &ar b/ Increase in oil pricesc/ *olitical Instabilityd/ 7ovt *olicies

e/ %ocial 6isturbance

Thus, there is al#ays a need for hedging.

Fixed Exchange Rate Systems

+. C!rrency BoardA In this system, currency notes issued by the country depend upon thedeclared exchange rate and the amount of foreign currency reserves. If India has a forex reserveof '% +1, India can issue +1 ;111 !illion -upees#orth of currency notes. Ho#ever, in this case, monetary policies have to be in consonance #ithother country. Thus, it kills the economic sovereignty of the nation and therefore difficult to

follo#.

Examples are Hong Bong, Estonia, and !ulgaria

2. Fixed PegA In this system, exchange rate is declared by the country and ratified by theI)F. Thereafter, exchange rate does not change till it is revised by the 7ovt. -eluctance by thegovt to revise the rate due to political or other compulsions can lead to long term conseuences.%outh East (sian crisis #as partly result of this system.

Reasons for So!th East Asian Crisis '())*+

a/ Countries had adopted complete convertibility on Current as #ell as Capital account.This made flight of capital very easy. There #as no #ay to control out#ard flight ofcapital at the time of crisis.

b/ They adopted Fixed *eg system against dollar. There #as massive influx of foreigncurrency through hot investments, foreign currency loans by banks, etc. This money #asinvested in assets like real estate and stocks. There #as massive rise in asset prices andan asset bubble #as created.

c/ There #as massive current account deficit. Imports far exceeded exports.

d/ High inflation rates due to increased money supply. Inflation #as not reflected in

exchange rateM firstly, due to Fixed *eg system and secondly, due to govtsG reluctance torevise the rate do#n#ards #hich #ould have affected investorsG sentiments. %peculatorssuddenly realiNed that due to overvalued currencies, it #as beneficial to convert localcurrency into dollars and they #ent for it hammer and tongs. 6ue to relatively small siNeof economies a fe# tens of billion dollars each/, in three trading sessions, Forexreserves became nil.

4. Flexi,le Peg System @ This system provides a *arity band #hich allo#s limitedflexibility for movement of exchange rate on either side of the parity rate. !ands can be verynarro# or very #ide. Examples are !angladesh, China, and Egypt.

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Floating Exchange Rate Systems

+. Managed FloatA This is the system that #e are currently follo#ing in India. Exchangerate is free to float but under constant #atch of Central !ank -!I/. It generally intervenes onlyon occasions #hen there are #ild movements. It basically acts as stabiliser.

2. Indeendent FloatA In this system 7ovt is 9ust not bothered #hich #ay its currency ismoving. This is the system follo#ed by rich and advanced countries like '%(, Bu#ait, %audi

(rabia, etc.

India follo#ed Fixed *eg %ystem since independence. Indian rupee #as pegged against 'B . In +;;,rupee #as devalued. In +3


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!ecause of its long history of economic instability, every economic crisis in the Third &orld,particularly in "atin (merica, caused investors to pull out of (rgentina, creating a self@fulfillingprophesy. It #as investorsG hair@trigger reaction to crises else#here that caused (rgentinaGs instability,Thus, the adverse effects of these crises #ere greater in (rgentina than in most other ne#@gro#theconomies. (nother reason for this enhanced vulnerability is that (rgentina stood alone #ith its fixed@exchange@rate policy, #hereas the floating currencies of its neighbours depreciated. !y 211+, the peso#as significantly overvalued, in no small part due to the dollar itself having become overvalued. Thedevaluation of the !raNilian real had a particularly large effect. It reduced demand from (rgentinaGslargest trading partner, and businesses began to move from (rgentina to !raNil in search of lo#erproduction costs. (s the credibility of the peso at its pegged value declined, and the government had toexpend huge sums to support the currency, #hich in turn necessitated more borro#ing. 'nder theseconditions, interest rates that #ere already high rose even higher, and as both debt and interest ratesrose, the ability of the government to service its debt became increasingly doubtful. (rgentinacontinued to keep the peso pegged to the dollar by external borro#ings.

The buNNards came home to roost in 6ecember 211+. The nation rapidly descended into anunprecedented chaos. (s economic activity shuddered to a virtual halt, governments resigned and #erehastily replaced amid sporadic rioting. The follo#ing month, #hen Eduardo 6uhalde the fifth personto hold the presidency in t#o #eeks/ unpegged the peso in 0anuary 2112, the peso crashed hard, losingmore than 31K of its value and inflation rising to >+K though it #as still far far better than theexpectations of four digit hyper inflation experienced in late 1s decades. !ut inflation had fallen backto 4.2K by 2114.

%o, #e kno# no# #hat agony #as the country saved from by the much maligned and ever pouting )r*5 Darsimha -ao, #ho displayed the rare courage to stand up against the economically blind politicalclass of the country including his o#n party men/ in appointing )r )an )ohan %ingh as Finance)inisterM and the practical economist )r )an )ohan %ingh himself, #hose economic prescriptions tocure the ills of the economy #ere as effective as any measures ever #ere any #here in the #orld in itsmodern history.

Mexican Economic Crisis

)exican Economic trouble of +> #as not a Q*rash+but a Crisis as it lasted 9ust +1 months and themelt do#n #as not as spectacular as in (rgentina. This crisis #as also triggered by #rong currencypolicies of the govt. In 6ec +>, )exican *eso fell from the pegged rate of 4.4 peso to a dollar to 3.3peso.

Though the crisis #as triggered byM first? the devaluation of currency in 6ecember +> and second?floatation of currency soon afterM the seeds #ere so#n earlier.

)exico had a fixed exchange rate of 4.4 peso to a dollar. In +>, as the general election dre# near, the

incumbent govt #ent into a spending blitN (politicians are same every where). (s a result, current accountdeficit ballooned to a record of 3K. In order to fund the spending, the govt issued bonds repayable indollars. High current account deficit and fixed exchange rate led to over valuation of *eso byapproximately 21K. %ome investors #ere alarmedM other smelled the opportunityM and together theyuickly encashed the bonds in dollars. Foreign exchange reserves fell drastically. 6eclining reservesnecessitated devaluation of currency. Ho#ever, political compulsions did not allo# this simple but hardprescription till the incumbent govt lasted.

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Dext 7ovt #hich took over po#er in 6ec +>, devalued the currency to > pesos to dollar. That did notprove adeuate and #ithin days peso #as allo#ed full float #hich led to crashing of peso to 3.2 pesosto a dollar.

)exicoGs immediate neighbour, '%(, intervened immediately by first buying pesos from open marketand then arranging a loan of '%


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(bove represents amount of currency in denominator here ID-/ to be paid for each unit of currency innumerator here '%6/. Ruotation is al#ays in double numbers #ith minor difference bet#een the t#o.First number is called theBid Rateand second number is calledAsk Rate. !id rate is al#ays lo#erthan the (sk -ate.

Bid Rateis the rate at #hich the money changer is #illing to buy a particular currency.

Ask Rateis the rate at #hich the money changer is #illing to sell same currency.

SreadA (s stated earlier, there is al#ays a positive difference bet#een (sk -ate and !id rate. Thisdifference is called %pread and it is the profit margin that the dealer earns by trade.

%pread (sk -ate A !id -ate

%pread K +11

.$

.$&$

Forex market behaves like any other commodity market. Here too, there is #hole sale and retail market.

&hole sale market consists of (uthorised 6ealers and !ig Corporate Houses like TC%, Infosys and&ipro #ho have high forex exposures. !ut spreads in #hole sale market are lo#er.

-etail )arket is populated by money changers, ordinary citiNens, small exporters and importers andsmall corporates.

/ositions

In any financial market, t#o positions can be taken A "ong or overbought position and

A %hort or oversold position.

%hy are ositions created.

*ositions are taken in anticipation of currency exchange rate movement in one direction.

If a position is taken and the trend appears to be reversing currency depreciates against expectation ofappreciation or vice@versa/, the positions are liuidated by manipulating the !id and (sk rates.Example @ If it is a long$overbought position, both (sk and !id rates #ill be lo#ered. %imilarly, if thereis an oversold position, both (sk rate and !id -ate #ill be hiked.

The uotations are normally in four decimal places. If a dollar is being uoted against -upee, it #ill beuoted as follo#s? @

>;.;.


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(r#itrage

(s in any other trade, arbitrage opportunities exist in Forex trade also. (rbitrage is basically takingadvantage of differential in rates at t#o locations or markets or sources. For instance, .id (.uying)$ateof one dealer may be higher than&sk (Selling) $ateof another dealer. ( smart operator can buyfrom second dealer and sell to first dealer and earn some money. This transaction is called (rbitrage."et us see the above process in numbers.

6ealer ( 6ealer !

>;.;.;.;.Thus, a person #ill obtain '%6$ID- uote >;.4121$>;.411 from a dealer in India and ID-$'%6uote 1.12+4$1.122> from another dealer in '%( (1S currency used as base in 1S& So, the quotation will benumber of 1S2 to be paid for each !#$). If the bases of uotes are different, ho# do #e compare the uotes=Comparison of t#o uotes becomes difficult. Therefore, there is a need toI5=ERSEone of the uotesso that the base is common.

'%6$ID- >;.4121Inverse the uote

ID-$'%6 12+;.1>;.4121

+

/$

+==

!#$1S2

That #as a simple case #hen only mean rate is given. Do# let us see #hat happens #hen bidand ask rates are uoted.

'%6$ID- >;.4121$>;.411

12+;.4121

+

/$

+===

.!2&S3 !#$1S21S2

!#$

12+.141,1.>;

+

/$

+ ===&S3

.!2 !#$1S21S2!#$

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(4lease note that for finding .!2 rate, we have to inverse &S3 rate and for finding &S3 rate we have to inverse

.!2 rate hat is the logic for this5

*urrency trade is basically a .&$"%$ trade !n any other trade, commodity is traded against a currency

6owever, in currency trade, both sides have currencies but of different type !t is like one side having wheat andthe other side having rice and both ready to e7change their commodity for the other+s for a negotiated e7change

rate !n such a situation there is no seller and no buyer Saying it other way round, both are sellers and both arebuyers hen one buys other+s commodity, he simultaneously sells his commodity So, when one trader says 8 !

am willing to sell one dollar for

$s 9, it can also be interpreted as : he is willing to buy $upee for ';9 dollar "hus, his &S3 rate of $s 9 for adollar has become his .!2 rate for a $upee in inverse quote at ';9 dollar "herefore, when currency quotes

(e7change rates) are inversed, .id and &sk rates also have to be inversed)

"&o Point Ar,itrageA &hen t#o locations are involved in the dealing, it is possible to buy a currencyfrom one location$market and sell it in other market and earn arbitrage. For example, some one canpurchase dollars in India and sell them in '% market for -upee. This is called T#o *oint (rbitrage.

"hree Point Ar,itrage A %ome times (rbitrage opportunity is available by currency exchangeoperations across t#o or three markets. In such an operation, first one currency is purchased in onemarket and then sold in second market for a third currency. Third currency is then sold in third or firstmarket for original currency.

%uppose, there are three currencies (, ! and C. Ruotes are available for ($!, !$C and C$(

(*;&).!2 < (.;&).!2X (*;.).!2

&S3&S3

.!2

*..&&*

/$

+

/$

+/$ =

(D6

(*;&)&S3 < (.;&)&S3X (*;.)&S3

.!2.!2

&S3

*..&&*

/$

+

/$

+/$ =

Forard .uotes

For#ard uotes are one #here a dealer uotes for purchase and selling of forex at a future date. Theseuotes are mainly useful for exporters and importers #ho commit to sell their #are or buy the importedstuff based on exchange rate prevailing on that date. Ho#ever, money is received or paid in foreigncurrency at a much later date. (ny large adverse movement of exchange rate in the interim can lead toheavy losses. Therefore, importers and exporters cover their risk by utilisation of these for#ard uotes.5arious terminologies associated #ith for#ard uotes are as follo#s?

Sot 6ealA %ettlement on TL2 days Q"> refers to Transaction 6ate. Thus, delivery of forex andpayment of cash for a transaction done on )onday has to be completed (settled)by &ednesday/

Sotcash6ealA %ettlement on T L 1 days %ame day payment/Sot"om6ealA %ettlement on T L + 6ay Dext 6ay *ayment/

For#ard deals could be TL+1, T L 41, T L 1, etc. (&dd = working days for each settlement).

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Inter 6ealer For#ard Ruotes are not direct. :nly differential amount to spot deal rates are uoted.Thus, if

7!*$ID-spot


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(ns. For + month +< days

daysdays

daysdays

+;.141$>;.;.2;;.141$>;.;.2;< n 4 months

For#ard *remium +114

+2>;.2;;.2;;.,2;<

! +3471*Thus, there is a 1.


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Factors affecting the Forex for&ard ?!ote

+. InflationA The currency of the country experiencing higher inflation rate#ill depreciate in value

2. Interest RateA Capital #ill move from lo# interest rate country to higherinterest country. Thus, currency of country #ith higher interest rate #ill appreciate due to higherdemand.

For#ard -ate

++

$-

$2

!

!Spot$ate

+

+

&hereI-6 Interest -ate in 6omestic )arketI-F Interest -ate in Foreign )arket

Pro,lem 1(

7iven %pot '%6$ID- >


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invest in treasury bond at +2K #hile simultaneously buying '%6 ; months For#ard >;

.>>K

Thus, if you invest in ID-, you #ould make a loss of .>>K in for#ard deal #here as your earningfrom interest #ould be +2 A 3 > A < 4.>>K.

This kind of transaction is possible only #hen 7ovt gives freedom to buy and sell ID- or '%6 in bothcountries.

Do# in this case, borro# ID- >.23.312

Thus, there #ould be gain of ID- >.2< @ >3.312 ID- 1.>1< per ID- >.1121 invested or 4.>>K.

Pro,lem 1/

%pot -ate '%6$ID- ? >4.31$>>.14.31L1.>1$>>.1>.+1$>>.34.31

>4.31@>>.3.1K

Interest -ate 6ifferential A 2 ;K

Thus, #hile #e lose >.K in for#ard mkt, #e earn ;K in money mkt. Thus, net gain is ;A>.+.2K.

%tart #ith '%6 +11 borro#ed from '% market.

"iability in '% market after ; months

+

+11

2

+2

;++11

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'%6 +1+%o, if #e borro# ID- and invest in '%6 is moving at a premium in ID- #e #ill make a loss

Interest (r#itrage

Interest (rbitrage refers to the international flo# of short term liuid capital Fixed 6epositsdenominated in Foreign Currencies or Convertible local currency/ to earn a higher interest abroad. InIndia #e have D-Is investing in fixed deposits to earn higher interest rates. Interest arbitrage can beuncovered or covered.

@ncovered Interest Ar,itrage

In order to be able to able to take benefit of higher interest opportunity in foreign country, it is oftennecessary to convert the domestic currency to foreign currency #hile investing in foreign country andthen reconverting principal and interest earned to local currency at the time of maturity.

In the countries #here interest rates are higher, inflation is also higher. nominal interest rate is mostlyeual to real interest rate L inflation/. &hen inflation is higher, the currency mostly depreciates overtime. Thus, there is a risk of depreciation of investment due to lo#er exchange rate during the re@conversion after maturity. If such a foreign exchange risk is covered, #e have covered interestarbitrage, else, #e have uncovered interest arbitrage.

%uppose, interest rate in India is ++K #here as it is


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Interest Rate 6ifferential Covered Interest Ar,itrage and Interest Parity "heory 4

2

(rbitrage

+

1

@+ .

.

@2

@4 @4 @2 @+ 1 + 2 4 For#ard Exchange -ate A 6iscount or premium in percent per annum

Explanation of the above figure

Ar,itrage #!tflo& &ill take lace

+. If L/ve interest rate differential is U For#ard 6iscount like at *oint (,Interest -ate 6ifferential 2, and F#d 6iscount 1.;

>


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Take a hypothetical case #here a "ong straddle has been entered into #ith *ut :ption purchased at%trike *rice of ID- >3 and a Call :ption at %trike *rice of ID- >;. %imilarly, in the put the option, theoretically profit #illstart the moment price falls belo# -s >3. Ho#ever, in order to recover the premium that #e paid, priceshould fall to minimum -s >;. Thus, #hen #e account for premiums also, the lines shift and ne#graph #ill look like as sho#n by firm lines. Do# #e see that at any exchange rate, the person does notsuffer any loss. In the #orst case scenario, at the spot rate of ID- >;, he #ould break even. In any othersituation, he #ould make some profit. There could be some loss at times in case the premium is toohigh and spread bet#een the call and put rate being relatively small (situation represented in graph with lightblue lines Goss is shown in such case as orange shaded area which is comparatively small/.

Exotic #tions

&hat have been discussed so far #ere 5anilla :ptions Contracts as practiced in India. These #ere thecontracts #here there #ere no conditions attached to the contracts. In many countries, options contractsare available #ith additional conditions. %uch contracts are called Exotic :ptions Contracts. &hilethese options contracts are not available in India through official channels, there is no bar in enteringinto them on :TC :ver the counter/ basis.

+. "!nnel #tion Contract &ith ero Premi!m @ This contract isalso called cylinder options contract. In this case, the upper limits of exercise price for Call:ption is specified. Even if the spot price of asset exceeds the limit price, deal #ould be done atlimit price only. Thus, the loss to the Call %eller has been limited. %imilarly, limit price for

exercise of *ut option is also specified thus limiting the max loss of the *ut option #riter. %incethe loss of #riter has been capped, and the possible gain of the buyer has been capped, there isNero premium.

Eg. *ut :ption sold at %trike *rice of ID- >;.2< #ith the exercise price capped at ID->;. Do#, even if the spot rate falls to ID- >>, the exercise price #ill be considered to be ID- >;only and the seller #ill pay only ID- 1.2< per dollar to the buyer.

2. 4nock #!t #tionsA This is a further amendment to the Tunnel:ption. In this case, if the spot price moves beyond the limit price, the contract is knocked out#hich means that contract becomes null and void and no settlement takes place. %uch kind of

Page of 47 - International Finance (Ver 1.1)

*ut :ption %trike*rice "ine

Call :ption%trike *rice "ine

*ut :ption

minus *remium Call :ption plus*remium

Gong Strangle Craph

>;

>< >3

*rofit

"oss

41


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contract is not possible under (merican Contracts method. This happens only in Europeancontracts #here the contract expiry date is fixed. The premium for such contract is again verylo# because sellerGs position is #ell protected.

4. ook Back #tion A This is one option #hich has very highpremium because it is heavily loaded in favour of buyer. 'nder this option, the deal is done atmost favourable price for the buyer in the period preceding the settlement date. It allo#s thebuyer to look back and select the most favourable rate in the past for settlement. %o, if the ratesin the past #ere >;.++, >;.4+, >;.;.>;.4, >;.21 on the days fromcontract to the settlement date, Call option buyer can look back into the past and select 829):#hich is the highest in the period as the settlement price. (t the same time a put option buyer#ill be allo#ed to select >;.++ as the exercise price because that is most favourable to him.

>. Average Rate #tion Contract A This is also called (sianContract. 'nder this contract, the exercise price is the average of closing prices since contractdate.

S%APS

'nlike Futures and :ptions, Sa" is not a risk management strategy. It is a strategy to takeadvantage of differential opportunities for different people.

%#ap, as the name suggests, is the exchange of liabilities. T#o people having liabilities of differenttypes exchange their liabilities for some perceived advantage. For example, a French company #antingdollar loan might be getting better rates in French Francs. (nother company in '% might #ant FrenchFrancs but it is advantageous for it to borro# dollars. The t#o can borro# #hat is advantageous tothem and then mutually exchange their currencies along #ith their payment liabilities #ithout involving

their lenders.

It could also be a s#ap bet#een current and future liabilities of same person. ( person may purchasespot currency V by selling currency 8 and simultaneously selling for#ard currency V buying currency8. Thus, there is one spot deal and one for#ard deal. %uppose, you are due to receive '%6 +111 threemonths from no# and have some excellent investment opportunity in '%6. %o, you spot buy the '%6+111 against ID- and for#ard sell three months/ '%6 +111. :nce you receive '%6 +111 threemonths later, you suare up the for#ard position and get back the rupees that you had invested.

%#ap comes in many forms, like interest rate s#aps, currency s#aps, positions s#ap, etc.a/ %pot For#ard %#ap A (s explained above.

b/ For#ard For#ard %#ap A !oth transactions are in future but executable on differentdates.

c/ Interest %#apd/ Currency %#ap

Interest S&asa/ Fixed to Fixed Interest rate %#apsb/ Fixed to Floating Interest rate %#apsc/ Floating to Floating Interest -ate %#aps.

Page of 47 - International Finance (Ver 1.1)4+


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Exam"le )

Company ( is offered loan in the market ++K fixed and "I!:- L 1.


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C!rrency S&as

Cross C!rrency S&as Along %ith S&a of Interest Rate ia,ility9

First ever such deal #as bet#een I!) and the &orld !ank. I!) had CHF loan and #anted to convertinto '%6 loan. :n the other hand &orld !ank #anted CHF loan but interest rates in %#itNerland hadalready risen uite a bit. The t#o agreed to s#ap the loan and &orld !ank floated '%6 bonds in '%market for euivalent amount to CHF loan of I!). :nce the money #as collected, they s#apped theirloans. I!) began to service '% lenders on behalf of &orld !ank #hile &orld !ank began to serviceI!) lenders in %#itNerland.

Do# suppose, &orld !ank issued bonds 4K in '% market for '%6 +11,111,111 and I!) loan #asCHF 411,111,111 #ith exchange rate being CHF 4 per '%6.

Comany Pay to Market #ther Party

ays to Co

Pay to other

Party

5et Rate of

Interest

$ain

&orld !ank 4K 4.+1K .+1 K

I!) K .+1K 4.+1 4K

!iggest Challenge in case of s#ap transaction is to find another party #hich has correspondingreuirements #here amount, duration, and type match. To fill this gap, banks act as a mediator$broker.They charge a small fees in form of percentage of interest gained from both the parties.

Even #ith banks acting as mediator, it is not al#ays possible to finding a matching company. %o, atrend is emerging #here in the banks have started acting as the counter party. (!s it not the same as basic

function of banks5 !n case of direct lending and deposits, they do not match the tenure and amount Same is the condition in

this case).

( normal deposit and lending function carries t#o risks?

a/ Credit RiskA The borro#er may default in payment.

b/ Interest Rate RiskA In case of interest rates movement, the customer at disadvantagemay foreclose his account but the one #ho gains #ill not. The loss #ill then have to beborne by the bank.

In case of s#ap functions there could be another risk, ie.

c/ Exchange Rate RiskA The t#o currencies may move in a divergent fashion leading tosame situation as in case of interest rates.

Thus, it is necessary to cover their positions #ith counter s#ap.



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Pro,lemA

Comany Fixed Floating Preference

( ,+ ; "ibor L 1.


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for euros has fallen from 3 to 4$Z+.11.

Comany Pay toMarket

Receivefm other

Co

6ifferential

Pay tootherCo

5et Rate ofInterest

$ain

Centralia K .,???) from Spanish M#* for years and then a lump sum

payment of 1S2 ',??,??? at the end of years Spanish M#* will receive payment H E annum (ie %uro ',@=,==)= from

*entralia over the same period and then %uro 'IIIII at the end of the years)

"oan 8 + 8 2 8 4 8 > 8 < 8 ; 8 3 8 8 Centralia +311111 +4;111 +4;111 +4;111 +4;111 +4;111 +4;111 +4;111 +311111

%pain)DC

+ +42222 +42222 +42222 +42222 +42222 +42222 +42222 +

Calculating *resent 5alue of above payments?

(4lease note that above are #1!"!%S (where a fi7ed amount is paid every year for a number of years) of year each at

different rates of interests "here are three methods to calculate the 4resent alue of an annuity and can be calculated by

any of the three methods -irst method is e7plained on previous page)

Second Method? *5 of an annuity ( )

+

n

rrr*

+

++

"hird Method? @ Tables are available at the end of every F) book #hich give value of annuity factorfor any given combination of interest rate and duration. The annuity factor can be used to multiply #ithprincipal amount to arrive at the present value of any annuity.

("he problem with first method is that it is too long and cumbersome, where as third method requires availability of tables

!t also does not give value for fraction of interest rates like DD "hus, second method is by far the best method)

%o, *5 of Centralia Income +4;111( )

+

31;.1+1;.1

+

1;.1

+

+4;111 x


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3 %ep 211; a loan of '%6


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available at "ibor plus > to < K #here as -upee loans cost as much as to +1K. Thus, there is stillmargin of 4 to < K available for an Indian Company.

&hen an Indian company or bank takes a 8en loan, it is hoping that the 8en #ont appreciate comparedto Indian currency, nor #ill the interest rate in 0apan fluctuate #ildly during the loan period. !ut,lendersG expectations are 9ust the opposite. They are hoping that 8en #ill appreciate and even theinterest rates in 0apan #ill harden. The deal takes place because of contrary expectations of t#o parties.

%imilarly, %#iss Frank "ibor rate is currently at 2K. (dd a fe# percent and it is still cheaper to borro#but #ith the risk of "ibor increasing as also appreciation in value of %#iss Frank #hich may #ipe outall the gains of lo#er interest rate prevailing no#.

&hile there is a cap placed on EC!, there is no cap on %#ap deals.

Balance of Payment ConcetAcco!nting

!alance of *ayment (ccount is (ccounting record of economic transactions #ith the #orld. (nytransaction #hich can be converted into money terms is recorded. !alance of *ayment account has

three main heads? @

a/ Current (ccount -evenue Transactions/

b/ Capital (ccount

c/ -eserve (ccount "iability of Central !ank/

The rules for accounting are A

a/ Cr all transactions #hich lead to receipt of Forex from rest of the #orld and 6r thereceipt of forex itself.

b/ 6r all transactions #hich lead to payment of forex to -est of &orld -o&/. Cr thepayment of forex itself.

This account also follo#s the typical double entry book keeping system. There is a debit entryfor every credit entry and vice versa. (!t is the same principle which we studied while studying &ccounting*redit the account which generates the income (so *r sales account for sales) but debit the account which receivesthe payment (so 2r cash account)

-eserve !ank !ulletin for !alance of *ayment status %ep 211;/ is available athttp?$$rbidocs.rbi.org.in$rdocs$!ulletin$*6Fs$32


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"ransortA Fares paid for material and men for international movement. Ticket fares paid forinternational travel are accounted under this head but not the travel fares #ithin thecountry.

$9n9i9e9A $overnment5otIncludedElse#here

Some "yical "ransactionsD

+. (n Indian Company exporting goods #orth -s +11 million to rest of the #orldand receiving payment in bank.

!y )erchandise Cr +11 million To !anking 6r +11 million

2. Indian Co. exporting to -o& on '%6


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CAPI"A ACC#@5" C#5=ER"IBII"

The govt has allo#ed 6e@0ure *urrent &ccount *onvertibilitybut not 6e@Facto convertibility.&hat it means is that current account convertibility is only in the name. &hile there are no limitsplaced on current account convertibility for import and export purposes, there are logical limitsimposed on convertibility for other reasons like personal travel, business travel, medical treatment,%tudies, )aintenance, etc.

Convertibility on Capital (ccount, also called full float of rupee, is still far #ay off. Eventhough Tarapore Committee (Salient $ecommendations listed below) had recommended Capital (ccountConvertibility, 7ovt and -!I are treading a cautious approach. The repercussions of Capital (ccountConvertibility can be disastrous if things go #rong. The #orld learnt it through East (sian EconomicCrisis in +3. !ooming Economies suddenly collapsed in a matter of days.

:nce Capital (ccount convertibility is allo#ed, every one is allo#ed a free hand to invest inand dis@invest from the country as much as and #henever he #ants. (t the first sign of trouble,investors rush to dis@invest and the cascading effect on economy is crippling. Currently, there are capson ho# much can one invest abroad or ho# much can a foreign company invest in #hich

company$sector. In addition, before investing, companies have to register themselves. There are caps onEC! as #ell.

For further details on Capital account, read last semester notes on FE)( compiled andfor#arded by )r *arab.

REC8MME>D($I8>S 8F $(R(/8RE C8MMI$$EE 8>

C(/I$(9 (CC8>$ C8>@ER$IBI9I$A

( committee on *apital &ccount *onvertibility, #as setup by the -eserve !ank of India -!I/ under

the chairmanship of former -!I deputy governor %.%. Tarapore in to [lay the road map[ to capitalaccount convertibility. The committee submitted its report in +3. (t the moment it is still a report andcentral bank has to accept the recommendations of the committee.

The five@member committee had recommended a three@year time frame for complete convertibility by+@2111. The highlights of the report including the preconditions to be achieved for the full float ofmoney are as follo#s?@

Pre-Conditions+. 7ross fiscal deficit to 76* ratio has to come do#n from a budgeted >.< per cent in

+3@ to 4.. 7ross D*(s of the public sector banking system needs to be brought do#n from thepresent +4.3K to


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h/ There is a strong case for liberalising the overall policy regime on goldM !anks and FIsfulfilling #ell defined criteria may be allo#ed to participate in gold markets in India andabroad and deal in gold products.

I5"ER5A"I#5A FI5A5CIA MAR4E"S

International Financial )arket can be divided as follo#s?

a/ Euro Currency )arketb/ International forex and bond marketc/ International euity market

Euro Currency Markets

%hat is E!ro C!rrency.Euro currency is not to be confused #ith currency of European 'nion. It has no relation to Euro or forthat matter #ith any currency in particular.Eurocurrencyis the term used to describe deposits residing in banks that are located outside theborders$legal 9urisdiction of the country of currency the deposits are denominated in. For example, a

deposit denominated in '% dollars residing in a 0apanese bank is a Eurocurrency deposit, or morespecifically a Eurodollar deposit.

(s the example identifies, it is important to note that despite its name, Eurocurrencies are not limited toEurope and as such it must not be confused #ith the Euro. The use of this idiosyncratic term arose fromthe fact that Eurocurrency markets first developed in Europe during the +


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2. #il crisis#hich benefited gulf countries. *etro dollars earned by middle east countries neededto be invested. (merica has been having a love hate relationship #ith )iddle East for a longtime and therefore they did not #ant to part all their petro dollars in '%(. In addition, depositrates on external deposits #ere comparatively lo# in '%(.

4. -elaxation of banking norms in the European region.)ain centers of Euro Currency markets are "ondon, Frankfurt, %ingapore, Hong Bong, etc.

CategoriGation of E!ro C!rrency Market+. E!ro 6eosit Market E!ro Credit MarketA This refers to simple deposit and lending function

of a third country currency in Euro !ank.2. Euro commercial paper market.4. E!ro Bond MarketA E.g. (n Indian Corporate house floating bond denominated in terms of

8en or dollars in "ondon.

Advantages of E!ro 6eosit Credit MarketEuro !anks are normally beyond the tight controls of Central !anks of the country and do not need tofollo# the stringent %"- and C-- ratios, interest rate regulations, etc. This lo#ers their cost ofoperation and Thus, they are able to offer better deposit and lending rates than normal domestic banks.

#ffshore Financial Centre:FC are certain specific locations on the #orld map A

+. &hich are tax heavens2. En9oy scenario of lo# or no government regulations and4. :ffer the advantage of banking secrecy and anonymity. "ike erst#hile %#iss !anks #hich #ere

notorious for being repository of black money of the #orld, :ffshore Financial centres areprovide similar secrecy and anonymity though they do not en9oy same kind of confidence as%#iss !anks.

There are some


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c/ :ffshore banks do not need to follo# the reserve reuirement guidelines and have lo#erregulatory expenses Thus, their lending rates are lo#er and deposits rates moreattractive.

Page of 47 - International Finance (Ver 1.1)>4


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International Bond MarketCategoriNation of International bond market Aa/ Euro !ondsb/ Foreign !ondsc/ 7lobal !onds

E!ro Bonds!onds #hich are floated in the currency other than the currency of the country in #hich they are floated

by a company of the third country called Euro !onds. Thus, if an Indian company floats '%6denominated bonds in 'B, they #ill be called Euro !onds.

Foreign Bonds!onds #hich are floated in the local currency of the country of floatation by a foreign company arecalled Foreign !onds. Thus, if an Indian company floats '%6 denominated bonds in '%(, they #ill becalled Foreign !onds.

"yes of Foreign Bondsa/ ankee BondsA These are foreign bonds floated in '%(b/ B!lldog BondsA These are foreign bonds floated in 'B

c/ Sam!rai and Shi,osai BondsAi/ SamuraiA These are 8en bonds floated in 0apan in open market.ii/ Shi#osaiA These are 8en bonds floated on *vt *lacement basis.

d/ 6ragon BondsA These are foreign bonds issued in local currencies of the %outh (siancountries.

#ther "yes of Bonds+. Straight BondsA These are plain vanilla bonds #ith fixed rate of interest and fixed date of

maturity.2. Floating Rate BondsA These are "I!:- linked interest rate variable interest rate bonds #here

in interest rate is ad9usted every ; months.

4. Con&erti#le BondsA These bonds convert into euity share after the specified period of time.In this category, there could be fully convertible or partly convertible bonds.>. Floating rate #ond ith collarsA These floating rate bonds have upper and lo#er limits of

interest rate variation. Thus, the max and min interest payable are capped irrespective ofmovement of interest rate in the market.


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3. Calla#le BondsA These are the bonds #herein the company reserves the option to call back thebonds prior to maturity but after the lock@in period. %uch bonds are issued #hena/ 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.. /utta#le BondsA These are bonds #herein the buyer has option to sell back to company any

time after the lock@in period. %uch bonds are issued if the company does not en9oy very goodcredit rating in the market to give some confidence to the investors.

. Dual Currency Bonds or -y#rid BondsA These are bonds #hich are sold in one currency andpayment of interest or principal or both is done in another currency. Eg. (n Indian companymay float a '%6 bond in '% and pay the interest and principal back in ID-.

Bond Iss!e Proced!re+. Issuing company takes the approval of the !oard of 6irectors.2. Issuing company appoints "ead )anager.4. In consultation #ith the issue manager, the company appoints Co@)anagers, 'nder #riters,

!rokers to the issue.>. The "ead manager prepares the draft document for the bond issue and the bond rate is decided.


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f/ Syndicate oans A These are large loans for #hich no single bank #ants to take fullexposure. Thus, a group of banks 9oin together and lend as a group. Thus, the risk isspread out. "oan to Enron Corporation for 6abhol *o#er *ro9ect is one example ofsyndicated loan.

Proced!re of Syndicate oans+. !orro#er prepares Information )emorandum.2. I) carries details of the borro#er, the amount of loan needed, proposed maturity period

of the loan, purpose of the loan etc.4. !orro#ers send invitations to the international banks along #ith the I).>. !orro#er receives credit proposals and analyses them.


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lecture notes international finance printed

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