END TERM EXAMINATION, DECEMBER 2012 INTERNATIONAL FINANCIAL MANAGEMENT- MS 217 MBA III Ans1.

Spot Rate: Rs/AUD = 33/33.04 Rs/Euro = 56.49/56.56 Spot Rates for 31st June 2011: Rs/AUD = 32.15/32.21 Rs/Euro = 57.27/57.32 Case I Current Scenario Revenue for 2000 Units in Rupees would be := 2,000 x AUD 500 x 33 (Spot Bid Rate) = Rs. 3,30,00,000 Cost for 2,000 Units in Rupees would be :a) RM = 2,000 x Euro 200 x 56.56 (Spot Ask Rate) = Rs. 2,26,24,000 b) Variable Cost = Rs. 1,250 x 2,000 = Rs. 25,00,000 c) Fixed Cost = Rs. 10,00,000 Total Cost = a+b+c = Rs. 2,61,24,000 Profit = Revenue- Cost = Rs. 3,30,00,000- Rs. 2,61,24,000 = Rs. 68,76,000 Case II Shipment in Last Week of July11 Change In Revenue = 2,000 x AUD 500 x 0.85 (i.e. 33- 32.15) = Rs. 8,50,000 (Decrease In Profits) Change In Cost = 2,000 x Euro 200 x 0.76 (i.e. 57.32-56.56) =Rs.3,04,000 (Increase In Costs) Net Transaction Exposure = Rs. 8,50,000+ Rs. 3,04,000 = Rs. 11,54,000

Now, Contribution Per Unit is of = = Rs. 3,361 Required Units = = 2046 (approx) Thus, Increase In Units is of 46 (approx) i.e. (2,046- 2,000) is required so as to maintain the current profits level of Rs. 68,76,000 after accounting for transaction exposure. Q 2: Briefly explain the impact of Macro-economic factors on exchange rates. What is the need to control exchange rates by central bank? Quote two strategies adopted by RBI recently to protect the declining Rupee. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well. Determinants of Exchange Rates Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. 1. Differentials in Inflation As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically experience depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. 2. Differentials in Interest Rates Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. (i.e. FC - TVC)

3. Current-Account Deficits The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. 4. Gross Domestic Product: When the gross domestic product increases it decrease the home currency depreciation. So the gross domestic product is influencing the exchange rate fluctuations decrease the home currency depreciation. So the gross domestic product is influencing the exchange rate fluctuation. Need to control exchange rate: Foreign exchange controls are various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents or on the purchase/sale of local currency by nonresidents. Common foreign exchange controls include: Banning the use of foreign currency within the country Banning locals from possessing foreign currency Restricting currency exchange to government-approved exchangers Fixed exchange rates Restrictions on the amount of currency that may be imported or exported The system of exchange control to be established was as follows: (a) To prohibit the acquisition of foreign exchange either directly or indirectly or the dealing in foreign exchange by residents in British India except under their authority (b) To require residents in British India to declare their belongings of foreign currencies and foreign securities and on the issue of special orders to surrender them (c) To prohibit the acquisition by residents of securities from persons resident outside India or the export of securities from India except with their permission; and (d) To prohibit dealings in bullion except under their authority Methods or Devices of Exchange Control. 1. Influencing Exchange Rate. Exchange control is exercised either by regulating international movements of goods through various devices or by the purchase and sale of foreign currency at specified rates in order to

maintain a particular range of exchange fluctuations. Exchange control can be exercised by influencing demand for, and supply of, currencies in the exchange market. This can be done indirectly by devices like tariffs, quotas, bounties, changes in interest rates, etc. Imposition of import duties and of import quotas will reduce imports, cut down the demand for foreign currency, lower its value or raise the value of the domestic currency. Export duties, which are not so common, will have the opposite effect. Bounties affect the other way about. Export bounty will raise and import bounty (which exists nowhere) will lower the value of the home currency. A rise in the interest rates attracts funds from abroad, increases demand for domestic currency and raises its value, and vice versa. But these are the ways in which exchange is influenced and not controlled. The effect of such devices can be offset by similar devices adopted by rival nations. These measures are not necessarily adopted for controlling exchange and are not sufficiently strong to bring rates of exchange under effective control. Hence, more direct methods have to be adopted. 2. Controlling Exchange Rate. There are two methods generally adopted for controlling exchange: Intervention: In this case, the government enters the exchange market either to purchase or to sell foreign exchange in order to bring the rate up or down to the desired level. This method has been called intervention and leads to exchange pegging. Restriction: In this case, the government can prevent the existing demand for, or supply of, the country, in which they are interested, from reaching the exchange market. This method has been called restriction. The second method has been more popular because intervention proved a weak weapon and was also expensive. 3. Exchange Control Proper. Exchange restriction is exchange control proper. For this three things are done: (a) all foreign dealings are centralised, usually in the central bank; (b) the national currency cannot be offered for exchange without previous permission, and (c) it is made a criminal offence to enter into an unauthorised foreign exchange transaction. The usual procedure is to order all exporters to surrender claims on foreign currency to the central bank and ratio the foreign exchange made so available among the licensed importers. Exchange, control thus involves import control. Up to 1939, Germany was a pioneer in the method of exchange control although exchange control was adopted in several other European countries also during the Great Depression (1929-33). Ans3. Duration = 6 months (180 Days) Spot Rate (Rs/$) = 52.70/72 Forward Rate (6 months) = 52.80/82 ROI$(6 months) = 4.20/4.50 % ROIRs(6 months) = 7.00/10.00 %

Case I - Pay Immediately Discount = $2,500 Net Payment = $5,47,500 ($5,50,000- $2,500) Payment in Rupees = $5,47,500x52.72 (Spot Ask Rate) = Rs. 2,88,64,200 Case II Forward Cover Net Payment = $5,50,000 Payment In Rupees = $5,50,000x 52.82 (Forward Ask Rate) = Rs. 2,90,51,000 Case III Money Market Net Payment = $5,50,000 Investment Required = = $ 527831.094 Borrowing in Rupees @ Spot Rate = $527831.09 x 52.72 = Rs. 2,78,27,255.28 Interest Payment @ 7% = Rs. 19,47,907.87 Net Cost = Rs. 2,78,27,255.28 + Rs. 19,47,907.87 = Rs. 2,97,75,163.15 Case IV- Bridge Loan Discount = $2,500 Net Payment = $5,47,500 ($5,50,000 - $2,500) Payment In Rupees = $5,47,500x 52.72 (Spot Ask Rate) = Rs. 2,88,64,200 Interest @13.5% p.a = Rs.2,88,64,200x % (As For 6 Months) = Rs. 19,48,333.5 Total Cost = Rs. 2,88,64,200 + Rs. 19,48,333.5 = Rs. 3,08,12,533.5 Total Cost is least for Case I and then for Case II. Q4: Highlight the salient features of foreign exchange management Act, 1999 & Reserve Bank of India Act, 1934 & Income tax Act, 1961 regulating the foreign exchange markets in India. Foreign Exchange Management Act, 1999

Ans:

The Foreign Exchange Management Act (FEMA) is an Act to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments

and for promoting the orderly development and maintenance of foreign exchange market in India. It was passed in the winter session of Parliament in 1999 replacing Foreign Exchange Regulation Act. This act seeks to make offenses related to foreign exchange civil offenses. It extends to the whole of India., which replaced Foreign Exchange Regulation Act (FERA), since FERA had become incompatible with the pro-liberalization policies of the Government of India. It has brought a new management regime of Foreign Exchange consistent with the emerging framework of the World Trade Organization (WTO). It is another matter that the enactment of FEMA also brought with it the Prevention of Money Laundering Act 2002, which came into effect from 1 July 2005. MAIN FEATURES OF THE ACT: REGULATING THE FOREIGN EXCHANGE MARKETS IN INDIA. Activities such as payments made to any person outside India or receipts from them, along with the deals in foreign exchange and foreign security is restricted. It is FEMA that gives the central government the power to impose the restrictions. Restrictions are imposed on people living in India who carry out transactions in foreign exchange, foreign security or who own or hold immovable property abroad. Without general or specific permission of the Reserve Bank of India, FEMA restricts the transactions involving foreign exchange or foreign security and payments from outside the country to India the transactions should be made only through an authorized person. Deals in foreign exchange under the current account by an authorized person can be restricted by the Central Government, based on public interest. Although selling or drawing of foreign exchange is done through an authorized person, the RBI is empowered by this Act to subject the capital account transactions to a number of restrictions. People living in India will be permitted to carry out transactions in foreign exchange, foreign security or to own or hold immovable property abroad if the currency, security or property was owned or acquired when he/she was living outside India, or when it was inherited to him/her by someone living outside India. Exporters are needed to furnish their export details to RBI. To ensure that the transactions are carried out properly, RBI may ask the exporters to comply with its necessary requirements.

RBI ACT, 1934: The Reserve Bank of India (RBI) is India's central banking institution, which controls the monetary policy of the Indian rupee. It was established on 1 April 1935 during the British Raj in accordance with the provisions of the Reserve Bank of India Act, 1934. The share capital was divided into shares of 100 each fully paid which was entirely owned by private shareholders in the beginning. Following India's independence in 1947, the RBI was nationalized in the year 1949.

FEATURES OF THE ACT ARE: The RBI plays a key role in the regulation & development of the foreign exchange market & assumes three broad roles relating to foreign exchange: Regulating transactions related to the external sector & facilitating the development of the foreign exchange market Ensuring smooth conduct & orderly conditions in the domestic foreign exchange market Managing the foreign currency assets & gold reserves of the country.

INCOME TAX ACT, 1961: The Income-tax Act, 1961 is the charging Statute of Income Tax in India. It provides for levy, administration, collection and recovery of Income Tax. Recently the Government of India has brought out a draft statute called the "Direct Taxes Code" intended to replace the Income Tax Act, 1961 and the Wealth Tax Act, 1956. FEATURES OF THE ACT ARE: Where the gross total income of an assessee, being an Indian company, or a person (other than a company) who is resident in India includes any income received by the assessee from the Government of a foreign State or foreign enterprise in consideration for the use outside India of any patent, invention, design or registered trade mark, and such income is received in convertible foreign exchange in India, or having been received in convertible foreign exchange outside India, or having been converted into convertible foreign exchange outside India, is brought into India, by or on behalf of the assessee in accordance with any law for the time being in force for regulating payments and dealings in foreign exchange, there shall be allowed, in accordance with and subject to the provisions of section 80 O, a deduction of an amount equal to fifty per cent of the income so received in, or brought into, India, in computing the total income of the assessee : Provided that such income is received in India within a period of six months from the end of the previous year or within such further period as the competent authority may allow in this behalf. Provided further that no deduction under this section shall be allowed unless the assessee furnishes a certificate, in the prescribed form, along with the return of income, certifying that the deduction has been correctly claimed in accordance with the provisions of this section. Where the gross total income of an individual resident in India, being an author, playwright, artist, musician, actor or sportsman (including an athlete), includes any income derived by him in the exercise of his profession from the Government of a foreign State or any person not resident in India, there shall be allowed in computing the total income of the individual, a deduction from such income of an amount equal to seventy-five per cent of such income, as is brought into India by, or on behalf of, the assessee in convertible foreign exchange within a period of six months from the end of the previous year or within such further period as the competent authority may allow in this behalf. Provided that no deduction under this section 80RR shall be

allowed unless the assessee furnishes a certificate, in the prescribed form, along with the return of income, certifying that the deduction has been correctly claimed in accordance with the provisions of this section. Ans5. Case I- Payment After 1-month Currency (1) S$ USD ($) EURO () Pounds () Payment in Respective Currency (2) 3,39,555 2,29,740 1,75,470 1,22,000 Interest Payments in Respective Currency (3) 976.22 957.25 424.053 472.75 Total Payments in Respective Currency (4 = 2+3) 340531 230697 175894 122473 Forward Rate (Ask) (5) 27.25 42.04 56 83.16 Payment in Rupees (6 = 4 x 5) 9279475.745 9698512.39 9850066.94 10184833.89

Notes:Column 3: Interest = Payment x (Rate/12) E.g S$ = 3,39,555 x = S$ 976.22 and so on.

Column 5: Ask Rate = Spot Rate + Corresponding Swap Points E.g S$ = 27.18 + 0.07 = 27.25 and so on.

Case II- Payment After 2-months (Fixed as1,20,000) Currency Xge Xge Payment in Interest Rate Rate Respective Payments w.r.t w.r.t Currency in Pound Pound (@Bid Respective (Bid) (Ask) Rate) Currency (1) (2) (3) (4) (5) S$ 3.0460 3.0600 3,65,520 2,132.2 USD ($) 1.9775 2.0309 1.4854 1 2,37,300 1,77,936 1,20,000 2,076.375 889.68 940

Total Payments in Respective Currency (6 = 4+5) 3,67,652.2 2,39,376.38 1,78,825.68 1,20,940

Forw- Payment ard Rupees Rate (Ask) (7) 27.25 42.04 56 83.16

in

(8 = 6 x 7) 1,00,18,522.5 1,00,63,382.8 1,00,14,238.1 1,00,57,370.4

EURO () 1.4828 Pounds () 1

Notes:Column 2: Bid Rate (S$/) = Column 3: Ask Rate (S$/) = = = = 3.046 and so on. = 3.060 and so on.

Column 4: Column 2 x 1,20,000 E.g S$ = 3.0460 x 1,20,000 = S$ 3,65,520 Column 5: Interest = Payment x (Rate/6) Column 7: Ask Rate = Spot Rate + Corresponding Swap Points

Q6 Economic Exposure is managed through various marketing, production and financial management strategies, as the traditional hedging tools are not appropriate techniques for managing economic exposure. Discuss different types of strategies a firm can adopt to manage economic exposure. Ans: Exposure refers to the degree to which a company is affected by exchange rate changes. Exchange rate risk is defined as the variability of a firms value due to uncertain changes in the rate of exchange. Foreign exchange exposure is the risk of loss stemming from exposure to adverse foreign exchange rate movements. It is a measure of the potential change in a firms profitability, net cash flow, and market value because of a change in exchange rates Types of exposure

Transaction exposure Translation Exposure

Economic/ Operational exposure

Transaction exposure - The transaction exposure component of the foreign exchange rates is also referred to as a short-term economic exposure.This relates to the risk attached to specific contracts in which the company has already entered that result in foreign exchange exposures. A company may have a transaction exposure if it is either on the buy side or sell side of a business transaction. Any transaction that leads to an inflow or outflow of a foreign currency results in a transaction exposure.

Transaction exposure arises from: Purchasing or selling on credit goods or services whose prices are stated in foreign currencies. - Borrowing or lending funds when repayment is to be made in a foreign currency. - Otherwise acquiring assets or incurring liabilities denominated in foreign currencies. Translation Exposure - Translational exposure of foreign exchange is of an accounting nature and is related to a gain or loss arising from the conversion or translation of the financial statements of a subsidiary located in another country. -

Translation exposure = exposed assets- exposed liabilities A company such as General Motors may sell cars in about 200 countries and manufacture those cars in as many as 50 different countries. Such a company owns subsidiaries or operations in foreign countries and is exposed to translation risk. At the end of the financial year the company is required to report all its combined operations in the domestic currency terms leading to a loss or gain resulting from the movement in various foreign currencies. Economic/Operating Exposure - It is defined as the extent to which the value of the firm, as measured by the present value of all expected future cash flows, will change when exchange rates change. Economic exposure is a rather long-term effect of the transaction exposure. If a firm is continuously affected by an unavoidable exposure to foreign exchange over the long-term, it is said to have an economic exposure. Such exposure to foreign exchange results in an impact on the market value of the company as the risk is inherent to the company and impacts its profitability over the years. Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms. Operational Strategies for Managing Economic/Operating Exposure By its very definition, operating exposure is the impact of exchange rate changes on the firm's actual operations. Therefore, the first place to consider how to manage this exposure is to consider operation responses to exchange rate changes. Ideally the firm would like to set up its operations, production, sourcing, marketing such that the firm can respond to change in the real exchange rate so as to take advantage of the improved competitive positions and/or limit the harm caused by the degradation of competitiveness. These may be either ex ante actions that provide the firm an operating option, or marginal changes in activity intensity that try to mitigate the adverse impact of exchange rate fluctuations on firm value. Unlike financial hedging which provide the firm a deterministic cash flow in response to exchange rate movements with out any real economic actions on the part of the firm, operational strategies require the firms to react to the new economic environments resulting from the exchange rate change and make changes to the economic behavior of the firm. As we shall see below, there are operating strategies which will act as hedges of operating exposure in the

short term and others that are more suited to hedge the long term economic exposure of a firm. Marketing Strategies for Managing Operating Exposure Market Selection: A major strategic consideration for a firm is what market to sell in and the relative marketing support to devote to each market. For example, firms may decide to pull out of markets that have become unprofitable due to real exchange rate changes, and more aggressively pursue market share or expand into new markets when the real exchange rate depreciates. These decisions depend, among other things, on the fixed costs associated with establishing or increasing market share. Market selection and market segmentation provide the basic parameters within which a company can adjust its marketing mix over time. They are primarily medium and longer term decisions and may not be feasible strategies to react to exchange rate exposure in the short run. For shorter run marketing reactions to exchange rate exposure, the firm may have to turn to pricing or promotional policies. Pricing Policies: As we saw previously, in response to changes in real exchange rates, a firm has to make a decision regarding market share versus profit margin. This involves the pass through decision with respect to the foreign currency price of foreign sales. Of course, such a decision should be made by setting the price that maximizes dollar profits to the firm; however, since the world is stochastic, this is not always a clear choice. The decision on how to adjust the foreign currency price in response to exchange rate changes will depend upon how long the real exchange rate change is expected to persist, the extent of economies of scale that occur from maintaining large quantity of production, the cost structure of expanding output, the price elasticity of demand, and the likelihood of attracting competition if high unit profitability is apparent. The longer the exchange rate change is expected to persist, the greater the price elasticity of demand, the greater are the economies of scale and the greater is the possibility of attracting competition, the greater will be the incentive to lower home currency price and expand demand in light of a home currency depreciation, and to keep home currency price fixed and maintain demand in light of a home currency appreciation. However, in deciding to change prices, the firm should take into account the impact on cash flows not just today but in the future as well, as once a customer is lost, he may be lost for a long period of time making it difficult for a firm to regain market share Promotional Strategies: An essential issue in any marketing program is the size of the promotional budget for advertising, selling and merchandising. These budgets should explicitly build in exchange rate impacts. An example is European ski areas in the mid 1980s. When the dollar was strong, they found that they obtained larger returns on advertising in the U.S. for ski vacations in the Alps as the costs compared to the Rocky Mountains has fallen due to the currency movements.

 Production Strategies for Managing Operating Exposure All of these responses have involved attempts to alter the dollar value of foreign currency revenues. However, sometime real exchange rates change but such a large margin that marketing strategies and pricing decisions cannot make the product profitable. Firms facing such circumstances must either drop the products or cut costs. Product mix, product sourcing and plant location are the principle production strategies that companies can use to manage competitive risks that cannot be handled by marketing strategies alone. The basic idea is to diversify the production mix such that the effect of exchange rate changes washes out or tie costs more closely to foreign competitors. Diversifying Operations: One possibility to dealing with the impact of exchange rate exposure on the firm's cash flows is to have the firm diversify into activities with offsetting exposures to the exchange rate. For example, combine the production and exporting of a manufactured good with an importing operation that imports competitive consumer goods from foreign producers. This creates a natural operating hedge that keep total dollar cash flows steady in light of real exchange rate movements. While the benefits of this strategy are obvious, it has some potential drawbacks: it may lead the firm to enter into activities in which it has no apparent comparative advantage resulting in an inefficient source of resources, or alternatively, the firm may view the two activities as complementary and allow cross subsidization to occur for long periods of time and not consider the economic viability of each operation on its own. Put another way, unless done carefully, this can be an expensive way to hedge an operating exposure. Diversifying Sources of Inputs: For firms wishing to stick to their knitting, the goal of a production strategy should be to reduce operating costs. The most flexible way to do this in light of a real home currency appreciation is to purchase more components from overseas. As long a the inputs are not priced in a globally integrated market (i.e., gold or oil), then the appreciation should lower the dollar cost of the inputs and thus total production costs. For the longer term, the firm may wish to consider the option of designing new local facilities that provide added flexibility in making substitutions among various sources of inputs, either form domestic sources or foreign sources. However, this strategy does not bode well for the concept of good supplier relations, and potential costs associated with constantly switching suppliers needs to be taken into consideration when evaluating this strategy. Plant Location: The most obvious way to be able to take advantage of relative costs changes due to real currency movements is to have production costs based in different currency by actually having production capacity in different countries. The simplest response is to move production to your competitors market. Then any relative costadvantage he may gain from exchange rate changes also accrues to firm as well. Alternatively, placing a plant in a third country based upon the intensity of certain inputs to production

(i.e., labor, raw materials) may make more sense; however one needs to think about the correlations between the third country exchange rate and the foreign competitor's exchange rate to evaluate the hedge value of such an decision. The primary exposure management advantage to having foreign plant locations arises from the ability of the firm to shift production among the plants in response to real exchange rate change. Thus a firm with foreign plant can always produce at capacity in the location where costs are low, and meet additional demand from progressively higher costs locations. This is a generally a method for long run management of operating exposure, as plants take time to build. However, in response to a real exchange rate change that is expected to persist for some time, a firm may decide to undertake the development of foreign production through licensing or foreign acquisition. Financial Techniques Forward Contracts - When a firm has an agreement to pay (receive) a fixed amount of foreign currency at some date in the future, in most currencies it can obtain a contract today that specifies a price at which it can buy(sell) the foreign currency at the specified date in the future. This essentially converts the uncertain future home currency value of this liability (asset) into a certain home currency value to be received on the specified date, independent of the change in the exchange rate over the remaining life of the contract. Futures Contracts - These are equivalent to forward contracts in function, although they differ in several important features. Futures contracts are exchange traded and therefore have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. Given that futures contracts are available in only certain sizes, maturities and currencies, it is generally not possible to get an exactly offsetting position to totally eliminate the exposure. The futures contracts, unlike forward contracts, are traded on an exchange and have a liquid secondary market that make them easier to unwind or close out in case the contract timing does not match the exposure timing. In addition, the exchange requires position taker to post s bond (margins) based upon the value of their positions. This virtually eliminates the credit risk involved in trading in futures. Money Market Hedge - Also known as a synthetic forward contract, this method utilizes the fact from covered interest parity, that the forward price must be exactly equal to the current spot exchange rate times the ratio of the two currencies' riskless returns. It can also be thought of as a form of financing for the foreign currency transaction. A firm that has an agreement to pay foreign currency at a specified date in the future can determine the present value of the foreign currency obligation at the foreign currency lending rate and convert the appropriate amount of home currency given the current spot exchange rate. This converts the obligation into a home currency payable and eliminates all exchange risk. Similarly a firm that has an agreement to receive foreign currency at a specified date in the future can determine the present value of the foreign currency receipt at the foreign currency borrowing rate and borrow this amount of foreign currency and convert it into home currency at the current spot exchange rate. Since as a pure hedging need, this transaction replicates a forward, except

with an additional transaction, it will usually be dominated by a forward (or futures) for such purposes; however, if the firm needs to hedge and also needs some short term debt financing, wants to pay off some previously higher rate borrowing early, or has the home currency cash sitting around, this route may be more attractive that a forward contract. Options - Foreign currency options are contracts that have an up front fee, and give the owner the right, but not the obligation to trade domestic currency for foreign currency (or vice versa) in a specified quantity at a specified price over a specified time period. There are many different variations on options: puts and calls.

Q. 7 (a) Outline the historical framework of various exchange rate regimes on a global basis highlighting the role of IMF. Ans7(a) Exchange rate regimes refers to mechanism, procedures and institutional framework for determining exchange rates at a point in time and changes in them over time, including factors which induce the changes. The International Monetary System facilitates transfer of funds between parties, conversion of national currencies into one another, acquisition and liquidation of financial assets, and international credit creation. The IMF classifies member countries into eight categories Currency Union (No separate legal tender)- The currency of another country circulates as the sole legal tender (formal dollarization), or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union. Adopting such regimes implies the complete surrender of the monetary authorities' independent control over domestic monetary policy. Currency Board Arrangement- A monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. This implies that domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets, eliminating traditional central bank functions, such as monetary control and lender-of-last-resort, and leaving little scope for discretionary monetary policy. Some flexibility may still be afforded, depending on how strict the banking rules of the currency board arrangement are. Conventional Fixed Peg Arrangements- The country (formally or de facto) pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed from the currencies of major trading or financial partners and weights reflect the geographical distribution of trade, services, or capital flows. The currency composites can also be standardized, as in the case of the SDR. There is no commitment to keep the parity

irrevocably. The exchange rate may fluctuate within narrow margins of less than 1 percent around a central rate, or the maximum and minimum value of the exchange rate may remain within a narrow margin of 2 percent, for at least three months. The monetary authority stands ready to maintain the fixed parity through direct intervention (i.e., via sale/purchase of foreign exchange in the market) or indirect intervention (e.g., via aggressive use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or through intervention by other public institutions). Flexibility of monetary policy, though limited, is greater than in the case of exchange arrangements with no separate legal tender and currency boards because traditional central banking functions are still possible, and the monetary authority can adjust the level of the exchange rate, although relatively infrequently. Pegged Exchange Rates within Horizontal Bands - The value of the currency is maintained within certain margins of fluctuation of at least 1 percent around a fixed central rate or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent. It also includes arrangements of countries in the exchange rate mechanism (ERM) of the European Monetary System (EMS), which was replaced by the ERM II on January 1, 1999. There is a limited degree of monetary policy discretion, depending on the band width. Crawling Peg The currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators, such as past inflation differentials vis--vis major trading partners, differentials between the inflation target and expected inflation in major trading partners, and so forth. The rate of crawl can be set to generate inflation-adjusted changes in the exchange rate (backward looking), or set at a preannounced fixed rate and/or below the projected inflation differentials (forward looking). Maintaining a crawling peg imposes constraints on monetary policy in a manner similar to a fixed peg system. Exchange Rates within Crawling Bands - The currency is maintained within certain fluctuation margins of at least 1 percent around a central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent, and the central rate or margins are adjusted periodically at a fixed rate or in response to changes in selective quantitative indicators. The degree of exchange rate flexibility is a function of the band width. Bands are either symmetric around a crawling central parity or widen gradually with an asymmetric choice of the crawl of upper and lower bands (in the latter case, there may be no preannounced central rate). The commitment to maintain the exchange rate within the band imposes constraints on monetary policy, with the degree of policy independence being a function of the band width.

At last we can say that there are only two types of exchange rates only: 1. Managed Floating with No Predetermined Path for the Exchange Rate - The monetary authority attempts to influence the exchange rate without having a specific exchange rate path or target. Indicators for managing the rate are broadly judgmental (e.g., balance of payments position, international reserves, parallel market developments), and adjustments may not be automatic. Intervention may be direct or indirect. 2. Independently Floating - The exchange rate is market-determined, with any official foreign exchange market intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it. In these regimes, in principle, the authorities may pursue an independent monetary policy. 7(b) Define Balance of payments. What is the need to monitor it? Ans: Balance of payment - A Balance of Payment (BOP) account is a systematic record of all economic transactions (involving foreign payments) between residents of a country and the rest of the world carried out in specific period of time. Provides data for economic analysis Reveals changes in the composition & magnitude of foreign trade Provides indications of future repercussions of countrys past trade performances Reveals the weak and strong points of a countrys foreign trade relations

A Surplus in the BOP implies that the demand for the countrys currency exceeded the supply and that the government should allow the currency value to increase in value or intervene and accumulate additional foreign currency reserves in the Official Reserves Account A Deficit in the BOP implies an excess supply of the countrys currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value.

Balance of Payment

Current Account Capital Account

Official Reserve account

1.

Current Account - All transactions relating to goods, services and unrequited transfers constitute current account. Flow of items pertaining to specific period of time. Visible items include goods Invisible items include services Capital Account All transactions indicating changes in stock magnitudes concerning capital receipts and payments constitute capital account Relates to - Borrowing - Capital repayment - Sale of assets - Change in stock of gold - Change in reserve of foreign currency Official Reserve Account - represent the holdings by the government or official agencies of the means of payment that are generally accepted for the settlement of international claim. Eg: FOREX, GOLD

2.

3.

Need to monitor Balance of payment- There is a need to monitor Balance of payment as BOP guides in the following Guide to Economic Conditions and Direction Pictogram of Economic Changes Indicator of Foreign Changes Indicator of Foreign Dependency Knowledge of Foreign Investment Indicator of Foreign Trade Helpful in National Planning Determinant of National Economic Policy Helpful for International Financial Organisations

Q8. Highlight the major factors that need to be considered while evaluating an international project vis--vis a domestic one. How cost of capital is determined in such case? Ans. Factors that need to be considered while evaluating an international project It must be economically feasible to locate an operation in an area, or the area should not be considered for the project. As businesses continue to rationalize the size and location of their operations, all factors affecting profitability must be reviewed.

The critical factors impacting site selection decisions vary slightly in importance from project-to-project, but they are considered by all companies deciding where to expand or locate facilities. Please find below a summary of the key issues which should be evaluated by a company prior to making a site selection decision. 1. Location: A company must start the site selection process by identifying the potential geographic areas that could work for the project. There is no point in considering a location for the project, if you cannot serve clients from the prospective area. 2. Workforce: A business must be confident that there is an ample supply of prospective team members, with the necessary education and skill sets. As important, a company must be comfortable in its ability to attract, retain and afford the people required for its operations. 3. Real Estate: A company must evaluate potential real estate options in the locations under consideration for the project to ensure its requirements can be met. In most cases, several adequate real estate options exist for a project, but this should be verified. 4. Tax Structure: A business must have a complete picture of the local, regional and state tax environment to make certain it can operate profitably. Several areas of the country have made changes to their tax structures, and it is important to understand how these changes negatively or positively impact a companys project. 5. Infrastructure: A company must be confident that there is adequate infrastructure in place to meet the projects current and future requirements. Transportation, telecommunications and electric infrastructure, just to name a few, are critical infrastructure factors to evaluate during the site selection process. 6. Incentives: A business must have a thorough understanding of what forms of local, regional and/or state economic development incentives are available to help the company lower its project costs. Incentives should never drive site selection decisions, but they are important to ensure the economic feasibility of the project. 7. Regulatory Environment: A company must understand how local, regional and state governmental regulations will impact its business and project. Critical issues such as building plan approvals, environmental permits, utility connection approvals and waste disposal permits, can have a significant financial and timing impact on a companys project. 8. Cost of Living: A business must evaluate the cost of living in a potential geographic area. It is important for a company to understand the cost of living for an area to make certain it appreciates the impact on its team members who would be working in the selected community. 9. Unionization Rates: A company must review unionization rates prior to making a site selection decision for a new or expanded facility. Clearly, unionization rates and right-towork laws impact some industries more than others, but it should be considered by all businesses. 10. Quality of Life: A business should consider the quality of life in a region and state as a part of its decision making process. This business climate factor has become more important during the past decade as companies look to attract and retain knowledge workers.

Additional factors may impact a companys final decision regarding the location of a new or expanded operation; however, the aforementioned issues should always be on the list. These factors can be used quite effectively to eliminate potential locations from consideration. Once a business narrows its options to a few potential locations, the relationships built between the companys team members, economic development organizations and governmental entities become critical in selecting a location and successfully completing the project. Multinational corporations (MNC) frequently invest in foreign countries through their subsidiaries established in those foreign countries (also called host countries). These subsidiaries may be viewed as the MNCs' investment arms, or business arms, in host countries. Multinational corporations' foreign investment analysis is complicated by a variety of factors and risks that are not encountered by purely domestic firms or purely national investments. These complicating factors and risks stem from: involvement of more than one company the existence of parent and subsidiary involvement of more than one country home (or parent's) country and host (or foreign or subsidiary's) country tax differentials between home and host countries requirement to convert funds from one currency to another currency and the associated risks due to unpredictable exchange rate movements country risk: the host country's political, social, economic and financial risk factors.

The basic concepts, principles and techniques of project analysis still apply to multinational corporations' foreign investments. Gaining access to global capital markets should allow a firm to lower its cost of capital. A firm can improve access to global capital markets by increasing the market liquidity of its shares and by escaping its home capital market Global Cost & Availability of Capital Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home market A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital This in turn will limit the firms ability to compete both internationally and vis --vis foreign firms entering its market Firms resident in small capital markets often source their long-term debt and equity at home in these partially-liquid domestic markets

The costs of funds is slightly better than that of illiquid markets, however, if these firms can tap the highly liquid international capital markets, their competitiveness can be strengthened Firms resident in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs A national capital market is segmented if the required rate of return on securities differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections Firms constrained by any of these above conditions must develop a strategy to escape their own limited capital markets and source some of their long-term capital needs abroad

Dimensions of the Cost and Availability of Capital Strategy

Weighted Average Cost of Capital

k WACC k e
Where

E D k d (1 t) V V

kWACC = weighted average cost of capital ke kd t E D V = risk adjusted cost of equity = before tax cost of debt = tax rate = market value of equity = market value of debt = market value of firm (D+E)

Cost of Equity and Debt Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

k e k rf (k m k rf )
Where ke krf km = expected rate of return on equity = risk free rate on bonds = expected rate of return on the market = coefficient of firms systematic risk

The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt. Cost of Capital for MNEs versus Domestic Firms An MNE should have a lower cost of capital because it has access to a global cost and availability of capital

This availability and cost allows the MNE more optimality in capital projects and budgets compared to its domestic counterpart

Q9. Briefly describe the following (any two) a) b) c) d) Ans a) FDI and FII in india Foreign direct investment (FDI) is a direct investment into production or business in a country by a company in another country, either by buying a company in the target country or by expanding operations of an existing business in that country. Foreign direct investment is in contrast to portfolio investment which is a passive investment in the securities of another country such as stocks and bonds. Foreign direct investment has many forms. Broadly, foreign direct investment includes "mergers and acquisitions, building new facilities, reinvesting profits earned from overseas operations and intracompany loans". In a narrow sense, foreign direct investment refers just to building new facilities. The numerical FDI figures based on varied definitions are not easily comparable. Foreign direct investment in India. Foreign investment was introduced in 1991 as Foreign Exchange Management Act (FEMA), driven by minister Manmohan Singh. As Singh subsequently became a prime minister, this has been one of his top political problems, even in the current (2012) election. India disallowed overseas corporate bodies (OCB) to invest in India. Foreign Institutional Investor (FII). An investor or investment fund that is from or registered in a country outside of the one in which it is currently investing. Institutional investors include hedge funds, insurance companies, pension funds and mutual funds. The term is used most commonly in India to refer to outside companies investing in the financial markets of India. International institutional investors must register with the Securities and Exchange Board of India to participate in the market. One of the major market regulations pertaining to FIIs involves placing limits on FII ownership in Indian companies. Foreign Institutional Investor (FII) is used to denote an investor - mostly of the form of an institution or entity, which invests money in the financial markets of a country different from the one where in the institution or entity was originally incorporated. FII investment is FDI and FII in india Currency Swaps Euro currency market Convertibility

frequently referred to as hot money for the reason that it can leave the country at the same speed at which it comes in. In countries like India, statutory agencies like SEBI have prescribed norms to register FIIs and also to regulate such investments flowing in through FIIs. In 2008, FIIs represented the largest institution investment category, with an estimated US$ 751.14 billion. Both FDI and FII is related to investment in a foreign country. FDI or Foreign Direct Investment is an investment that a parent company makes in a foreign country. On the contrary, FII or Foreign Institutional Investor is an investment made by an investor in the markets of a foreign nation. In FII, the companies only need to get registered in the stock exchange to make investments. 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 have the liberty to sell it and take it back. But in Foreign Direct Investment, this is not possible. In simple words, FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily. This difference is what makes nations to choose FDIs 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 the enterprises capacity or productivity or change its management control. In an FDI, the capital inflow is translated into additional production. The FII investment flows only into the secondary market. It helps in increasing capital availability in general rather than enhancing the capital of a specific enterprise. The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor. FDI not only brings in capital but also helps in good governance practices and better management skills and even technology transfer. Though the Foreign Institutional Investor helps in promoting good governance and improving 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 FDIs are long term. In short 1. FDI is an investment that a parent company makes in a foreign country. On the contrary, FII is an investment made by an investor in the markets of a foreign nation.

2. 3. 4.

FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily. Foreign Direct Investment targets a specific enterprise. The FII increasing capital availability in general. The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor.

The details of data regarding amount of Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) inflows into Indian economy for the past four years are as under:
S. No. Financial Year (April-March) 1. 2. 3. 4. TOTAL 2008-09 2009-10 2010-11 2011-12 (AprilFebruary 2012) Amount of FDI equity inflows In Rs. Crores 142829 123120 88520 133181 487650 In US$ million 31396 25834 19427 28403 105060 Investment by FIIs Foreign institutional investors Fund (net) (in terms of US $ million) (-) 15017 29048 29422 17365 60818

Source: RBIs Bulletin dated 09/04/2012 (Table no. 44) Indias efforts to attract Foreign Direct Investment are an ongoing and continuous exercise. The Government has taken concerted steps to provide investor-friendly environment in the country. Measures undertaken to improve business environment in the country include eGovernance. MCA-21, Investment Policy liberalization, Single Window Systems by State Governments, Single window for payment of income tax and corporate tax, ICE-Gate for online filing of custom and exercise documents, Right to Information Act 2005 and Micro, Small and Medium Enterprises Act 2006. In addition, the Government has initiated the implementation of the eBiz Project, a Mission Mode Project under the National eGovernance Project, to provide an online single window to investors & businesses for registrations, filing, approvals, clearances etc. This project aims to create a business and investor friendly ecosystem in India by making all business and investment related regulatory services across Central, State and Local governments available on a single portal, obviating the need for the investor or the business to visit multiple officers or a plethora of websites. b) Currency Swaps A swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. Swaps involve exchange of one set of financial obligations with another e.g. fixed rate of interests with floating rate of interest, one currency obligation to another, a floating price of a commodity to fixed price etc. Specifically, the two counterparties agree to exchange one stream of cash flows against

another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Types of Swaps Interest rate swaps Currency swaps Interest rate swap The most common type of swap is a plain Vanilla interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Suppose a party has an obligation to pay a fixed rate of interest on a bond and another party has a floating rate debt instrument. If these parties exchange their interest obligations, then the principal amount remains with the original parties. Only interest rate payments are swapped. Both the parties should gain, otherwise they will not agree to the swap. The gain will be in the form of lower costs. Currency Swaps A currency swap is a foreign-exchange agreement between two institute to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from a central bank liquidity swap. Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal Two counterparties use a Swap Bank to: Convert a liability denominated in one currency into a liability denominated in another currency Swap principal in the beginning Swap interest during the period Return swapped principle at the end

In a currency swap, unlike in an interest rate swap, the principal is exchanged at the beginning and at the end of the swap.

Although the first step may be notional, typical currency swaps involves three steps; 1. Initial exchange of principal amount: In the first step, the counterparties exchange the principal amounts of the swap at an agreed exchange rate. This rate is generally based on the spot exchange rate however; a forward rate set in advance of the swap commencement date may also be used. The principal amounts may be exchanged on physical or notional, without any physical change, basis. 2. Exchange of interest: It is the second key step for a currency swap. The counterparties exchange interest payments on agreed dates based on outstanding principal amounts at the fixed interest rates agreed at the beginning of transaction. 3. Re-exchange of principal maturity: This step involves re-exchange of the principal sum at the maturity date by the counterparts. In order to determine the actual sums involved generally the original spot rate is used. There are four types of basic currency swaps: fixed for fixed. fixed for floating. floating for fixed. floating for floating. Fixed-to-fixed currency swaps: The counterparties to a fixed-to-fixed currency swap may wish to enter the swap because of each ones comparative advantage which may be in either direction. It can be illustrated by an example quoted from Winstone (1995). US Company US dollar Sterling Comparative advantage Take a loan Exchange rate Principal exchange Interest paid Interest received 5.0% 7.5% 2.0% $, 0.5% $ 10 million from 5.0% = $1.50 15 million from 7% 7.0% for loan 5.0% for $ loan 15 million from 8.0% = $1.50 $ 10 million from 6.5% 6.5% for $ loan 8.0% for loan UK Company 7.0% 8.0%

Coupon Payment Interest gains Dealer

5.0% for $ loan 0.5% gain of 1 % from US$ debt

8.0% for loan 0.5% loss of 1% from debt

The above table shows that a US company is able to borrow from low fixed rates in US bond market. On the other side, a UK company is also able to raise low fixed rates funds from UK bond market. In case of both the companies wish to raise funds denominated by other countrys currency, first, each will borrow from its own domestic market by using the comparative advantage. Second, via fixed-to-fixed swap each will be able to raise lower cost of their funds in terms of foreign currency. However, the case is such that the US companys credibility is better in each market, the swap transaction would be as it is shown in the above Table.

Fixed (floating) to floating currency swaps These swaps are used for to swap from fixed rate obligations in one currency to floating rate obligations in another currency. Similar to the previous example, a US company is able to borrow at fixed rate in US bond markets, while a UK company is able to borrow sterling at floating LIBOR based rates. In case of foreign currency fund requirements, a cross-currency coupon swap will reduce each companys lending cost. The following figure shows the mechanism of cross-currency coupon swaps. Assume that the US dollars at fixed rates are priced in the swap at a number of basis points above the T-bond rates. The dealer might quote 71 - 78 bp if the T-bonds are currently yielding 7.50% p.a. then fixed rate payer (UK company) will pay 7.50% + 78bp = 8.28% against 6m sterling LIBOR received flat. The counterparty will receive 71bp over T-bond yield which is 7.50% + 71bp = 8.21% fixed and pay 6m LIBOR sterling flat. The spread of 7bp will be retained by the dealer as a gain from this transaction. c) Euro currency market The money market in which Eurocurrency, currency held in banks outside of the country where it is legal tender, is borrowed and lent by banks in Europe. The Eurocurrency market is utilized by large firms and extremely wealthy individuals who wish to circumvent regulatory requirements, tax laws and interest rate caps that are often present in domestic banking, particularly in the United States.

Euro currency is the term used to describe deposits residing in banks that are located outside the borders of the country that issues the currency, the deposit is denominated in. For example- a deposit denominated in US Dollars residing in a Japanese bank is a EURO currency deposit or more specifically a EURO dollar deposit . How it originated? After the second world war, the amount of US dollars outside the United States increased enormously. As a result enormous sums of US dollars were in custody of foreign banks outside the United States. During the Cold war period, especially after the invasion of Hungary in 1956, the Soviet Union feared that its deposits in North American banks would be frozen as a retaliation. It decided to move some of its holdings to Moscow Narodny bank, a soviet union bank with a British charter. The British bank than deposit that money in US banks. There will be no chance of confiscating that money because it belonged to British bank and not directly to Soviets. On Feb, 28, 1957, the sum of dollar 800,000 was transferred creating the first Eurodollars. Gradually as a result of successive commercial deficits of united stated, the Eurodollar market expanded worldwide. Thus the currencies involved in Eurodallar market are in no way different from currencies deposited in banks of home country. It is not Eurodollar not under the orbit or surveillance of monetary policy, where the currency in the home country is under the regulation of national monetary policy. Definition and background The Eurocurrency market consists of banks (called Eurobanks) that accept deposits and make loans in foreign currencies. A Eurocurrency is a freely convertible currency deposited in a bank located in a country which is not the native country of the currency. The deposit can be placed in a foreign bank or in the foreign branch of a domestic US bank. [Note of caution! The prefix Euro has little or nothing to do with the newly emerging currency in Europe.] In the Eurocurrency market, investors hold short-term claims on commercial banks which intermediate to transform these deposits into long-term claims on final borrowers. The Eurocurrency market is dominated by US $ or the Eurodollar. Occasionally, during weak dollar periods (latter part of 1970s and 1980s), the EuroSwiss franc and the EuroDM markets increased in importance. The Eurodollar market originated post WWII in France and England thanks to the fear of Soviet Bloc countries that dollar deposits held in the US may be attached by US citizens with claims against communist governments!

Features of Euro currency market It is an international market and is under no national control: it has come up as the most important channel for mobilising and deploying funds on an international scale. It is a short term money market. Eurodollar markets are the time deposit market. The deposits here have a maturity period on day to several months. Eurodollar is a short term deposit. It is a wholesale market: It is so because Eurodollar is a currency that is dealt in large units. Size of individual transaction is usually above dollar 1 million. It is highly competitive and sensible market: Highly Competitive: this market is characterized as highly competitive because the market is growing and accepted internationally Sensible: The Eurodollar market is highly sensible because it responds faster to the changes in demand and supply of the funds and also reacts to changes in the interest rates Eurocurrency market The Eurocurrency market operates like any other financial market, but for the absence of government regulations on loans that can be made and interest rates that can be charged. Dominance of Dollar Denominated Transactions: Dollar is a leading currency traded in the market (about 90% to 95% marketshare). However other currencies are now emerging thus reducing the role of dollar somewhat(about 80% market share) Euro Japanese Yen Pound Sterling d) Convertibility Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies must be exchanged. The state of or the ease with which a currency may be exchanged for a foreign currency. Currency convertibility is vitally important in the foreign exchange market; higher convertibility means that a currency is more liquid and, therefore, less difficult to trade. Factors affecting convertibility include the availability of foreign currency reserves in a given country and domestic regulations seeking to protect local investors from bad investment decisions in, say, a currency undergoing a period of hyperinflation. A few socialist governments even issue inconvertible currencies, such as the Cuban peso, in order to protect their citizens from perceived capitalist infiltration.

Currency Trading Freely convertible currencies have immediate value on the foreign exchange market, and few restrictions on the manner and amount that can be traded for another currency. Free convertibility is a major feature of a hard currency. Some countries pass laws restricting the legal exchange rates of their currencies, or requiring permits to exchange more than a certain amount. Some currencies, such as the North Korean won, the Transnistrian ruble and the Cuban national peso, are officially nonconvertible and can only be exchanged on the black market. If an official exchange rate is set, its value on the black market is often lower. Convertibility controls may be introduced as part of an overall monetary policy. For example, restrictions on the Argentine peso were introduced during an economic crisis in the 1990s, and scrapped in 2002 during a subsequent crisis. Commodity Money Convertibility first became an issue of significance during the time banknotes began to replace commodity money in the money supply. Under the gold and silver standards, notes were redeemable for coin at face value, though often failing banks and governments would overextend their reserves. Historically, the banknote has followed a common or very similar pattern in the western nations. Originally decentralized and issued from various independent banks, it was gradually brought under state control and became a monopoly privilege of the central banks. In the process, the fact that the banknote was merely a substitute for the real commodity money (gold and silver) was gradually lost sight of. Under the gold exchange standard, for example the Bretton Woods Institutions, banks of issue were obliged to redeem their currencies in gold bullion, or in United States Dollarswhich in turn were redeemable in gold bullion at an official rate of $35/troy ounce. Due to limited growth in the supply of gold reserves, during a time of great inflation of the dollar supply, the United States eventually abandoned the gold exchange standard and thus bullion convertibility in 1974. Under the contemporary international currency regimes, all currencies' inherent value derives from fiat, thus there is no longer any thing (gold or other tangible store of value) for which paper notes can be redeemed.