Question Paper

International Finance and Trade – II (222) : April 2004

Section D : Case Study (50 Marks)
• This section consists of questions with serial number 1 - 4.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section D.

Case Study
Read the case carefully and answer the following questions:
1. Evaluate the investment proposal of Indian Laboratories Ltd. (ILL) in Guyana using Adjusted Present
Value (APV) technique.
(20 marks) < Answer >
2. Discuss why NPV technique is difficult to apply for appraising projects in foreign countries involving
foreign capital outlay.
(8 marks) < Answer >
3. Countries impose restrictions on the profit or the capital that can be repatriated by a foreign subsidiary
to its parent company. Discuss the various ways by which companies can circumvent restrictions on
profit repatriations.
(12 marks) < Answer >
4. Explain the various types of foreign exchange exposures. What are the types of exposure ILL will face for
its project in Guyana.
(10 marks) < Answer >
Indian Laboratories Ltd. (ILL) is an emerging global pharmaceutical company with proven research
capabilities. The company is focused on creating and delivering innovative and quality products to help people
in leading healthier lives. ILL’s expertise in the development and manufacture of quality organic intermediates,
bulk actives and finished dosage forms have been critical to the company’s success in delivering innovative and
affordable life-saving medicines to customers world-wide including Europe, Japan and the US.
The US market offers huge opportunities for the Indian pharmaceutical companies because a number of new
drugs are going to off patent over the next few years. For companies that are among the earliest generic
companies to enter after a drug goes off patent, the rewards can be huge. For this reason, for past one year ILL
has scouted for a suitable place for setting up a manufacturing facility near US. It has identified Guyana, a
West Indies country, to set up the manufacturing plant as it is very close to US and due to its location ILL can
also increase its market reach in Mexico and Latin American countries. The management of the company
already had a few set of negotiations with the Guyana Government, which is keen to get the manufacturing
plant and have also shown some willingness to offer concessional financing. Currently ILL market its products
through a subsidiary, which acts as an agent for distribution and marketing of the company’s product in US.
After the new plant will come out in Guyana, this subsidiary will market the products produced in Guyana.
The cost for the project has been estimated at US$ 200 million in plant and machineries and other facilities and
US$ 20 million in working capital requirement. The land for the proposed project will be provided free of cost
by the Guyana’s Government in lease. The implementation of the project will be started soon and will be
operational after one year. The capacity utilization of the project for first five years has been estimated as
follows:

Year 1 2 3 4 5
Capacity Utilization (%) 50 60 70 75 80
At 100% capacity utilization, the sales revenue at current prices has been estimated at US$ 400 million. The
company currently exports various drugs to US, which is marketed by its subsidiary. For the running year the
export is estimated at US $ 50 million, which is expected to grown by 20% annually for next five years. The
net profit margin on such exports is 20%, net profit is expected to grow to keep pace with inflation rate in US.
When the project will be operational, there will be no need for such exports.
The company has accumulated profits of US $ 50 million in various banks in US, which can be repatriated to
India without any constraint. The company is planning to use this fund for the project in Guyana.
The life of the project can be taken as five years for the appraisal purposes. The value of plant and machineries
and other facilities after five years can be assumed to fetch 20% of the initial investment and working capital
requirement can be realized at 100% of initial amount.
The product mix is expected to remain identical throughout the five years and contribution is expected to be the
45% of sales for all the five years. The fixed cost excluding depreciation is estimated at US $ 25 million at the
current prices, selling and administration expenses will be expected to 8% of sales. All the revenues and costs
are expected to go up according to the inflation rate in US. The company estimated that a profit of US $
250,000 at current prices can be repatriated illegally in all the five years of operation, which will also keep pace
with the level of inflation in US. The initial investment in plant and machineries will be depreciated at 20%
written-down-value method.
The project would increase the borrowing capacity of ILL in India by about Rs. 450 crore, out of 80% of which
is expected to be used by the company. The Government of Guyana has also offered a concessional loan of US
$50 million at 5% for five years, the comparable loan is available to the company at 8% in Guyana. This
concessional loan will be repayable in four equal installments starting at the end of second year. The company
faces a borrowing rate of 12% in India. The risk free rate of interest in India and Guyana are 5% and 3%
respectively.
The corporate income tax rate in Guyana is 30%, and the same in India is 35%. There is a double tax avoidance
treaty in between India and Guyana, under which full credit is given to Indian companies for taxes paid in
Guyana, provided, the rate does not exceed the Indian tax rate of 35%.
The long term inflation forecasts in India and US are 5% and 2.5% respectively. A risk consultancy firm in
Mumbai has advised the company that in the current year rupee will appreciate against dollar by 2% from the
current spot rate of Rs.45.50/$, but after that it will follow purchasing power parity between rupee and dollar.
The return required by Indian shareholders of the company is 15%.
END OF SECTION D

Section E : Caselets (50 Marks)

• This section consists of questions with serial number 5 - 11.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section E.

Caselet 1
Read the caselet carefully and answer the following questions:
5. Discuss the advantages, which attract the borrowers of one country to raise capital from international
capital markets.
(9 marks) < Answer >
6. What are the reasons behind the tightening the norms for ECB by the government? Do you think such
restrictions are justified? Discuss.
(8 marks) < Answer >
The process of integration of the Indian economy into the global economy began with liberalization and
structural reform initiatives a decade ago. The development of technology has contributed immensely in
making the world into a global village. The corporate world has taken advantage of this technological
revolution in a big way so that it can better utilize the available resources. This has made many companies raise
capital from different countries. The relaxation of norms in different countries with regard to the flow of
foreign funds and the development of the markets have in a big way contributed to this. Though the phenomena
of raising capital from other countries is popular in some of the developed countries since the early 1970s this
is catching up in India in a big way. With the onset of reforms in Indian financial sector many Indian corporates
would like to explore funding possibilities abroad. Indian firms had raised $1.1 billion till August as cheaper
foreign loans and a rising rupee helped cut borrowing costs at home. India’s foreign exchange reserves rose to a
record in the week ended December 21 and the rupee has gained nearly 6% since January due to inflows from
foreign portfolio investors, expatriate remittances and trade flows.
But recently the Government has tightened the norms for external Commercial Borrowing (ECB) by saying
external borrowings above $50 million would be allowed for equipment imports and infrastructure project.
Finance ministry said no bank, financial institution or non-banking financial institution would be allowed
access to external commercial borrowings or provide guarantees for such loans. In addition to the above,
hedging is compulsory for forex exposure on loans under the automatic route and only AAA-rated companies
will be able to do so because a cap of 150 basis points over LIBOR has been placed. The intention of the
government behind this is to push domestic credit to safeguard Indian banks and financial institutions. But this
restriction is a hurdle in achieving full capital account convertibility. Even as we are discussing ways to achieve
full capital account convertibility, we continue to apply restrictions and attempt to safeguard domestic markets
rather than permitting market forces to decide the dynamics.
In general, the role of capital market is to provide liquidity where the entities that have surplus funds can
provide funds to the entities, which are in need of funds. It may be the individuals, companies, or the
Government who need funds for their expansion plans or welfare plans which they can get from the
individuals, institutions, or companies who have excess funds in the form of savings after meeting their
consumption needs. As there is a wide gap between the seekers of funds and the lenders of funds, the
intermediaries can be in the form of commercial banks or investment banks.
There are various routes by which company can raise fund in the international market. ECB includes
commercial bank loans, buyers’ credit, suppliers’ credit, securitized instruments such as floating rate notes and
fixed rate bonds etc., credit from official export credit agencies and commercial borrowings from the private
sector window of multilateral financial institutions.
ECBs can be used for any purpose (rupee-related expenditure as well as imports) except for investment in stock
market and speculation in real estate. They are a source of finance for Indian corporates for expansion of
existing capacity as well as for fresh investment. Corporates are free to raise ECB from any internationally
recognized source, such as banks, export credit agencies, suppliers of equipment, foreign collaborators, foreign
equity-holders, international capital markets etc. ECBs provide an additional source of funds to Indian
companies, allowing them to supplement domestically available resources.
The growth in the global debt market has formed the prospect for development of international businesses for
the people who wish to borrow or invest money. From the borrowers’ angle, a borrower can borrow at lower
cost by using the global capital market and from the investors’ angle it provides the investors with an
opportunity to diversify their investment portfolio and reduce the risk. However, tighter norms on the ECBs by
curtailing the arbitrage is expected to restrict inflows and increase the domestic credit off-take in the country.

Caselet 2
Read the caselet carefully and answer the following questions:
7. Do you think appreciation of rupee against dollar have any significant adverse impact on the Indian
economy? Discuss.
(5 marks) < Answer >
8. What are the approaches the Indian companies can adopt to cope with this situation? Explain.
(7 marks) < Answer >
9. What measures according to you the RBI should take to manage rupee-dollar exchange rate?
(6 marks) < Answer >
The RBI held the view, for long, that strong exchange reserves need to be maintained, due to the bad
experience India had to go through in 1991. It has been a widely known policy of the RBI to keep
accumulating dollar reserves, whenever there are strong inflows of foreign funds, which also ensures that the
rupee does not appreciate much. The policy has, over the years, resulted in the foreign exchange reserves
increasing to over $100 billion. However, this policy has also led to the RBI being criticized for interfering in
the foreign exchange markets too often.
Several justifications have been given for this policy. The first one, as mentioned in the opening sentence, is
the lack of confidence in the international architecture. That is, the liquidity support available to a country
when it suffers from Balance of Payments problems could be inadequate, not available when needed urgently,
or be set with political preconditions not acceptable to the country facing the problems. The second reason is
often the desire to contain the risks that may arise from external shocks. External private capital often comes in
when the country is doing well and exits at the first indication of trouble. Having large reserves is essential to
contain the panic conditions that prevail in the markets in such situations. The third reason is the opportunity
created by the current excessive liquidity in the international financial markets and the associated low interest
rates. If the interest rates escalate later, capital may again reverse its direction, and flow to the markets in the
developed countries. Reserves accumulated at present will be helpful to withstand such shocks later. The final
reason, which is no less important, is that foreign currency reserves are required to withstand the periodical
volatility in the foreign exchange markets. The markets of emerging economies are less efficient and cannot be
depended upon to make automatic adjustments to correct the volatility in the markets. Similarly, a politically
sensitive event like the Pokhran blasts or skirmishes with Pakistan on the border can cause a lot of Non-
Resident Indians (NRIs) who are currently pumping money into the country to withdraw it over night. Such
swings in sentiment can play havoc with the exchange rates, and the government will be called on to play a
stabilizing role in such a situation.
The consistent accumulation of dollars has been often stopping the rupee from appreciating, though there have
been strong inflows of the dollar, on numerable counts in the past. The resultant liquidity released into the
system used to be sterilized by the RBI through issue of government securities. To an extent, the inclination of
the banks to invest in government securities beyond the statutory requirements has come in handy for the RBI
in achieving stability in the exchange rate of the rupee.
However, the situation changed from early last year (2003), when the rupee started appreciating against the
dollar. At the same time, the rupee has been depreciating against other major currencies like the Euro and Yen,
indicating that the appreciation is basically due to the weakness of the dollar against these currencies. The RBI,
this time, chose to allow some amount of appreciation of the rupee, against the dollar.
The appreciation gained momentum due to inflows of dollars continuing, with the NRIs encouraged by the gain
of the rupee. Added to this, the prices of crude oil fell, easing the pressure on the need for payments for oil
imports. With the fear of losing out due to further improvement in the rupee exchange rate, exporters also
rushed to remit the dollars to India, pushing the exchange rate further up. The sustained positive current
account balance also appears to have had its impact in generating the positive sentiments for the rupee.
It has been alleged, however, that most of the fund flows to India are to gain from the arbitrage. Investors
always prefer to invest in a currency that is appreciating, so that they can gain from the interest and also from
the appreciation if the currency. However, this argument is refuted on several counts. The spread on the NRI
deposits is capped at 2.5% and is often not more than forward premium on the dollar in the Indian market. The
investment by the FIIs in debt funds is limited to $1 billion, all the FIIs put together. This cap prevents them
form making any meaningful arbitrage gains. The variability in interest rates in the two currencies involved,
keeping in view the narrow spreads, can add risk to the seemingly risk-less arbitrage. In view of these
arguments, it can be said that the flow of dollars into India is driven by factors other than the strength of the
rupee and the resultant opportunities for arbitrage.
Caselet 3
Read the caselet carefully and answer the following questions:
10. How does the international asset swap mechanism work? Explain.
(7 marks) < Answer >
11. Discuss the various benefits of international asset swaps.
(8 marks) < Answer >
International asset swaps can be used to achieve international diversification without eroding the level of
foreign exchange reserves and weakening local market development. These asset swaps demand limited foreign
currency flows, which implies that there is a need for only net gains or losses to be exchanged. Asset swaps
protect foreign investors from market manipulation and expropriation risk and have much lower transaction
costs than outright investments. In spite of all this, asset swaps are constrained by the attractiveness of local
markets to foreign investors, and by various regulatory issues covering counter-party risk, collateral
considerations, accounting, valuation, and reporting rules. Institutional investors, especially pension funds and
life insurance companies, are becoming the major participants in the financial systems of many developing
countries. In some cases like Egypt, Malaysia or Sri Lanka, the sector is dominated by public agencies, but in
several countries, including Argentina, Brazil, Chile, Cyprus, Hungary, Mauritius and especially South Africa
private institutions play a prominent role in the accumulation of long-term financial resources. But in most
developing countries, pension funds and other institutional investors operate under strict limitations on their
foreign investments, mainly because of the shortage of foreign exchange reserves and the fear of capital flight.
The imposition of exchange controls on investment in foreign assets affects the financial performance of
pension funds and insurance companies. Exchange controls prevent an international diversification of risk and
a reduction in the exposure of contractual savings institutions to domestic currency and market risk. Pension
funds and other institutional investors in most developing countries are not generally allowed to invest
overseas. Even OECD countries, until the early 1980s, used to apply tight quantitative restrictions on overseas
investments by local institutions. The most common rationale for such restrictions is to reduce the risk of
capital ‘flight’, especially institutionalized capital flight. Another rationale is to invest the locally mobilized
long-term savings ‘at home’ to stimulate the development of local capital markets and enhance employment
opportunities for the same workers. Even in the absence of legal limitations on foreign investing by local
institutional investors, there are other significant barriers—the most important are risk of expropriation by
foreign governments and transaction costs. These costs can be so large that they may offset any diversification
benefits that would otherwise accrue, especially when relatively low volumes of funds are involved.
International diversification improves the risk/return trade-off of investment portfolios by reducing the
exposure to cyclical and long-term structural shifts in local economic performance. In the US, where the
large local economy is highly diversified and where presence of global corporations provides an indirect
avenue of international diversification, overseas assets are less than 12% of total assets, although this represents
a significant increase over time. Removing exchange controls and fully integrating with international capital
markets should be the ultimate objective of policy in all developing countries. However, complete removal of
exchange controls is often constrained by the paucity of foreign exchange reserves and the fear of stimulating
capital flight, especially if confidence in future stability is low.
Asset swaps are clearly a second best option compared to the lifting of exchange controls. Developing
countries should consider authorizing their institutional investors to engage in international asset swaps. But
they should authorize to use properly designed swap contracts, preferably based on the basket of liquid
securities, permit only global investment banks to act as counter-parties, require use of global custodians,
properly monitor credit risk, maintain adequate collateral, and adopt market-to-market valuation rules.
END OF SECTION E
END OF QUESTION PAPER

Suggested Answers
International Finance and Trade – II (222) : April 2004
Section D : Case Study
1. The expected exchange rate for different periods are as follows:
Current spot Rs/$ = 45.50
45.50
= 44.61
At time, t=0, Rs./$ = 1.02
1.05
44.61 × = 45.70
t = 1, , Rs./$ = 1.025
1.05
45.70 × = 46.81
t = 2, Rs./$ = 1.025
1.05
46.81 × = 47.95
t= 3, Rs./$ = 1.025
1.05
47.95 × = 49.12
t = 4, Rs./$ = 1.025
1.05
49.12 ×
= 50.32
t = 5, Rs./$ = 1.025
The adjusted present value is given by :
n
( S t C t + E t ) ( 1 − T) n D t T n
r Bo T  n
Rt 
∑ ( 1 + ke )
+∑ ∑ + So  CLo − ∑ 
t =1 ( 1 + k d ) ( 1+ kb ) t =1 ( 1 + k c ) 
t t
t =1
t
t =1  
APV = So (Co – Ao) + +
n
It
∑
( 1 + ki )
t
t =1
+
Blocked fund = 0
Initial outlay = 44.61 × 220 = Rs.9814.20 mln.
Loss of profits from export sales
Year 1 2 3 4 5
Sales (US$ mln.) 61.5 75.65 93.04 114.44 140.77
Net profit 12.3 15.13 18.61 22.89 28.15
Profit (Rs. mln.) 562.11 708.24 892.35 1124.36 1416.51
Cash flow form operation
Year 1 2 3 4 5
Sales 205 252.15 301.53 331.14 362.05
Contribution 92.25 113.47 135.69 149.01 162.92
Fixed cost 25.63 26.27 26.92 27.60 28.29
 Selling & Admn. Exp 16.4 20.17 24.12 26.49 28.96
PBT 50.22 67.03 84.65 94.92 105.67
Tax @ 35% 17.58 23.46 29.63 33.22 36.98
PAT (US $ mln.) 32.64 43.57 55.02 61.70 68.69
Exchange rate 45.70 46.81 47.95 49.12 50.32
PAT (Rs. mln.) 1491.65 2039.51 2638.21 3030.70 3456.48
Less: Loss profit from exports 562.11 708.24 892.35 1124.36 1416.51
Net cash flow 929.54 1331.27 1745.86 1906.34 2039.97
Termln.al cash flow * 3019.20
Total cash flow 929.54 1331.27 1745.86 1906.34 5059.17

Terminal cash flow = 200 × 0.20 + 20

= $ 60 mln.
= 60 × 50.32 = Rs.3019.20
Present value of total cash flow
= 929.54 × PVIF(15%,1) + 1331.27 × PVIF (15%,2) + 1745.86 × PVIF (15%,3)
+ 1906.34 × PVIF (15%,4) + 5059.17 × PVIF (15%,5)
= Rs.6568.75 mln.
Depreciation schedule
Year 1 2 3 4 5
Opening balance 200 160 128 102.40 81.92
Depreciation 40 32 25.60 20.48 16.38
Closing balance 160 128 102.40 81.92 65.54
Present value of depreciation tax shield
= 40 × 0.35 × 45.70 × PVIF(5%,1) + 32× 0.35× 46.81× PVIF(5%,2) + 25.60× 0.35× 47.95× PVIF(5%,3)
+ 20.48× 0.35× 49.12× PVIF(5%,4) + 16.38 × 0.35× 50.32× PVIF(5%,5)
= 639.80× 0.952+524.27× 0.907+429.63× 0.864+352.09× 0.823+288.48× 0.784
= Rs.1971.74 mln.
Tax shield due to incremental borrowing capacity
= 0.12 × (4500× 0.80) × 0.35× PVIFA(5% ,5)
= Rs.654.54 mln.
Note: Above two cases discount rate is taken as risk free interest rate in US, assuming that the company
will be able to achieve the projected sales, hence the probability of positive cash flows is high.
Concessionary loan repayment schedule
Year Principal o/s at the Interest Principal Total
end of year payment repayment repayment
1 50 2.50 - 2.50
2 37.5 2.50 12.5 15.0
3 25 1.875 12.5 14.375
4 12.5 1.25 12.5 13.75
5 - 0.625 12.5 13.125
Benefits due to concessionary loan
= 44.61 [50- {2.50 × PVIF (8%,1) + 15.0 × PVIF (8%,2) + 14.375 × PVIF (8%,3)
+ 13.75 × PVIF (8% ,4) + 13.125 × PVIF(8% ,5)}]
= 44.61 [50 – 45.63]
= Rs. 194.95 mln.
Illegally repatriated profit
Year 1 2 3 4 5
 Profit (US $ mln.) 0.256 0.263 0.269 0.276 0.283
Profit (Rs. mln.) 11.70 12.31 12.90 13.56 14.24
Present value of illegally repatriated profit
= 11.70 × PVIF (15%,1) + 12.31 × PVIF (15%,2) + 12.90 × PVIF (15% ,3) + 13.56 × PVIF (15% ,4)
+ 14.24 × PVIF (15%,5)
= Rs.42.81 mln.
APV = – 9814.20 + 6568.75 + 1971.74 + 654.54 + 194.95 + 42.81
= – Rs.381.41 million
As the APV is negative the project may not be accepted. However, we have considered a project life of 5
years, which is too less to evaluate such a project.
< TOP >
2. There are two main reasons why it is difficult to apply the traditional NPV technique to overseas projects.
The first type of reason involves the difficulties which cause cash flows – the numerators in NPVs – to be
seen from two different perspectives: that of the investor’s home country and that of the country in which
the project is located. The correct perspective is that of the investors home country, which we assume to be
the same for all shareholders. The second type of reasons involves the degree of risk of foreign projects and
the appropriate discount rate – the denominator of the NPV. Following are the issues which affect both the
cash flows and the discount rate and thus make the NPV technique insufficient:
• • Blocked funds
• • Effect on cash flows of other divisions
• • Restriction on repatriations
• • Taxability of cash flows
Coupled with the above issues the additional risks faced with foreign investments that are not explicitly
faced with domestic investments are foreign exchange risk and country risk. These risks provide sufficient
reason for difficulties in applying NPV technique to foreign capital projects. Both country risk and
exchange rate risk can make optimal capital structure change over time. This is difficult to incorporate
within the weighted average cost of capital used in the NPV technique. Again if the government of foreign
country give some subsidized loan it will not be possible to incorporate the benefit arising from such loans
in NPV framework.
< TOP >
3. There are a number of legal ways to circumvent restrictions on profit repatriations.
• • Transfer pricing
• • Royalties
• • Leading and lagging
• • Financing structure
• • Inter-company loans
• • Currency of invoicing
• • Reinvoicing centers
• • Countertrade
Transfer Pricing
Transfer pricing refers to the policy of invoicing purchase and sale transactions between a parent company
and its foreign subsidiary on terms which are favorable to the parent company, thus shifting a part of the
subsidiary’s rightful profits to the parent. As this method of circumventing repatriation restrictions is very
common, authorities are generally very alert as to the price at which transfers are made.
Royalties
The foreign subsidiary may use the parent company’s trademarks and copyrights and pay royalties as
compensation. As this is not a transfer of profit, the normal restrictions on profit repatriation do not cover
these payments.
Leading and Lagging
Leading and lagging payments between the parent company and the subsidiary, based on expected
movements in exchange rates can help in transferring profits from the latter to the former. Suppose the
subsidiary has to pay its parent company a sum which is denominated in a currency that is expected to
harden. The subsidiary lags (delays) the payment so that a part of the subsidiary’s profits get transferred to
the parent company. In the event of such a payment being denominated in a currency that is expected to
 depreciate, the subsidiary leads (advances) the payment, again with the same effect.
Financing Structure
An overseas project can be funded solely through equity investments, or through a mixture of equity and
debt. In cases where there are restrictions on repatriation of profits and repayment of capital, part of the
project can be funded through loans from the parent company to the foreign subsidiary. Generally, there are
fewer restrictions on payment of interest and repayment of loans than on profit repatriation. Also, interest
payments are tax deductible for the subsidiary whereas dividend payments are not (for the parent company
both are taxable). There is another tax incentive involved as repayment of loans is non-taxable in the hands
of the parent company, whereas funds transferred as dividends are. This way, repatriation restrictions can
be maneuvered around, along with getting additional tax advantages, by extension of loans to the subsidiary
by the parent company, instead of making direct equity investments.
Inter-company Loans
The methods mentioned above are fairly common ways of getting around regulations in a legal manner.
Over a period of time, authorities have become aware of them and frown upon payments to a foreign parent
company, under whatever disguise. Hence the danger of the subsidiaries being disallowed from making
such payments always looms large. To get around these problems, companies can resort to inter-company
loans. The simplest way is that two companies make parallel loans to each others’ subsidiaries, with the
amounts and timing of the loans and the interest payment as also the loan repayment matching. This can be
refined if each of the subsidiary companies is based in the same country as the other’s parent company. In
that case, the loans come totally out of the ambit of exchange control regulations as both the loans are made
within the countries involved.
Currency of Invoicing
Choice of currency in which intra-group trade is invoiced is an important tool for transferring profits within
different companies of the same group. Exchange controls are generally imposed to prevent the local
currency from depreciating. If the currency is expected to depreciate despite the controls, the exports from
the subsidiary based in that country to other group companies can be invoiced in that country’s currency.
Also, the imports of that subsidiary from other group companies can be invoiced in some hard currency
(one that is expected to appreciate). As the country’s currency depreciates, the subsidiary’s profits will fall
from what they would have been otherwise, and the profits of other group companies will increase.
Reinvoicing Centers
Trades between companies in the same group can be routed through a reinvoicing center. Reinvoicing
centers act as an intermediary by buying from one company and selling them on to the other. The margin
between the buying and the selling rates is the amount of profit transferred from the subsidiary to the
reinvoicing center. Such centers are mainly used for the management of exposures, but can also be used for
converting non-repatriable cash flows into repatriable cash flows, when set up in countries with lesser
capital controls. In addition to such conversion, setting up of such reinvoicing centers in tax havens can
reduce the overall taxes, and hence increase the after-tax cash flows.
Countertrade
Countertrade involves the parent company and the subsidiary buying from and selling to each other. The
most common form taken is barter trade. While the goods transferred from the subsidiary (the value of
which may be very high compared to the value of goods received by it) may not be useful for the parent
company directly, it can sell them to some third party, with the proceeds serving as an indirect transfer of
the subsidiary’s profits.
< TOP >
4. Exposure can be classified into three kinds on the basis of the nature of item that is exposed, measurability
of the exposure and the timing of estimation of exposure. These are
• • Transaction exposure
• • Translation exposure
• • Operating exposure
Transaction Exposure
Transaction exposure is the exposure that arises from foreign currency denominated transactions which an
entity is committed to complete. In other words, it arises from contractual, foreign currency, future cash
flows. For example, if a firm has entered into a contract to sell computers to a foreign customer at a fixed
price denominated in a foreign currency, the firm would be exposed to exchange rate movements till it
receives the payment and converts the receipts into the domestic currency. The exposure of a company in a
particular currency is measured in net terms, i.e. after netting off potential cash inflows with outflows.
Translation Exposure
Translation exposure is the exposure that arises from the need to convert values of assets and liabilities
denominated in a foreign currency, into the domestic currency. For example, a company having a foreign
 currency deposit would need to translate its value into its domestic currency for the purpose of reporting at
the time of preparation of its financial statements. Any exposure arising out of exchange rate movement
and the resultant change in the domestic-currency value of the deposit would classify as translation
exposure. It needs to be noted that this exposure is mostly notional, as there is no real gain or loss due to
exchange rate movements since the asset or liability does not stand liquidated at the time of reporting.
Hence, it is also referred to as accounting exposure. This fact makes the measurement of translation
exposure dependent on the accounting policies followed for the purpose of converting the foreign-currency
values of assets and liabilities into the domestic currency.
Operating Exposure
Operating exposure is defined as “the extent to which the value of a firm stands exposed to exchange rate
movements, the firm’s value being measured by the present value of its expected cash flows”. Operating
exposure is a result of economic consequences (rather than accounting consequences, as in the case of
transaction and translation exposure) of exchange rate movements on the value of a firm, and hence, is also
known as economic exposure.
Transaction and translation exposure cover the risk of the current profits of the firm being affected by a
movement in exchange rates. On the other hand, operating exposure describes the risk of future cash flows
of a firm changing due to a change in the exchange rate.
The exposure arising out of contractually fixed cash flows can be managed using various techniques, but
where the exposure arises out of cash flows that are not fixed contractually, or where the change in the
domestic-currency value as a result of exchange rate movements cannot be predicted exactly, these
techniques become ineffective. Due to this difficulty in managing such exposure with the traditional
techniques, it is also referred to as the residual exposure. The future cash flows of a firm are dependent not
only on the exchange rate movements, but also on the relative rates of inflation prevailing in different
countries. The interplay of these two forces determines the future cash flows and their variability, and
hence, the operating exposure faced by a firm.
ILL will mainly face translation exposure as it has to convert Guyana subsidiaries assets and liabilities into
domestic currency. It will also face transaction exposure if it exports some raw material and services to the
subsidiary in Guyana.
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Section E: Caselets
Caselet 1

5. Some of the advantages which attract the borrowers of one country to raise capital from international
capital markets are:
Low cost of capital
In the domestic capital market, the availability of liquid funds is normally limited, this leads to a
competition among the borrowers to get maximum out of the available minimum capital in the market
which will result in the raising of the cost of capital, which may become higher than cost of capital in the
international market. As a result, companies have to pay more interest on borrowings. But if the money is
borrowed from the international markets there might be less need for paying more interest as there would
be high supply of funds. The problem of less liquidity in the domestic market is not only restricted to the
developing countries but also to the developed countries.
Currency requirement
Keeping in view of the company’s future expansion plans, capital imports etc. company may need to
borrow in foreign currencies in the international capital market.
Flexibility
Greater flexibility is available for structuring an issue in international capital market than in the markets of
developing countries.
International Positioning
An international issue positions the issuing company, for a much higher visibility and an international
exposure. This will help in future for further fund raising activities.
Absence of regulatory interference
The restrictions imposed by the national government on the foreign issues increase the cost of issuing the
bond, whereas in case of euro bonds market they are less as they fall outside the purview of any single
country’s regulatory framework.
Disclosure norms
 In the euro bond market, the disclosure norms are less stringent when compared to issue of bonds in their
domestic markets or in the markets of developed countries like US.
Investment Climate
The current global scenario is luring the companies of various countries to borrow from the euro bond
market, since the historic low level of dollar interest rates and depreciating dollar against most of the major
currencies have reduced the cost of borrowings in the international capital markets substantially.
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6. As per the Finance mister’s speech there are mainly three reasons behind restriction in the ECB. One, there
is enough liquidity in the domestic market, so corporates must first tap that. Two, some push to be provided
to domestic credit market to safeguard the interest of domestic banks and financial institutions since there
are not enough borrowers in the market. And three, the Finance Ministry and RBI want the industry to be
cautious about taking excessive foreign currency exposure as the current trend of a weakening dollar could
reverse anytime as growth and productivity picks up in the US. With the US economy on the recovery path
and that any time in future dollar may appreciate against other currencies and rupee.
The restriction on ECB may be justified for a short span of time in the view of recovery of US economy.
RBI has already insisted on the hedging of smaller foreign currency loans also. On the negative side the
RBI’s restriction in this era of globalization will great barriers in the capital account convertibility process.
Once we are going to the path of fully open economy, government intervention is not justified and
corporate should be allowed to take a view on the attendant risks. In fact, the ECB policy had evolved over
the past decade in such a manner as to enable the corporates incrementally greater freedom to manage their
risks. The new guidelines have somewhat reversed that process. In this era of globalization, ECB
restrictions is not desirable and it may be detrimental to the long term interest of Indian economy.

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Caselet 2

7. So far, the appreciation of rupee did not appear to have any significant adverse impact on the Indian
economy. The appreciating rupee have expected to reduce exports due to stronger rupee and increase
cheaper imports and thus worsening the balance of payment position. However, the export has grown by
record percentage in 2003-04 and balance of payment position is also not annoying. The probable reason
for this is that the appreciation of rupee against dollar is lower than the appreciation of the other competing
countries like China, Hong Kong and Malaysia. Another reason is appreciation of rupee is also offset
substantially by the fall in the expenditure on imports, as Indian exports are heavily dependent on import.

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8. India companies have adopted several approaches to cope with this situation, apart from looking for
business from other countries. Of these, the one most often heard about is that the invoicing is being done
in Euro, instead of the dollar. Some firms also tried to shift the currency of invoicing to the rupee, which
completely eliminates the foreign exchange risk for the exporter. However, this approach is not without its
own problems. Given that Indian exporters do not have much bargaining power, buyers try to reduce the
prices denominated in Euro or the rupee.
Another approach used widely is to book forward contracts to cover the receivables. If the exporter enters
into forward contract for the full amount of the receivable, the entire amount is converted at the forward
rate offered by the bank, eliminating the risk. But, in a situation where the dollar is expected to depreciate,
even the forward rate will be lower than the current conversion rate, and the exporter will lose part of his
revenues. Some firms have, however, tried to use the current situation to generate some profits by using
loopholes in the mechanism for booking forward contracts. They overstate their receivable to be, say $5 mn
while it is in fact only $3 mn. Later, they buy $2 mn from the spot market and deliver it to the bank. If the
actual appreciation of the rupee is more than that implied by the forward contract, the firm then earns a
profit in the transaction, to the extent of the difference in the two exchange rates, on the amount of $2 mn.
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9. RBI can take any one of the following measures to manage rupee-dollar exchange rate. The first of such
measures is that the rupee should be allowed to appreciate even more freely, since there is not much
evidence from other economies that a stronger currency by itself would result in macroeconomic problems.
The second measure is that the intervention in the markets should be more aggressive and should be used to
bring down the value of the rupee like before, to maintain the competitiveness of the Indian exports. The
third measure is that the rupee should be allowed to appreciate relatively quickly. The RBI, however,
maintains that it does not have any fixed view on the level at which the rupee should be pegged. But, it can
be noted from the way the exchange rates are managed in other countries that it is the managed float, which
 is in vogue mostly. Most of the developed countries keep interfering in the markets, to bring down the
volatility in the exchange rates, with the possible exception of the countries whose currencies are reserve
currencies. A managed float, it appears, is what the RBI considers as desirable rather than a completely free
float.
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Caselet 3

10. The basic mechanics of international asset swaps are easy to present. Pension funds that already own
domestic equities engage in a swap with a global pension intermediary, probably an investment bank with
operations in international financial center. In an equity swap, the total return per dollar on the domestic
stock market is exchanged annually for the total return per dollar on a market value weighted-average of
the world stock markets. Equity swaps effectively transfer the risk of the domestic stock market to foreign
investors and provide the local pension funds with the risk-return pattern of a well-diversified world
portfolio. Since there are no initial payments between parties, there are no initial capital flows in or out of
the country. Subsequent payments, which may be either inflows or outflows, involve only the difference
between the returns on the two stock market indices. No principal amounts flow across the exchanges from
the swap arrangements. Furthermore, the local investors make net payments overseas precisely when they
and their country can ‘best’ afford it: namely, when the domestic market has outperformed the world
markets. In those years in which the domestic market under performs the world stock markets, the swap
generates net cash flows into the country to the domestic investors. A different type of swap could enable
them to hedge equity risk altogether. This second type of swap would call for the pension fund to swap the
total return on its equity portfolio for a risk-free interest rate denominated in a ‘strong’ currency or in units
of constant purchasing power. This type of swap would work the same way as an equity swap, except that
the net cash flows produced by the swap would result in the pension fund receiving a risk-free rate of
return. A third possibility is to swap the income stream from holdings of domestic bonds for the interest
income (fixed or floating) of foreign bonds. Again local swap counterparts only make payments when the
local bond market outperforms the international bond market.
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11. The main benefits of asset swaps come from a significant improvement in the efficient frontier of risk
versus expected return. The global equity markets can be used to achieve better diversification and the
global fixed income markets can be used to achieve better hedging opportunities. The latter would be
particularly important for people in countries where there is no local entity, including the government,
capable of issuing fixed income securities that are free of risk. Swapping the income stream from holdings
of domestic bonds for the interest income (fixed or floating) of foreign bonds would be particularly
attractive for countries, that in addition to prohibiting their own institutional investors from investing
overseas do not also allow foreign institutions to invest in the local bond market. Asset swaps could offer
some protection from sudden outflows of capital that could be triggered by the high volatility of sentiment
among international fund managers. Moreover, asset swaps can also mitigate the other barriers to invest
abroad–expropriation risk and high transaction costs.
With swap contracts, trading and ownership of actual shares remain with domestic investors. Pension funds
and other institutional investors in developing countries are constrained in achieving broad international
diversification by strict controls on foreign investments. These controls are motivated by the desire to
prevent capital flight and preserve scarce foreign exchange reserves. International asset swaps can be used
to achieve international diversification while averting capital flight and stimulating local capital market
development. The global equity markets can be used to achieve better diversification and the global fixed
income markets can be used to achieve better hedging opportunities.
The other benefits of properly designed swap contracts are the ease of transactions, the avoidance of large
foreign exchange transactions, the minimization of brokerage and other transaction costs, and the protection
from market manipulation risks.
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