International Finance

Section A
Part One:
1. B
2. C
3. A
4. B
5. C
6. B
7.
8. C
9. B
10. C

Part Two:
1. Interest Rate Parity System for Exchange rates:

Interest rate parity is an economic concept, expressed as a basic algebraic identity

that relates interest rates and exchange rates. The identity is theoretical, and
usually follows from assumptions imposed in economic models. There is
evidence to support as well as refute the concept. Interest rate parity is a non-
arbitrage condition which says that returns from borrowing in one currency,
exchanging that currency for another currency and investing in interest-bearing
instruments of the second currency, while simultaneously purchasing futures
contracts to convert the currency back at the end of the holding period, should be
equal to the returns from purchasing and holding similar interest-bearing
instruments of the first currency. If the returns are different, an arbitrage
transaction could, in theory, produce a risk-free return. Looked at differently,
interest rate parity says that the spot price and the forward or futures price of a
currency incorporate any interest rate differentials between the two currencies.

2. Direct & Indirect Quotes of exchange rates:

Direct Quote: Direct quotation is the dollar price of one unit of foreign currency.
In direct quote, a foreign exchange rate quoted as the domestic currency per unit
of foreign currency. This is also called as American quote. In American quote; it
 involves quoting in fixed units of foreign currency against variable amounts of
the domestic currency. Thus USD/INR 43.20-43.50 is a Direct Quote in India.

Direct exchange rate quotations are most frequently used by banks in dealing
with their non-bank customers. In addition, the prices of currency futures
contracts traded on the Chicago Mercantile exchange are quoted using the direct
method.

Indirect Quote: Indirect quote is the number of a foreign currency that required
to purchase one dollar. In simple term we can say, in indirect quote, foreign
exchange quoted as the foreign currency per unit of the domestic currency. This
is also called as European quote. In a European quote, the foreign currency is a
variable amount and the domestic currency is fixed at one unit. Thus INR/USD
2.560-2.552 is an direct quotation in India per rupees one hundred.

3. International Mutual Fund:

A mutual fund is essentially a mechanism of pooling together the savings of a

large number of small investors for collective investment, with an avowed
objective of attractive yields and capital appreciation, holding the safety and
liquidity as prime parameters.

International mutual funds are those funds that invest in non-domestic securities
markets throughout the world. Investing in international markets provides
greater portfolio diversification and let you capitalize on some of the worlds best
opportunities. International mutual fund may be profitable when some markets
are rising and others are declining.

However, fund managers need to keep close watch on foreign currencies and
world markets as profitable investments in a rising market can lose money if the
foreign currency rises against the dollar. In recent years international mutual
funds have gained popularity. This can be attributed to removal of trade barriers
and expansion of economics, which has sparked off growth in various regions of
the world.

4. Swaps in foreign exchanges markets:

A swap is a privately negotiated agreement between two parties to exchange

cash flows at specified intervals (payment dates) during the agreed-upon life of
the contract (maturity or tenor). Usually, at the time the contract is initiated, at
 least one of these series of cash flows is determined by a random or uncertain
variable, such as an interest rate, foreign exchange rate, equity price or
commodity price.

Swaps can be divided into five generic types, in order of their quantitative
importance.
(a) Interest rate swap: Interest rate swaps can be explained as an agreement
between two parties (counterparties) when one stream of future interest
payments is exchanged for another based on specified principal amount.
(b) Currency Swap: Currency swap can be defined as a swap that involves the
exchange of principal and interest in one currency for same in another
currency.
(c) Credit default swap: A credit default swap agreement in which one party is a
lender and faces credit risk from a third party, and the counterparty in the
credit default swap agrees to insure this risk in exchange of regular periodic
payments (essentially an insurance premium).
(d) Commodity swap: Commodity swap is a swap agreement where exchanged
cash flows are dependent on the price of an underlying commodity.
(e) Equity swap: An equity swap can be explained as a swap in which the cash
flows exchanged are based on the total return on some stock market index
and an interest rate.

Section B
Caselet 1
1.
2.
Caselet 2
1.
2.
Section C
1. Factors affecting Foreign Exchange Rate:

The demand and supply of the currency should determine the exchange rates.
Demand and supply depend on many factors, which are ultimately the cause of
exchange rate fluctuation.
The factors that affect the exchange value are:
(a) International trade: International trade is an important factor that affect
exchange rate. Demand and supply is depending on trade of goods and
services between countries. Suppose if India imports are higher, the demand
for foreign currency in India will be high. Higher demand for foreign
currency means high value of foreign currency and low value of India
currency.
(b) Capital movement: Capital movement is another factor that affects the
exchange rate. Suppose in India there is large inflow of capital through
foreign investment, then the currency of India get appreciates and if there is
large outflow capital, this mean Indian currency depreciates.
(c) Political factor: It decides the strength of the country. Stable efficient
government encourages for the development of country. The political factors
influencing exchange rates include the established monetary policy along
with government action or inaction on items such as the money supply,
inflation, taxes, and deficit financing. Active government intervention or
manipulations, such as central bank activity in the foreign currency markets,
also have an impact.
(d) Change in prices: Change is prices an important role in exchange rate.
Demand and supply depends on the change of price. Suppose the price in
India increases, the goods of India becomes costlier, therefore demand of
goods decreases. Also exports will decreases and demand for rupee will fall,
this leads to the depreciation of Indian currency.
(e) Strength of economy: It is important factor that affect the exchange rate. If
economic fundamentals are strong, the exchange rate of the country are
strong and stable Economic factors affecting exchange rates include hedging
activities interest rates, inflationary pressures, trade imbalances, and
Euromarkets activities.

Exchange Rate Quotations:

There are two methods of quotation for exchange rates between the dollar and
the currency of another country. The two methods are:

Direct Quote: Direct quotation is the dollar price of one unit of foreign currency.
In direct quote, a foreign exchange rate quoted as the domestic currency per unit
of foreign currency. This is also called as American quote. In American quote; it
involves quoting in fixed units of foreign currency against variable amounts of
the domestic currency. Thus USD/INR 43.20-43.50 is a Direct Quote in India.
 Direct exchange rate quotations are most frequently used by banks in dealing
with their non-bank customers. In addition, the prices of currency futures
contracts traded on the Chicago Mercantile exchange are quoted using the direct
method.

Indirect Quote: Indirect quote is the number of a foreign currency that required
to purchase one dollar. In simple term we can say, in indirect quote, foreign
exchange quoted as the foreign currency per unit of the domestic currency. This
is also called as European quote. In a European quote, the foreign currency is a
variable amount and the domestic currency is fixed at one unit. Thus INR/USD
2.560-2.552 is a direct quotation in India per rupees one hundred.

2. Balance of Payment:
The Balance of Payments (BOP) is a record of all transactions made between one
particular country and all other countries during a specified period of time
usually a year. Economic transactions include exports and imports of goods and
services, capital inflows, gifts and other transfer payments and changes in a
countrys international reserves.

Components of Balance of Payments:

The balance of payment statement records all types of international transcations
that a country consummates over a certain period of time.

It is divided into three sections:

1. Current Account: Current account refers to an account which records all the
transactions relating to export and import of goods and services and
unilateral transfers during a given period of time. Current account contains
the receipts and payments relating to all the transactions of visible items,
invisible items and unilateral transfers.
2. Capital Account: Capital account of BOP records all those transactions,
between the residents of a country and the rest of the world, which cause a
change in the assets or liabilities of the residents of the country or its
government. It is related to claims and liabilities of financial nature.
3. Official Reserve Account: The official reserve account, a subdivision of the
capital account, is the foreign currency and securities held by the
government, usually by its central bank, and is used to balance the payments
from year to year. In the United States, the New York Federal Reserve serves
as the Treasury's fiscal agent. The official reserves increases when there is a
trade surplus and decreases when there is a deficit. Sometimes the central
bank will use it to intervene in the foreign exchange market to set the
exchange rate to some objective. However, foreign interventions rarely work
because, while central banks only intervene for a short time, market forces are
always influencing the exchange rate, so the market equilibrium will soon
return after the intervention.