Master of Business Administration - MBA Semester 4

MF0006 - International Financial Management

Assignment Set- 1

Q1. Explain briefly the different exchange rate regime that are prevalent today.

Ans:- The exchange rate is an important price in the economy and some governments like to
control it, manage it or influence it. Others prefer to leave the exchange rate to be determined
only by market forces. This decision is the choice of exchange rate regime. Many alternative
regimes exist:

Floating Exchange Rate (Flexible) Regimes: A flexible exchange rate system is one where the
value of the currency is not officially fixed but varies according to the supply and demand for the
currency in the foreign exchange market. In this system, currencies are allowed to:

• Appreciate – when the currency becomes more valuable relative to others.

• Depreciate– when the currency becomes less valuable relative to others.

Fixed Exchange Rate Regimes: A Fixed exchange rate system is one where the value of the
currency is set by official government policy. The exchange rate is determined by government
actions designed to keep rates the same over time. The currencies are altered by the government:

• Revaluation – Government action to increase the value of domestic currency relative to

others.
• Devaluation – Government action to decrease the value of domestic currency.

After the transition period of 1971-73, the major currencies started to float. Flexible exchange
rates were declared acceptable to the IMF members. Gold was abandoned as an international
reserve asset. Since 1973, most major exchange rates have been “floating” against each other.
However, there are countries which have fixed exchange rate regimes.

Q2. What is arbitrage? Explain with the help of suitable example a tow-way and a three-
way arbitrage.

Ans:- Arbitrage is the activity of exploiting imbalances between two or more markets. Foreign
money exchangers operate their entire businesses on this principle. They find tourists who need
the convenience of a quick cash exchange. Tourists exchange cash for less than the market rate
and then the money exchanger converts those foreign funds into the local currency at a higher
rate. The difference between the two rates is the spread or profit.

There are plenty of other instances where one can engage in the practice arbitrage. In some cases,
one market does not know about or have access to the other market. Alternatively, arbitrageurs
can take advantage of varying liquidities between markets.
The term 'arbitrage' is usually reserved for money and other investments as opposed to
imbalances in the price of goods. The presence of arbitrageurs typically causes the prices in
different markets to converge: the prices in the more expensive market will tend to decline and
the opposite will ensue for the cheaper market. The the efficiency of the market refers to the
speed at which the disparate prices converge.

Engaging in arbitrage can be lucrative, but it does not come without risk. Perhaps the biggest risk
is the potential for rapid fluctuations in market prices. For example, the spread between two
markets can fluctuate during the time required for the transactions themselves. In cases where
prices fluctuate rapidly, would-be arbitrageurs can actually lose money.

There are basically two types of arbitrage. One is two-way arbitrage and the other is three-
way arbitrage. The more popular of the two is the two-way forex arbitrage.

In the international market the currency is expressed in the form AAA/BBB. AAA denotes the
price of one unit of the currency which the trader wishes to trade and it refers the base currency.
While BBB is international three-letter code 0f the counter currency. For instance, when the
value of EUR/USD is 1.4015, it means 1 euro = 1.4015 dollar.

If the speculator is shrewd and has a deeper understanding of the forex market, then he can make
use of this opportunity to make big profits. Forex arbitrage transactions are quite easy once you
understand the method by which the business is conducted.

For instance, the exchange rates of EUR/USD = 0.652, EUR/GBP = 1.312 and USD/GBP =
2.012. You can buy around 326100 Euros with $500,000. Using the Euros you buy
approximately 248420 Pounds which is sold for approximately $500,043 and thereby earning a
small profit of $43.

To make a large profit on triangular arbitrage you should be ready to invest a large amount and
deal with trustworthy brokers.

Arbitrage is one of the strategies of forex trading. To make a substantial income out of this
strategy you need to make an enormous amount of investment. Though theoretically it is
considered to be risk free, in reality it is not the case. You should enter into this transaction only
if you have deeper understanding of forex market. Hence, it would be wise not to devote much
time in looking out for arbitrage opportunities. However, forex arbitrage is a rare opportunity and
if it comes your way, then grab it without any hesitation.

Three Way (Triangular) Arbitrage

The three way arbitrate inefficiency now arises when we consider a case in which the EUR/JPY
exchange rate is NOT equivalent to the EUR/USD/USD/JPY case so there must be something
going on in the market that is causing a temporary inconsistency. If this inconsistency becomes
large enough one can enter trades on the cross and the other pairs in opposite directions so that
the discrepancy is corrected. Let us consider the following example :

EUR/JPY=107.86
EUR/USD=1.2713
USD/JPY = 84.75

The exchange rate inferred from the above would be 1.2713*84.75 which would be 107.74 and
the actual rate is 107.86. What we can do now is short the EUR/JPY and go long EUR/USD and
USD/JPY until the correlation is reestablished. Sounds easy, right ? The fact is that there are
many important problems that make the exploitation of this three way arbitrage almost
impossible.

Q3. You are given the following information:

Spot EUR/US: 0.7940/0.8007

Spot USD/GBP:1.8215/1.8240
Three months swap: 25/35
Calculate three month EUR/USD rate.

Master of Business Administration - MBA Semester 4

MF0006 – International Financial Management
Assignment Set- 2

Q1. What is meant by BOP? How are capital account convertibility and current account
convertibility different? What is the current scenario in India?

Ans:- The balance of payments (or BOP) of a country is a record of international transactions
between residents of one country and the rest of the world over a specified period, usually a year.
Thus, India’s balance of payments accounts record transactions between Indian residents and the
rest of the world. International transactions include exchanges of goods, services or assets. The
term “residents” means businesses, individuals and government agencies and includes citizens
temporarily living abroad but excludes local subsidiaries of foreign corporations.

The balance of payments is a sources-and-uses-of-funds statement. Transactions such as exports

of goods and services that earn foreign exchange are recorded as credit, plus, or cash inflows
(sources). Transactions such as imports of goods and services that expend foreign exchange are
recorded as debit, minus, or cash outflows (uses).

The Balance of Payments for a country is the sum of the Current Account, the Capital
Account and the change in Official Reserves.

The current account is that balance of payments account in which all short-term flows of
payments are listed. It is the sum of net sales from trade in goods and services, net investment
income (interest and dividend), and net unilateral transfers (private transfer payments and
government transfers) from abroad. Investment income for a country is the payment made to its
residents who are holders of foreign financial assets (includes interest on bonds and loans,
dividends and other claims on profits) and payments made to its citizens who are temporary
workers abroad. Unilateral transfers are official government grants-in-aid to foreign
governments, charitable giving (e.g., famine relief) and migrant workers’ transfers to families in
their home countries. Net investment income and net transfers are small relative to imports and
exports. Therefore a current account surplus indicates positive net exports or a trade surplus
and a current account deficit indicates negative net exports or a trade deficit.

The capital (or financial) account is that balance of payments account in which all cross-border
transactions involving financial assets are listed. All purchases or sales of assets, including direct
investment (FDI) securities (portfolio investment) and bank claims and liabilities are listed in the
capital account. When Indian citizens buy foreign securities or when foreigners buy Indian
securities, they are listed here as outflows and inflows, respectively. When domestic residents
purchase more financial assets in foreign economies than what foreigners purchase of domestic
assets, there is a net capital outflow. If foreigners purchase more Indian financial assets than
domestic residents spend on foreign financial assets, then there will be a net capital inflow. A
capital account surplus indicates net capital inflows or negative net foreign investment. A
capital account deficit indicates net capital outflows or positive net foreign investment.

Current scenario in India

The official reserves account (ORA) records the total reserves held by the official monetary
authorities (central banks) within the country. These reserves are normally composed of the
major currencies used in international trade and financial transactions. The reserves consist of
“hard” currencies (such as US dollar, British Pound, Euro, Yen), official gold reserve and IMF
Special Drawing Rights (SDR). The reserves are held by central banks to cushion against
instability in international markets. The level of reserves changes because of the central bank’s
intervention in the foreign exchange markets. Countries that try to control the price of their
currency (set the exchange rate) have large net changes in their Official Reserve Accounts. In
general, a net decrease in the Official Reserve Account indicates that a country is buying its
currency in exchange for foreign exchange reserves, to try to keep the value of the domestic
currency high with respect to foreign currencies. Countries with net increases in the Official
Reserve Account are usually attempting to keep the price of the domestic currency cheap relative
to foreign currencies, by selling their currencies and buying the foreign exchange reserves. When
a central bank sells its reserves (foreign currencies) for the domestic currency in the foreign
exchange market, it is a credit item in the balance of payment accounts as it makes available
foreign currencies. Similarly, when a central bank buys reserves (foreign currency), it is a debit
item in the balance of payment accounts.

The Balance of Payments identity states that: Current Account + Capital Account = Change
in Official Reserve Account. If a country runs a current account deficit and it does not run down
its official reserve to cover this deficit (there is no change in official reserve), then the current
account deficit must be balanced by a capital account surplus. Typically, in countries with
floating exchange rate system, the change in official reserves in a given year is small relative to
the Current Account and the Capital Account. Therefore, it can be approximated by zero. Thus,
such a country can only consume more than it produces (or imports are greater than exports; a
current account deficit) only if it has a capital account surplus (foreign residents are willing to
invest in the country). Even in a fixed exchange rate system, the size of the official reserve
account is small compared to the transactions in the current and capital account. Thus the
residents of a country cannot have a current account deficit (imports exceeding exports) unless
the foreigners are willing to invest in that country (capital account surplus).

Q2. What are foreign exchange markets? Who are the players in the foreign exchange
market ? What is meant by exchange rate quotations?

Ans:- The foreign exchange market is the largest and most liquid market in the world. The
estimated worldwide turnover of this market is at around $1½ trillion a day, which is several
times the level of turnover in the U.S. Government securities market, which is the world’s
second largest financial market. The turnover in the foreign exchange market is equivalent to
more than $200 in foreign exchange market transactions, every business day of the year, for
every man, woman, and child on earth!

The breadth, depth, and liquidity of the market are very impressive. Individual trades of $200
million to $500 million can take place. The quoted prices change as often as 20 times a minute
for active currencies. It has been estimated that the world’s most active exchange rates can
change up to 18,000 times during a single day.

Almost two-third of the $1½ trillion per day trade represents transactions among the dealers
themselves – with only one third accounted for by their transactions with financial and non-
financial customers. An initial dealer transaction with a customer in the foreign exchange market
often leads to multiple further transactions, sometimes over an extended period, as the dealer
institutions readjust their own positions to hedge, manage, or offset the risks involved.

The foreign exchange market is a twenty four hour market. Each business day arrives first in the
financial centers of Asia-Pacific —first Wellington, then Sydney followed by Tokyo, Hong
Kong, and Singapore. A few hours later, while markets are still active in these Asian centers,
trading begins in Bahrain and at other places in the Middle East. Later, when it is late in the
business day in Tokyo, markets open for business in Europe. When it is early afternoon in
Europe, trading in New York and other U.S. centers begin. Finally, completing the circle, when
it is mid or late afternoon in the United States, the next day has arrived in the Asia-Pacific area,
the first markets there have opened, and the process begins again.

The twenty-four hour market means that the exchange rates and market conditions can change at
any time in response to developments that can take place at any time in the day. Traders and
other market participants therefore, must be alert to the possibility that a sharp move in an
exchange rate can occur during an off hour, elsewhere in the world. The large dealing institutions
have thus introduced various arrangements for monitoring markets and trading on a twenty-four
hour basis. Some keep their New York or other trading desks open twenty-four hours a day,
others shift work from one office to the next, and the others follow different approaches.

The foreign exchange market consists of both an over-the-counter (OTC) market and an
exchange-traded segment of the market. The OTC market is an international OTC network of
major dealers – mainly but not exclusively banks – operating in financial centers around the
world, trading with each other and with customers, via computers, telephones, and other means.
The exchange-traded market covers trade in a limited number of foreign exchange products on
the floors of organized exchanges.

The OTC market accounts for well over 90 percent of total foreign exchange market activity,
covering both the traditional (pre-1970) products (spot, outright forwards, and FX swaps) as well
as the more recently introduced (post-1970) OTC products (currency options and currency
swaps). On the “organized exchanges,” foreign exchange products traded are currency futures
and certain currency options.

The main players in the foreign exchange market are

There are three types of participants in the foreign exchange market:

• customers,
• banks and
• brokers.

Customers, such as multinational corporations, are in the market because they require foreign
currency in the course of their cross border trade or investment business. For example, an
engineering firm based in the United Kingdom might use the foreign exchange market to buy the
dollars it needs to pay to a firm in the USA that is selling it capital goods; in this case, it would
sell pounds and buy dollars.

Commercial banks are by far the most active participants in the foreign exchange market. They
deal with other financial institutions and corporations who contact them, typically by telephone,
to ask for their rates, and may then buy foreign currency from, or sell, to the bank at those rates.
This process is known as market making: the banks will at all times quote buying (bid rates) or
selling rates (ask rates) for pairs of currencies – dollars to the pound, Japanese yen to the euro
and so on. The market makers earn a profit on the difference between their buying and selling
rates (spread).

The third type of participant, the brokers, who act as intermediaries between the banks. They are
specialist companies with computer links or telephone lines to banks throughout the world so
that at any time they know which bank has the highest bid (buying) rate for a currency, and
which the lowest offer (selling) rate.

The foreign exchange market links various foreign exchange trading centers from around the
world into a single, unified, cohesive, worldwide market. Foreign exchange trading takes place
among dealers and other market professionals in a large number of individual financial centers –
New York, Chicago, Los Angeles, London, Tokyo, Singapore, Frankfurt, Paris, Zurich, Milan,
and many others.

Foreign Exchange Rates and Quotation

Base Currency and Terms Currency

Exchange rate is a price to buy or sell currency. Exchange rate is terms currency per unit of
base currency. Base currency is the currency that is bought or sold. Terms currency is the
pricing currency. Let us understand this with the help of an example. Let us take the Euro-dollar
quote of $1.2120. The base currency is the euro. The terms currency is dollar. The price of 1
euro is $1.2120.

Every foreign exchange transaction involves two currencies — and it is important to keep
straight which is the base currency (or quoted, underlying, or fixed currency) and which is the
terms currency (or counter currency). A trader always buys or sells a fixed amount of the “base”
currency – most often the dollar – and adjusts the amount of the “terms” currency as the
exchange rate changes. The terms currency is thus the numerator and the base currency is the
denominator. When the numerator increases, the base currency is strengthening and becoming
more expensive; when the numerator decreases, the base currency is weakening and becoming
cheaper.

In oral communications, the base currency is always stated first. For example, a quotation for
“dollar-yen” means that the dollar is the base currency and therefore is in the denominator, and
the yen is the terms currency and therefore is in the numerator; “dollar-swissie” means that the
Swiss franc is the terms currency and dollar is the base currency; and “sterling-dollar” (usually
called “cable”) means that the dollar is the terms currency and pound is the base currency.

Currency Codes
Currency codes are also used to denote currency pairs. Each currency is assigned a three-letter
code. For example, US dollar is coded – USD (United States Dollar), euro is coded EUR
(EURo), Swiss frank is coded CHF (Confederation Helvetica Franc), Japanese yen is coded JPY
(JaPanese Yen) and the British pound is coded GBP (Great British Pound). The currency codes
are defined by ISO-4217 standard. Usually they are formed as a two-letter ISO-3166 country
code and the first letter of currency name. There are a few exceptions, the most notable being the
euro (EUR) which is not the currency of a single country but that of the European Union.

The standard symbols for some of the most commonly traded currencies are:

EUR: Euros

USD: United States dollar

CAD: Canadian dollar

GBP: British pound

JPY: Japanese yen

AUD: Australian dollar

CHF: Swiss franc

Bid Price and Ask Price

In the foreign exchange market there are always two prices for every currency – one price at
which the sellers of that currency want to sell, and another price at which buyers of the currency
want to buy. A market maker is expected to quote simultaneously for his customers both a price
at which he is willing to sell and a price at which he is willing to buy standard amounts of any
currency for which he is making a market. Thus, Forex quotes always include a bid and an ask
price. The bid price is the price at which the market maker (dealer) is willing to buy the base
currency in exchange for the counter (or terms) currency. The ask price is the price at which the
market maker is willing to sell the base currency in exchange for the counter currency. Traders
always think in terms of how much it costs to buy or sell the base currency. A market maker’s
quotes are always presented from the market maker’s point of view, so the bid price is the
amount of terms currency that the market maker will pay for a unit of the base currency; the
offer price (or ask price) is the amount of terms currency the market maker will charge for a
unit of the base currency. The difference between the bid and the ask prices is referred to as the
spread. A wide spread indicates illiquid trading conditions.

A market maker asked for a quote on “dollar-swissie” might respond “1.4975-85,” which
indicates a bid price of CHF 1.4975 per dollar and an offer price of CHF 1.4985 per dollar.
Usually, the market maker will simply give the quote as “75-85,” and assume that the
counterparty knows that the “big figure” is 1.49. The bid price always is offered first (the number
on the left), and is lower (a smaller amount of terms currency) than the offer price (the larger
number on the right). This differential is the dealer’s spread.

Direct and Indirect Quotes

Exchange rate quotes, as the price of one currency in terms of another, come in two forms:

a) “Direct” quotation is the amount of domestic currency per unit of foreign currency. Example:
Rs. 77.30 / £ in India, $1.7676 / £ in US and

b) “Indirect” quotation is the amount of foreign currency per unit of domestic currency.
Example Swedish Kroner 0.1763/Rs in India, 0.8251 Euro/$ in US.

European and American Terms

The phrase “American terms” means a direct quote from the point of view of someone located in
the United States. For the dollar, that means that the rate is quoted in variable amounts of U.S.
dollars per one unit of foreign currency (e.g., $1.2119 per Euro). The phrase “European terms”
means a direct quote from the point of view of someone located in Europe. For the dollar, that
means variable amounts of foreign currency per one U.S. dollar (or Euro 0.8251 per $1).

In daily life, most prices are quoted “directly,” so when you go to the shop you pay x dollars and
y cents for one loaf (unit) of bread (in US). For many years, all dollar exchange rates also were
quoted directly. That meant that the dollar exchange rates were quoted in European terms in
Europe, and in American terms in the United States of America. However, in 1978, as the
foreign exchange market was integrating into a single global market, for convenience, the
practice in the U.S. market was changed – at the initiative of the international broker community
– to conform to the European convention. Thus, OTC markets in all countries now quote dollars
in European terms against nearly all other currencies (amounts of foreign currency per $1). That
means that the dollar is nearly always the base currency, one unit of which (one dollar) is being
bought or sold for a variable amount of a foreign currency. The only exceptions to this
convention are quotes in relation to the euro, the pound sterling and the Australian dollar – these
three are quoted as dollars per foreign currency.

Pip

Prices are always quoted using five numbers (for example, JPY 134.85 / USD), the final digit of
which is referred to as a point or a pip. A pip is the smallest price change that a given exchange
rate can make.
Since most major currency pairs are priced to four decimal places, the smallest change is that of
the last decimal point – for most pairs this is the equivalent of 1/100 th of one percent, or one basis
point. For example, the smallest move the USD/CAD currency pair can make is $0.0001, or one
basis point. The smallest move in a currency does not always need to be equal to one basis point,
but this is generally the case with most currency pairs.

Q3. Distinguish between Eurobond and foreign bonds? What are the unique characteristics
of Eurobond markets?

Ans:- A Eurobond is underwritten by an international syndicate of banks and other securities

firms, and is sold exclusively in countries other than the country in whose currency the issue is
denominated. For example, a bond issued by a U.S. corporation, denominated in U.S. dollars, but
sold to investors in Europe and Japan (not to investors in the United States), would be a
Eurobond. Eurobonds are issued by multinational corporations, large domestic corporations,
sovereign governments, governmental enterprises, and international institutions. They are offered
simultaneously in a number of different national capital markets, but not in the capital market of
the country, nor to residents of the country, in whose currency the bond is denominated. Almost
all Eurobonds are in bearer form with call provisions and sinking funds.

A foreign bond is underwritten by a syndicate composed of members from a single country, sold
principally within that country, and denominated in the currency of that country. The issuer,
however, is from another country. A bond issued by a Swedish corporation, denominated in
dollars, and sold in the U.S. to U.S. investors by U.S. investment bankers, would be a foreign
bond. Foreign bonds have nicknames: foreign bonds sold in the U.S. are "Yankee bonds"; those
sold in Japan are "Samurai bonds"; and foreign bonds sold in the United Kingdom are
"Bulldogs."

Figure 4 specifically reclassifies foreign bonds from a U.S. investor`s perspective.

FIGURE 4
FOREIGN BONDS TO U.S. INVESTORS
Foreign currency bonds are issued by foreign governments and foreign corporations,
denominated in their own currency. As with domestic bonds, such bonds are priced inversely to
movements in the interest rate of the country in whose currency the issue is denominated. For
example, the values of German bonds fall if German interest rates rise. In addition, values of
bonds denominated in foreign currencies will fall (or rise) if the dollar appreciates (or
depreciates) relative to the denominated currency. Indeed, investing in foreign currency bonds is
really a play on the dollar. If the dollar and foreign interest rates fall, investors in foreign
currency bonds could make a nice return. It should be pointed out, however, that if both the
dollar and foreign interest rates rise, the investors will be hit with a double whammy.

Characteristics of Eurobond markets

1. Currency denomination: The generic, plain vanilla Eurobond pays an annual fixed
interest and has a long-term maturity. There are a number of different currencies in which
Eurobonds are sold. The major currency denominations are the U.S. dollar, yen, and euro.
(70 to 75 percent of Eurobonds are denominated in the U.S. dollar.) The central bank of a
country can protect its currency from being used. Japan, for example, prohibited the yen
from being used for Eurobond issues of its corporations until 1984.
2. Non-registered: Eurobonds are usually issued in countries in which there is little
regulation. As a result, many Eurobonds are unregistered, issued as bearer bonds. (Bearer
form means that the bond is unregistered, there is no record to identify the owners, and
these bonds are usually kept on deposit at depository institution). While this feature
provides confidentiality, it has created some problems in countries such as the U.S.,
where regulations require that security owners be registered on the books of issuer.
3. Credit risk: Compared to domestic corporate bonds, Eurobonds have fewer protective
covenants, making them an attractive financing instrument to corporations, but riskier to
bond investors. Eurobonds differ in term of their default risk and are rated in terms of
quality ratings.
4. Maturities: The maturities on Eurobonds vary. Many have intermediate terms (2 to 10
years), referred to as Euronotes, and long terms (10-30 years), and called Eurobonds.
There are also short-term Europaper and Euro Medium-term notes.
5. Other features:

• Like many securities issued today, Eurobonds often are sold with many
innovative features. For example:

a) Dual-currency Eurobonds pay coupon interest in one currency and principal in

another.
b) Option currency Eurobond offers investors a choice of currency. For instance, a
sterling/Canadian dollar bond gives the holder the right to receive interest and
principal in either currency.
1. A number of Eurobonds have special conversion features. One type of
convertible Eurobond is a dual-currency bond that allows the holder to
convert the bond into stock or another bond that is denominated in another
currency.
2. A number of Eurobonds have special warrants attached to them. Some of
the warrants sold with Eurobonds include those giving the holder the right
to buy stock, additional bonds, currency, or gold.