International Finance Semester - III

Q1. a. Discuss the functions of the IMF.

Ans:

The IMF is an international organization of 184 member countries. It

was established to promote international monetary cooperation,
exchange stability, and orderly exchange arrangements; to foster
economic growth and high levels of employment; and to provide
temporary financial assistance to countries to help ease balance of
payments adjustment

The purposes of the International Monetary Fund are:

1. To promote international monetary cooperation through a
permanent institution which provides the machinery for consultation
and collaboration on international monetary problems.
2. To facilitate the expansion and balanced growth of international
trade, and to contribute thereby to the promotion and maintenance
of high levels of employment and real income and to the
development of the productive resources of all members as primary
objectives of economic policy.
3. To promote exchange stability, to maintain orderly exchange
arrangements among members, and to avoid competitive exchange
depreciation.
4. To assist in the establishment of a multilateral system of payments
in respect of current transactions between members and in the
elimination of foreign exchange restrictions which hamper the
growth of world trade.
5. To give confidence to members by making the general resources of
the Fund temporarily available to them under adequate safeguards,
thus providing them with opportunity to correct maladjustments in
their balance of payments without resorting to measures
destructive of national or international prosperity.
6. In accordance with the above, to shorten the duration and lessen
the degree of disequilibria in the international balances of payments
of members.

IMF Facilities:
Over the years, the IMF has developed a number of loan instruments,
or "facilities", that are tailored to address the specific circumstances of
its diverse membership. Low-income countries may borrow at a
concessional interest rate through the Poverty Reduction and Growth
Facility (PRGF). Non-concessional loans are provided through five main
facilities: Stand-By Arrangements (SBA), the Extended Fund Facility
(EFF), the Supplemental Reserve Facility (SRF), the Contingent Credit
Lines (CCL), and the Compensatory Financing Facility (CFF). Except for

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the PRGF, all facilities are subject to the IMF's market-related interest
rate, known as the "rate of charge", and some carry an interest rate
premium, a "surcharge". The rate of charge is based on the SDR
interest rate, which is revised weekly to take account of changes in
short-term interest rates in the major international money markets.
The rate of charge is currently about 4 percent. The IMF discourages
excessive use of its resources by imposing a surcharge on large loans,
and countries are expected to repay loans early if their external
position allows them to do so.

Poverty Reduction and Growth Facility (PRGF). The IMF for many
years provided assistance to low-income countries through the
Enhanced Structural Adjustment Facility (ESAF). In 1999, however, a
decision was made to strengthen the focus on poverty, and the ESAF
was replaced by the PRGF. Loans under the PRGF are based on a
Poverty Reduction Strategy Paper (PRSP), which is prepared by the
country in cooperation with civil society and other development
partners, in particular the World Bank. The interest rate levied on PRGF
loans is only 0.5 percent, and loans may be repaid over a maximum
period of 10 years.

Stand-By Arrangements (SBA). The SBA is designed to address

short-term balance-of-payments problems and is the most widely used
facility of the IMF. The length of a SBA is typically 12-18 months.
Repayment must take place within a maximum of 5 years, but
countries are expected to repay within 2-4 years.

Extended Fund Facility (EFF). This facility was established in 1974

to help countries address more protracted balance-of-payments
problems with roots in the structure of the economy. Arrangements
under the EFF are thus longer (3 years) and the repayment period can
extend to 10 years, although repayment is expected within 4½ -7
years.

Supplemental Reserve Facility (SRF). The SRF was introduced in

1997 to meet a need for very short-term financing on a large scale.
The sudden loss of market confidence experienced by emerging
market economies in the 1990s led to massive outflows of capital,
which required loans on a much larger scale than anything the IMF had
previously been asked to provide. Countries must repay the loan after
a maximum of 2.5 years, but are expected to repay one year earlier. All
SRF loans carry a substantial surcharge of 3-5 percentage points.

Contingent Credit Lines (CCL). The CCL differs from other IMF
facilities in that it aims to help members prevent crises. Established in
1997, it is designed for countries implementing sound economic
policies, which may find themselves threatened by a crisis elsewhere in

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the world economy-a phenomenon known as "financial contagion". The

CCL is subject to the same repayment conditions as the SRF, but
carries a smaller surcharge.

Compensatory Financing Facility (CFF). The CFF was established

in the 1960s to assist countries experiencing either a sudden shortfall
in export earnings or an increase in the cost of food imports caused by
fluctuating world commodity prices. The financial terms are the same
as those applying to the SBA, except that CFF loans carry no surcharge.

Emergency assistance. The IMF provides emergency assistance to

countries that have experienced a natural disaster or are emerging
from conflict. Emergency loans are subject to the basic rate of charge
and must be repaid within 5 years.

The process of IMF lending: IMF loans are usually provided under an
"arrangement", which stipulates the conditions the country must meet
in order to gain access to the loan. All arrangements must be approved
by the Executive Board, whose 24 directors represent the IMF's 184
member countries. Arrangements are based on economic programs
formulated by countries in consultation with the IMF, and presented to
the Executive Board in a "letter of intent". Loans are then released in
phased installments as the program is carried

1 b. Discuss the role of the World Bank in International

Financial system.

World Bank is a development institution aimed at financing economic

development. It helps raise productivity by financing economic
development. More than 180 member countries represented by a
board of governors & a board of directors own the World Bank.

The World Bank constitute of five bodies which are following:-

IBRD-International bank for reconstruction and development:

Provides loans and development assistance to middle income countries
and worthy poor countries IBRD obtains its funds through the sale of
bonds in international capital markets.

IDA - International Development association: Provides interest

free loans to poorest countries. The IDA depends on contribution from
its wealthier member countries including some developing countries.

IFC- International Finance Corporation: Promotes growth in

developing countries by providing support to the Private sector. In

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collaboration with other investors the IFC invests in commercial

enterprises through both Loans & equity.

MIGA- The multilateral investment guarantee agency: Helps

encourage foreign direct investment in developing countries by
providing guarantees to foreign investors against loss caused by non-
commercial risks. It also provides advisory services to help government
attract private investments & disseminates information on investment
opportunities in developing countries.

ICSID- The international center for settlement of investment

disputes: helps promote international investment through conciliation
& arbitration of disputes between foreign investors & host countries.

As a development institution, the World Bank supports two broad

goals:
(i) Poverty reduction and
(ii) Economic and social development, the latter in support of the
countries ambition to join the European Union.

The central vehicle for supporting the national reform program of each
country is the so-called Country Assistance Strategy (CAS). Based on
an assessment of the country's priorities, past portfolio performance
and creditworthiness, the CAS sets strategic priorities and determines
the level and composition of financial and technical assistance that the
Bank seeks to provide the country. The framework for poverty
reduction and economic growth are the countries’ own Poverty
Reduction Strategy Papers (PRSPs), developed by the government
through a participatory consultation procedure.
In terms of financial assistance, over the last five years (1999-2003),
the World Bank has been supporting the region through wide range of
active and planned development projects, collectively amounting to
approximately US $3.9 billion. These projects are directed towards a
number of sectors, including: infrastructure and energy, private sector
development, poverty reduction and economic management, social
sectors, rural development and the environment."

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Q3. a) Discuss the role of different parties involved in

launching of GDR.

Ans: a) GDRs are a type of straight equity shares, which are issued in
the offshore market. These are essentially those instruments, which
possess a certain number of underlying shares in the custody of
depository bank. It is negotiable instrument, which are publicly traded
local currency share.

It is in the form of depository or certificate issued by the overseas

depository bank outside India and issued to the non- resident investors
against the issue of the ordinary shares or foreign currency convertible
bonds of the issuing company. In case of typical GDR, it is denominated
in US $ and the underlying shares are denominated in local currency of
the issuer. GDRs can be converted into equity shares by cancellation of
GDRs through intermediaries, if so desired by the investor and the sale
of underlying share in the domestic market through the local
custodian. They are treated as common equity of the issuing company
and are eligible to receive dividends and noting rights from the date of
the issuance. The depository receives the dividend from the co. in the
local currency and distributes the same to the shareholders of the
GDRs into dollars after converting them at the prevailing rate of
exchange. The voting rights are exercised by the depository as per the
agreement between the companies. These are bearer securities and
trading/settlement are done through book entries through CEDEL or
Euroclear.

Roles of different parties involved in launching for GDR

1. The Lead Manager(s) : An investment bank which has the

primary responsibility for assessing the market and successfully
marketing the issue. It helps the company at all stages from
preparing the documentation, making investor presentation,
selection of other manager(s) and post issue support. It exercise
due diligence in collecting and evaluating all possible information
which may have a bearing on the GDR issue.
2. Other managers or subscribers to the issue : They agree to
take and market parts of the issue as negotiated with the led
manager.
3. Depository : A bank or a financial institution, appointed by the
issuing company which has certain duties and functions to be
discharged vis-à-vis the GDT holders and the company. For this it
receives compensation both from the company as well as the
GDR holders.
4. Custodian: A bank appointed by the Depository, generally in
consultation with the issuing company which keeps custody of all

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depository property such as share certificates, dividends, right

and bonus shares etc. It receives its fees from the Depository.
5. Clearing Systems : EUROCLEAR (Brussels). CEDEL (LONDON)
are the registrars in Europe and Depository Trust Company (DTC)
are the registrars in USA who keep records of all particulars of
GDRs and GDR holders.
6. The Company: One, which wishes to launch GDR issue.
7. The Investor: One who is interested in investing in GDRs. He
pays money and receives Global Depository Receipts.

3 b) What are the steps involved while launching GDR?

Steps involved in launching of the GDR

1. Shareholders approval is required before going for issuance of GRD-

approval to be obtained at AGM of the company from the
shareholders.
2. Appointment of Lead manager (LM): without the appointment
of the lead manager, the GDR issue cannot be launched at all. Lead
manager is the most vital link between all concerned parties like
investors, banks, Govt. agencies etc. the entire success of the issue
depends on him. He is selected on the basis of his trade record in
relation to marketing capacity, market research capacity, placement
skills etc. LM’S duties inter alia include advising and guiding the
issuer/company industry scenario, international monetary and
security market, economic conditions, equity price, interest rates,
redemption rules etc.
3. Finalization of the issue structure: Co in consultation with LM
formulates and finalizes the issue structure of the proposal GDR and
arranges to obtain all approvals/permissions.
4. Documentation: the various types of documents, agreements,
deeds etc. are required to be executed in the issue of the GDR
issue. These are complex process, which includes prospectus,
depository agreement, trust deeds, underwriting agreement, voting
agreement, subscription agreement etc.
5. Launching, marketing, road shows: these are the next three
stages in the issue of any GDR .the marketing of the issue and road
shows are handled by LM. The road shows are a series of open
presentations with fund managers and analyst, investors etc.

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Q4. Write notes on following:

a) International Chamber of Commerce

b) Export import bank of India.
c) Export credit guarantee corporation (ECGC).
d) Factors affecting movement of rate of exchange

Ans:
(a) International Chamber of Commerce.
ICC (International Chamber of Commerce) is the voice of world
business championing the global economy as a force for economic
growth, job creation and prosperity.
Because national economies are now so closely interwoven,
government decisions have far stronger international repercussions
than in the past.
ICC – the world's only truly global business organization responds by
being more assertive in expressing business views.
ICC activities cover a broad spectrum, from arbitration and dispute
resolution to making the case for open trade and the market economy
system, business self-regulation, fighting corruption or combating
commercial crime.
ICC has direct access to national governments all over the world
through its national committees. The organization's Paris-based
international secretariat feeds business views into intergovernmental
organizations on issues that directly affect business operations.

Setting rules and standards

• Arbitration under the rules of the ICC International Court of
Arbitration is on the increase. Since 1999, the Court has received
new cases at a rate of more than 500 a year.
• ICC's Uniform Customs and Practice for Documentary Credits (UCP
500) are the rules that banks apply to finance billions of dollars
worth of world trade every year.
• ICC Incoterms are standard international trade definitions used
every day in countless thousands of contracts. ICC model contracts
make life easier for small companies that cannot afford big legal
departments.
• ICC is a pioneer in business self-regulation of e-commerce. ICC
codes on advertising and marketing are frequently reflected in
national legislation and the codes of professional associations.

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Promoting growth and prosperity

• ICC supports government efforts to make a success of the Doha
trade round. ICC provides world business recommendations to the
World Trade Organization.
• ICC speaks for world business when governments take up such
issues as intellectual property rights, transport policy, trade law or
the environment.
• Signed articles by ICC leaders in major newspapers and radio and
TV interviews reinforce the ICC stance on trade, investment and
other business topics.
• Every year, the ICC Presidency meets with the leader of the G8 host
country to provide business input to the summit.
• ICC is the main business partner of the United Nations and its
agencies.

Spreading business expertise

• At UN summits on sustainable development, financing for
development and the information society, ICC spearheads the
business contribution.
• Together with the United Nations Conference on Trade and
Development (UNCTAD), ICC helps some of the world's poorest
countries to attract foreign direct investment.
• In partnership with UNCTAD, ICC has set up Investment Advisory
Council for the least-developed countries.
• ICC mobilizes business support for the New Partnership for Africa's
Development. At ICC World Congresses every two years, business
executives tackle the most urgent international economic issues.
• The World Chambers Congress, also biennial, provides a global
forum for chambers of commerce.
• Regular ICC regional conferences focus on the concerns of business
in Africa, Asia, the Arab World and Latin America.

Advocate for international business

ICC speaks for world business whenever governments make decisions
that crucially affect corporate strategies and the bottom line.
ICC's advocacy has never been more relevant to the interests of
thousands of member companies and business associations in every
part of the world.

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Equally vital is ICC's role in forging internationally agreed rules and

standards that companies adopt voluntarily and can be incorporated in
binding contracts.
ICC provides business input to the United Nations, the World Trade
Organization, and many other intergovernmental bodies, both
international and regional.

(b) Export import bank of India:

The Export-Import Bank of India (Exim Bank) is a public sector financial
institution created by an Act of Parliament, the Export-import Bank of
India Act, 1981. The business of Exim Bank is to finance Indian exports
that lead to continuity of foreign exchange for India. The Bank's
primary objective is to develop commercially viable relationships with a
target set of externally oriented companies by offering them a
comprehensive range of products and services, aimed at enhancing
their internationalization efforts.
There are apex institutions in the country, which deal with major
economic activities, viz. industry, agriculture and foreign trade. The
Industrial Development Bank of India extends term industrial loans; the
National Bank for Agricultural loans; and the Exim Bank extends term
loans for foreign trade. All these institutions are wholesale banks. They,
therefore work closely with commercial banks and other state level
financial institutions that operate the retail banking system in the
country. Exim Bank provides a range of analytical information and
export related services. The Bank's fee based services help identify
new business propositions, source trade and investment related
information, create and enhance presence through joint network of
institutional linkages across the globe, and assists externally oriented
companies in their quest for excellence and globalization. Services
include search for overseas partners, identification of technology
suppliers, negotiating alliances, and development of joint ventures in
India and abroad. The Bank also supports Indian project exporters and
consultants to participate in projects funded by multilateral funding
agencies.
Exim Bank encourages Indian consultants to gain and enhance their
international exposure by assisting them in securing assignments
overseas.
Assignments are awarded under programme sponsored by
International Finance Corporation (IFC) in Washington to promote
private sector development in select countries and regions.
Arrangements set in place cover:
• Africa Project Development Facility
• African Management Services Company

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• Africa Enterprise Fund

• South-east Europe Enterprise Development Facility
• Mekong Project Development Facility
• Business Advisory and Technical Assistance Services (BATAS)
• Other Technical Assistance & Trust Funds
Exim Bank assists these agencies in the recruitment of Indian
consultants and meets the professional fees of the consultant selected
by IFC.
Consultancy assignments undertaken comprise pre-feasibility studies,
project and investment related services, management information
systems, operations and maintenance support mainly for SMEs in a
variety of sectors like agriculture, agro-industry, consumer goods, light
engineering, telecom.
Exim Bank provides financial assistance to Indian Companies by way of
a variety of lending programmes, viz.

Non-Funded
• Bid Bond
• Advance Payment Guarantee
• Performance Guarantee
• Guarantee for release of Retention Money
• Guarantee for raising Borrowings Overseas
• Other guarantees
Funded
• Pre-shipment Rupee Credit
• Post-shipment Rupee Credit
• Foreign Currency Loan
• Overseas Buyer's Credit
• Lines of Credit
• Loan under FREPEC programme
• Refinance of Export Loans
Forfeiting is a mechanism of financing exports by discounting export
receivables evidenced by bills of exchange/ promissory notes without
recourse to the exporter.
Exim Bank plays the role of an intermediary for facilitating the
forfeiting transaction between the Indian exporter and the overseas

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forfeiting agency.
Exim Bank provides financial assistance to Indian Companies for export
capability creation by way of a variety of lending programmes, viz.
• Lending Programme for Export Oriented Units
• Production Equipment Finance Programme
• Import Finance
• Export Marketing Finance Programme Lending Programme for
Software Training Institutes
• Programme for Financing Research & Development Programme for
Export Facilitation: Port Development
• Export Vendor Development Lending Programme Foreign Currency
Pre-Shipment Credit Working Capital Term Loan Programme for
Export Oriented units
Assistance is extended to Indian Promoter Companies by way of
programmes that address to different requirements of the promoter
company in setting up of the joint venture.
• Overseas Investment Finance Programme
For setting up joint ventures and wholly owned subsidiaries abroad.
• Asian Countries Investment Partners (ACIP) Programme
For creation of a joint venture in India with East Asian countries,
through four facilities that address different stages of a project cycle.

(c) Export credit guarantee corporation (ECGC):

The Government of India set up the Export Risks Insurance Corporation
(ERIC) in July 1957 in order to provide export credit insurance support
to Indian exporters. It was transformed into Export Credit & Guarantee
Corporation Limited (ECGC) in 1964. To bring the Indian identity into
sharper focus, the Corporation's name was once again changed to the
present Export Credit Guarantee Corporation of India Limited in 1983.
ECGC is a company wholly owned by the Government of India. It
functions under the administrative control of the Ministry of Commerce
and is managed by a Board of Directors representing Government,
Banking, Insurance, Trade, Industry, etc.
ECGC:
• Provides a range of credit risk insurance to exporters against loss of
goods and services.
• Offers guarantee to banks and financial institutions to enable
exporter obtain better facilities from them.
• Provides overseas investment insurance to Indian companies
investing in joint ventures abroad in the form of equity or loans.

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• Offers insurance protection to exporters against payments risks.

• Provides guidance in export related activities.
• Makes available information on different countries with its credit
ratings.
• Makes it easy to obtain export finance from banks/financial
institutes.
• Assists exporters in recovering bad debts.
• Information on credit- worthiness of overseas buyers.

Need for export credit insurance: Payments for exports are open to
risk even at the best of times. The risks have assumed large proportion
today due to the far-reaching political and economic changes that are
sweeping the world. An outbreak of war or civil war may block or delay
payment for goods exported. A coup or an insurrection may also bring
about the same result. Economic difficulties or balance of payment
problems may lead a country to impose restrictions on either import of
certain goods or on transfer of goods imported. In addition, the
exporters have to face commercial risk of insolvency or protracted
default of buyers. The commercial risk of a foreign buyer going
bankrupt or losing his capacity to pay is aggravated due to political
and economic uncertainties. Export credit insurance is designed to
protect exporters from the consequences of the payment risks, both
political and commercial, and to enable them to expand their overseas
business without fear of loss.

(d) Factors affecting movement of rate of exchange.

Following are the factors, which affects movement of rate of exchange:

1. Demand and supply: the currency in demand will be strong while
the currency, which is in excess supply, will be weak.
2. Interest rate: the currency of the country, having higher rates, will
be in great demand and hence will be strong.
3. Inflation: it has been seen that exchange rates move in direction
required to compensate for relative inflation rates.
4. Gross Domestic Product (GDP): the currency of the country,
having higher GDP, will be strong.
5. Balance of Trade and Balance of Payment: the currency of the
country, having surplus balance of trade and balance of payment
will be strong and vice versa.
6. Unemployment: the currency of the country, having higher
unemployment will be low and vice versa.
7. WAR: Internal or external: the currency of the country facing
either internal or external war will be weak.
8. Speculation: in developed markets speculators play important role
in determining the tread of the currency.

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9. Sentiments: as in the case of stock market, sentiments play vital

role in determining the tread of the currency.
10.Capital movements: higher the capital inflow, stronger will be the
currency and vice versa.
11.Exchange controls: the purpose of exchange control is to manage
the demand and supply of home currency by the government by
using controls basically to protect it. Currency control is the
restriction or availing foreign currency at home/abroad.
12.Political stability: the currency of the country, which is political
stable, will be more and vice versa.
13.Intervention by the central bank of the country: The central
bank of the country, at times, intervenes in the forex markets to
ensure that the objectives are met.

Exchange rates are dynamic and constantly changing. These changes

occur due to various factors stated above. Several of these are
normally short term but can extend to the medium or long term.
Some of these factors at a given point of time may have a large impact
as compared to the remaining. Exchange rate management is a
delicate skill and hence has to be undertaken carefully as it affects the
profitability of the company engaged in international trade.

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Q5. Consider yourself as an exporter from India.

a) Enumerate different risks involved in this transaction.

Ans:
5 a - What gives rise to foreign exchange transactions? Basically, there
are four important factors which give rise to foreign exchange deals or
transactions: (a) trade (exports/imports); (b) transfer (remittances); (c)
investment (say, FCNR transactions); and (d) speculation. If one were
to ask what is the proportion of speculation to the first three in the
global foreign exchange market, one would be shocked to know that
speculation accounts for nearly 96 per cent of the foreign exchange
turnover of about US$ 700 billion per day in the international foreign
exchange market. As we are aware, banks have established huge
dealing rooms, and foreign exchange dealers are consistently buying
and selling foreign currencies to make profits for their own institutions.
Although speculation or pure dealing, as opposed to a merchant
transaction, is anathema to banking, it is not "uncontrolled"
speculation, as most senior managements of banks have imposed
stringent controls to contain exposures and, therefore, the expression
used in the dealing rooms is normally that dealers are taking a view of
the market based on their educated judgments.

A corporate treasurer is puzzled by the concept of speculation by

banks and questions whether the speculation of this magnitude is good
for him. However, one cannot deny that without a number of
participating banks, and the sizable volume of business transacted,
foreign exchange markets would be very patchy, and the exchange
rates would move in an erratic manner. It is, therefore, clear that a
merchant customer is able to get competitive exchange rates which
move very smoothly except in times of extraordinary situations. We
can, therefore, conclude that speculation is in the interest of a
corporate treasurer rather than against him. A corporate treasurer is
able to talk to a number of banks to get the best possible rate for his
merchant transaction and end up striking a good bargain with a
competitive bank.

Risks
The identified risks in the foreign exchange market are: (a) rates; (b)
credit; (c) mismatched maturities; (d) country; and (e) business.

Rate Risk : Rate risk is normally assumed when a dealer quotes a

price against another currency and does not cover it immediately. He is
running the risk of the currency going against him. The rate risk is
assumed by corporate treasurer who has invoiced his exports or
imports in foreign currency at a predetermined Indian rupee rate and
does not cover his foreign exchange by entering into a forward
contract with a bank, For example, if an exporter invoices his goods in

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US dollar US $ l = INR 17.50, and exports the goods and when he

receives the payment if the exchange rate has moved against him he
may receive only INR 17.25 resulting in a loss of 25 paise per dollar.
Although in the present scenario of depreciating rupee this is unlikely
to happen, one can imagine the risk to which an exporter will be
exposed to in conditions of an appreciating rupee.

Credit Risk: Credit risk is assumed on counter parties with whom an

exchange transaction is concluded. If a spot contract is concluded
between a bank and a customer, the bank is taking a risk on the
customer, in the sense that if the bank delivers the foreign currency,
let us say in Tokyo, in an important transaction, because of the time
zone differences, the bank will be able to debit the customer's account
only after an interval of 4-5 hours and is, therefore, exposed to full
amount of the contract concluded. However, with regard to forward
contracts which can be liquidated in the market, the risk assumed is
between 1 0 per cent and 20 per cent of the contracted amount.

Risk of Mismatched Maturities: The risk of mismatched maturities

arises due to the mismatch of inflows and outflows of foreign
currencies. Technical, if one were to receive US$ 1 million and also
remit US$ 1 million today, one does not carry any exchange risk except
the loss of the spread to the bank, However, in real life, situations are
not so ideal and, therefore, corporate treasurers are exposed to risks of
mismatched maturities ' that is, a time lag between receipt and
payment of foreign currency, even if they are both exporters and
importers.

Country Risk : Country risk has assumed serious proportions in view

of the economic and political instability prevailing in many countries,
such as in Latin America, and Africa. It is advisable for a corporate
treasurer to check the country risk aspect before he concludes a deal
with problem countries, as he may not receive the foreign exchange
against his goods due to exchange control restrictions. The recent
Middle-East war has ravaged the economies of Iraq and Iran and,
therefore, all transactions with these countries must be carefully
handled to ensure that goods or funds are not blocked.

Business Risk : Business risk is common to all types of businesses,

such as hearing a wrong rate, communicating the wrong amount, etc;
however, in the foreign exchange business, it can be disastrous as
exchange rates move very quickly and errors could be difficult to
rectify without a loss. The corporate treasurers are, therefore, advised
to communicate all the details in writing with the banks to avoid any
misunderstandings.

5 b) Explain in detail as to how will you minimize these risks.

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Management of Exchange Risk

Generally, the corporate treasurers fall into one of the three

categories:
(a) Those who cover every exposure;
(b) Those who do not cover all; and
(c) Those who cover judiciously.

The first category belongs to corporate which are extremely

conservative and, therefore, cover every exposure immediately by
entering into a forward exchange contract with a bank their contention
is that they should best concentrate on the line of their business rather
than dabble in the speculative world of foreign exchange. If the
corporate cover every exposure, obviously they eliminate the foreign
exchange risk altogether. The second category belongs to corporate
which believe in the "do nothing" approach and cover their exposure
on a spot basis at whatever rate is offered on the date of remittance.
This category of corporate, therefore, believes in keeping exposures
open and, pays for the risk they assume. Although in some cases they
might benefit by favorable movements of exchange rates, they do not
crystallize their liabilities and will never know their rupee liabilities until
the date of remittance. The third category belongs to corporate which
cover their exposure judiciously by talking to corporate dealers of the
respective banks and deciding whether to book exposure or not,
depending upon short - term / long-term trends of currencies, the rate
of depreciation of the rupee against foreign currency, and the level of
premier and discounts prevailing in the inter-bank market.

It is, therefore, obvious that a corporate treasurer may belong to any

one of the three categories and depending upon circumstances, decide
his policy on foreign exchange objective may be stated to curtail losses
on account of exchange risk fluctuations to the extent of I per cent of
the cost of goods or projected cost during the period I January to 31
December 1990. Within these broad objectives, the operative staff can
be given authority to book exposure within 1/4 per cent or 1/2 per cent
of costs involved so that they do not have to revert to the senior
management every time an exposure decision needs to be taken. The
operating staff could then work in close co-ordination with the
corporate dealers of banks and efficiently cover the exchange risk on
an on-going basis.

Suggestions
Here are a few practical suggestions for corporate treasurers to
manage their exchange risk,
(a) Quotes from more than one bank: It is imperative that a
corporate treasurer takes advantage of rates quoted by different

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International Finance Semester - III

banks. The corporate treasurers must take quotes from at least two
banks before concluding business with any one of them. Exchange
rates will not be the same with banks depending upon currency
position of each bank, the nature of operation - whether cover
operation or trading operation, quality of dealers, and currency traded.
Although it may not be possible for a corporate treasurer to take away
business from one bank to another due to funded facilities, which may
be made available, it at least improves his bargaining power with the
bank, and in some cases he may be able to get an improved rate
quoted to him. Banks normally quote indicative rates in the morning,
which are subject to variation, and a firm rate is quoted only if a
corporate treasurer wishes to do business at that point of time.

(b) Indicate Your Interest: It is very important that a corporate

treasurer establishes a close rapport with the corporate dealer in his
bank and absolute confidence should exist between the two of them. It
is desirable that a corporate treasurer confides in the corporate dealer
and discloses his position, which he wishes to cover so that the
corporate dealer can keep this in mind and revert to him whenever an
opportunity arises to cover the position profitably. For instance, a
corporate treasurer can inform the dealer that he wishes to cover his
three months export exposure at US$ 5.56. A corporate dealer will call
the client whenever the spot rate appreciates and the premiums are
higher to give the benefit of the desired rate to the customer.

(c) Standing Instruction: If the corporate treasurer is not likely to be

available in the office, for some reason, it is expedient to leave a
standing instruction with a corporate dealer to cover his exposure, let
us say, at US$ 5.56 so that the corporate treasurer does not lose out
on an opportunity presented in the market

(d) Stop Loss Order: Stop loss orders are also a kind of standing
instruction to stop loss in a deteriorating market. For instance, if an
importer does not want to cover his exposure at a rate worse than US$
5.60, he should leave such instructions with a corporate dealer to stop
loss at US $ 5.60, a limit up to which he can sustain loss.

(e) Quick Decision: In a volatile foreign exchange market, quick

decisions are of paramount importance and, therefore, a corporate
treasurer should not keep dealers holding to give decisions. Once a
rate is quoted, a dealer is also running the risk and if the market
changes, the rate may not hold well. It is, therefore, important that the
senior management in a company delegate’s authority within certain
parameters to the operating staff so that they are able to quickly
respond to the dealers on telephone.

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(f) Partial Hedge: When in doubt, partial hedge is the answer. There
is no auspicious day for booking foreign exchange exposure and if one
feels that the rate offered is reasonable, one should at least book a
part of the exposure rather than leaving the entire exposure to be
covered on a single day in the future. What matters are the average
rate for a series of transactions rather than a good rate for one
transaction?

(g) Forward Period: There are spot rates and forward rates in the
foreign exchange market. Forward rates are quoted at either premium
or discount depending upon whether the currency is at premium or
discount and it is, therefore, important that a corporate treasurer
informs the appropriate period to the corporate dealer to enable him to
quote an accurate rate. For example, if an exporter wants to ship his
goods after a period of three months, he should ask for a three-month
forward rate rather than the spot rate.

Choice of Bank
A corporate treasurer cannot efficiently manage his foreign exchange
risk unless he is helped by a bank which has a well equipped dealing
room with the necessary infrastructure facilities and trained dealers
who have the support of over-seas dealing centers. The choice of a
bank will also depend upon the individual currency requirement. Many
banks have consultancy services, and publish newsletters, to keep
their clients advised about the happenings in the international
markets. The corporate treasurers should take advantage of such
services and keep in close touch with trends of the currencies, and
endeavor to manage their exposure in a professional manner.

In the last few years, many corporate treasurers have come to grief for
not appreciating exchange risks involved in foreign trade, resulting in
the escalation of project costs, working capital, and cash flow
problems. Although RBI has not allowed the introduction of
sophisticated products, such as options or swaps in the local market,
exchange risk can be managed more effectively by following the
approaches discussed in this paper.

Q6. Explain with the help of Flowchart complete cycle of L/C

mechanism and roles and responsibilities of all the parties to
L/C mechanism.

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Ans: A documentary credit (L/C) is an underwriting issued by a bank,

On behalf of the buyer (importer), to the seller (exporter), to pay for
the goods and services, provided that the seller presents documents,
which comply with the terms and conditions of the L/C.
There are 3 contractual relationships in the use of L/C.
• Between the Buyer and the Seller.
• Between the Buyer and the Bank which issues the L/C.
• Between the Seller and the Bank which issues the L/C.
In International trade, Buyers and Sellers are separated by long
distance, they may not know each other, and they might be governed
by different trade and exchange control regulations, legal segments,
political entities and currencies. The Sellers and Buyers wants are
different, so taking into consideration all the complexities of
International trade and requirements of both; the most ideal mode of
payment is documentary credit method.
Explanation of L/C Mechanism
The steps of L/C mechanism are explained in a flow chart below:

SHIPPING 10. GOODS

SHIPPING
CO.,
CO., DUBAI
MUMBAI

9. B/L 8. GOODS 20. GOODS 19. B/L

KIRLOSKAR, AHMED &CO.,

PUNE 1. CONTRACT DUBAI
(BENEFICIARY/EX (OPENER/
PORTER) IMPORTER)
11. DOC

6. 2. APPLIES
7. 17. PAYMENT
REQUEST FOR LC
ADVICE
TO ADD
OF
CONFIRM
CONFIRM
ATION 5. LC
ATION 18. DOC BBME BANK,
DUBAI,
3. LC (OPENING
SBI, PUNE BANK)
(L/C ADVISING
BANK, 13. DOC
CONFIRMING 16. DEBIT
BANK, ADVICE 4. ADVICE
NEGOTIATING
BANK) 15. PAYMENT
12.
Payment CITIBANK,
NEW YORK
(REIMBURS
There are 20 steps involved in the
14. CLAIM transaction, viz:
ING BANK)

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International Finance Semester - III

1. Ahmed and Co. and Kirloskar enter into a contract.

2. Ahmed and Co. approaches BBME, Dubai with the request to issue
Letter of Credit in favor of Kirloskar.
3. BBME, Dubai issues a L/C and sends it to SBI, Pune for advising it to
Kirloskar.
4. Simultaneously, BBME, Dubai nominates Citibank, NY, as
reimbursing bank and authorizes them to honor the claim of SBI,
Pune to the debit of its US $ account with them.
5. SBI advises the L/C to Kirloskar after verifying the authencity of the
L/C.
6. Kirloskar approaches SBI, Pune with request to add confirmation to
L/C.
7. SBI adds confirmation to L/C after satisfying itself about the
standing of BBME, Dubai and sends an advice to Kirloskar to that
effect.
8. Kirloskar hands over the goods to the Shipping Co. in Mumbai.
9. Shipping Co. issues a bill of landing to Kirloskar, Mumbai.
10.Shipping Co. arranges to ship the goods to its counterpart in
Dubai.
11.Kirloskar prepares other documents as per the terms of L/C and
submits the same to SBI for negotiations.
12.SBI scrutinizes the documents to ascertain that they are as per the
terms of L/C and if satisfied makes payment to Kirloskar.
13.SBI forwards documents to BBME, Dubai.
14.SBI claims reimbursement from Citibank, NY and requests them to
credit the proceeds to its US $ account with them under advice.
15.On receipt of reimbursement claim Citibank, NY credits the account
of SBI, Pune and sends advice to it to that effect.
16.Citibank, NY debit of BBME, Dubai and sends advice to BBME, Dubai
to that effect.
17.BBME, Dubai debits the account of Ahmed and Co.
18.BBME, Dubai hands over documents to Ahmed and Co.
19.Ahmed and Co. hands over bill of landing to Shipping Co. in Dubai.
20.Shipping Co, Dubai hands over goods to Ahmed and Co.

Roles and Responsibilities of Parties in L/C

a. Applicant: The Buyer is responsible for providing precise and clear

instructions for issuance of credit, and amendments there to. Since he
applies to the bank to issue L/C, in L/C parlance he is called Applicant.

b. Issuing Bank: The Bank, which issues the L/C, is called Issuing
Bank. Before issuing the L/C it must satisfy itself about the standing of
the applicant making a request for the issuance of credit. Once the
documents are presented it has to examine them to ascertain whether

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International Finance Semester - III

the documents presented are compliant and meet the requirements of

the credit. If so, they have to provide the payment to the Negotiating
Bank from whom the documents were received.

c. Advising Bank: The issuing bank will route the L/C through their
corresponding Bank (Advising Bank), in exporter’s country. The
Advising Banks responsibility is to establish apparent authenticity of
the credit before advising it to the Beneficiary.

d. Beneficiary: Since the exporter or Seller is beneficiary of L/C

arrangement, he is referred as Beneficiary. On receipt of a properly
worded, properly advised L/C; the beneficiary has to ship the goods,
prepare the documents as per the terms of the L/C and submit them to
his bank for negotiations.

e. Confirming Bank: Incase the exporter does not have the

confidence in the standing of the Issuing Bank then he can demand a
confirmed letter to credit. In which case, the Issuing Bank will request
their correspondent bank (Confirming Bank) to add confirmation to the
L/C. This bank will satisfy itself about the standing of the Issuing Bank,
making a request to add confirmation to Letter of Credit, before
agreeing to add confirmation. By adding confirmation it steps into the
shoes of Issuing Bank and it becomes bound to pay, accept or
negotiate the documents drawn under the L/C, provided they comply
with the terms and conditions of the L/C. For adding confirmation this
bank will recover commission.

f. Negotiating Bank: The Bank to whom beneficiary submits the

documents is Negotiating Bank. It must examine the document to
satisfy that the documents are drawn in compliance with the terms and
conditions of the L/C. If so, then this bank will make the payments to
the beneficiary and will forward the documents to the Issuing Bank to
get the payment.

g. Reimbursing Bank: Incase the currency of the transaction is other

than the currencies of the exporters or importers country; it will result
in delay in getting the payment. To avoid this delay the Issuing Bank,
at the time of issuing the L/C, will nominate a Bank in USA as
Reimbursing Bank. In such a case, the negotiating bank will send all
documents to issuing bank but will simultaneously lodge a
reimbursement with the nominated bank in USA. This will avoid in
getting the proceeds and the Beneficiary stands to benefit.

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