International Financial Management

Semester – VI

B.com

Edition: 2022
#44/4, District Fund Road, Behind Big Bazaar, Jayanagar 9th Block, Bengaluru,
Karnataka -560069
 INDEX

Contents
INDEX .......................................................................................................................................ii

SYLLABUS ............................................................................................................................... v

Module - 1: Introduction to International Finance ..................................................................... 1

1.1: Introduction ................................................................................................................. 1

1.2: Meaning of International Financial Management ....................................................... 2
1.3: The environment of an MNC ...................................................................................... 3
1.4: Agency Problem .......................................................................................................... 3
1.5: Modes of Entering the International Business ............................................................ 4
1.6: Differences between International and Domestic Financial Management.................. 8
1.7: Scope of International Finance .................................................................................... 9
1.8: Reasons for Growth ................................................................................................... 10
1.9: Features of International Finance .............................................................................. 10
1.10: Measuring Exchange Rate Movements ................................................................. 11
1.11: Exchange Rate Equilibrium ................................................................................... 11
1.12: Factors Affecting Foreign Exchange Rate Forecasting Exchange Rates .............. 14
1.13: Summary ................................................................................................................ 15
1.14: Terminal Questions................................................................................................ 16
1.15: Suggested Readings / Reference Books: ............................................................... 16
Module - 2: International Monetary System and BOP ............................................................ 17

2.1: Introduction to International Monetary System ........................................................ 17

2.2: Evolution of the International Monetary System ...................................................... 18
2.2.1: Bimetallism (Prior to 1875) ..................................................................................... 18
2.2.2: The Gold Standard, 1876 – 1913 ............................................................................. 19
2.2.3: Inter-War Years, 1914 – 1944 .................................................................................. 19
2.2.4: The Bretton Woods System 1945 – 1973 ................................................................. 20
2.2.5: Exchange Rate Regime Since 1973 ......................................................................... 22
2.3: Introduction to International Financial Institutions ................................................... 23
2.3.1: World Bank .............................................................................................................. 23
2.4: The International Monetary Fund (IMF) ................................................................... 24

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 2.5: The World Trade Organization (WTO) .................................................................... 25
2.6: WTO Agreements: .................................................................................................... 25
2.7: International Finance Corporation (IFC)................................................................... 26
2.8: Balance of Payment ................................................................................................... 27
2.9: Summary ................................................................................................................... 34
2.10: Terminal Questions................................................................................................ 35
2.11: Suggested Readings / Reference Books: ............................................................... 39
Module - 3: Forex Rates .......................................................................................................... 40

3.1: Define Foreign Exchange Market ............................................................................. 41

3.2: Features of the Foreign Exchange Market ................................................................ 41
3.3: Functions of Foreign Exchange Market .................................................................... 41
3.4: Players of the Foreign Exchange Market .................................................................. 42
3.5: Types of Foreign Exchange Market .......................................................................... 42
3.6: FEMA and RBI Regulations ..................................................................................... 43
3.6.1: The main Features of FEMA regulations are: ....................................................... 44
3.7: Introduction to FOREX ............................................................................................. 45
3.7.1: Rates/Quotations ...................................................................................................... 46
3.8: Forward Markets ....................................................................................................... 50
3.8.1: Premiums and Discounts in the Forward Market .................................................. 50
3.8.2: Quotations in Forward Market ................................................................................ 51
3.9: Settlements ................................................................................................................ 52
3.10: Arbitrage in Foreign Exchange Markets ............................................................... 54
3.11: Arbitrage in case of the forward market (or Covered Interest Arbitrage) ............. 56
3.12: Summary ................................................................................................................ 57
3.13: Terminal Questions................................................................................................ 57
3.14: Students Practice Practical Problems .................................................................... 60
3.15: Suggested Readings / Reference Books: ............................................................... 63
Module - 4: Foreign Exchange Risk and its Management ....................................................... 64

4.1: Introduction ............................................................................................................... 64

4.2: Meaning of Foreign Exchange Exposure .................................................................. 65
4.3: Types of Foreign Exchange Exposure ...................................................................... 66
4.3.1: Transaction Exposure .............................................................................................. 66
4.3.2: Translation Exposure............................................................................................... 74
4.3.3: Economic Exposure ................................................................................................. 76

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 4.3.4: Political Exposure .................................................................................................... 79
4.3.5: Interest Rate Exposure ............................................................................................. 82
4.4: Summary ................................................................................................................... 83
4.5: Terminal Questions ................................................................................................... 84
4.6: Practical Problems ..................................................................................................... 86
4.7: Students Practice Practical Problems ........................................................................ 87
4.8: Suggested Readings / Reference Books: ................................................................... 89
Module - 5: Forecasting Foreign Exchange Rate .................................................................... 90

5.1: Measuring Exchange Rate Movements ..................................................................... 90

5.2: Depreciation, Devaluation, Revaluation, Appreciation ............................................ 91
5.2.1: Devaluation of a currency ....................................................................................... 91
5.2.2: Depreciation of a currency ...................................................................................... 93
5.2.3: Revaluation............................................................................................................... 95
5.2.4: Currency Appreciation ............................................................................................. 96
5.3: Exchange Rate Equilibrium ...................................................................................... 97
5.4: Factors Affecting Foreign Exchange Rate Forecasting Exchange Rates ................ 100
5.5: International Parity Relationship ............................................................................. 101
5.5.1: Purchasing Power Parity (PPP) ............................................................................ 102
5.5.2: Interest Rate Parity Theory .................................................................................... 105
5.5.3: International Fisher Effect .................................................................................... 106
5.6: Summary ................................................................................................................. 108
5.7: Terminal Questions ................................................................................................. 109
5.8: Practical Problems ................................................................................................... 110
5.9: Students Practice Practical Problems ...................................................................... 111
5.10: Suggested Readings / Reference Books: ............................................................. 111
MODEL QUESTION PAPER .................................................................................................vii

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 SYLLABUS

Program: B.Com Semester: VI

Subject: INTERNATIONAL FINANCIAL MANAGEMENT
Total Lecture Hours: 60 Credits: 04

Course Objectives:
1. Familiarize the students with the knowledge of international Finance and Forex market.
2. Explain& articulate the 5 stages of IMS and numerical of BOP.
3. Discuss and elaborate the concepts forex rate in the Foreign Exchange Markets
4. Develop a comprehensive insight of Foreign Exchange Risk and Management of its
exposure.
5. Illustrate a holistic perspective towards Forecasting Foreign Exchange Rate and
international parity relationship.

Module – 1: Introduction to International Financial Management 10

Hours
Introduction to International finance and MNCs, Environment of MNCs, Problems of MNCs,
Meaning of International Financial management, features and scope of IFM, Objectives of
IFM, Differences between IFM and Domestic FM,

Module-2:International Monetary System and Balance of payment 08

Hours
Introduction to Monetary System, Stages in IMS, Introduction to International Financial
Institutions- World Bank, IMF, WTO, IFC and Roles of IFI. Introduction to BOP, Reasons
and Measures for Disequilibrium, Components- Current, Capital, Unilateral Transfer and
Official Reserve Account. Objectives of Maintaining BOP Account and Simple Problems.

Module – 3:Foreign Exchange Markets 12

Hours
Forex markets: Meaning, definition, features, structure of Forex market, functions, players in
currency markets, FEMA and RBI Regulations

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Introduction to FOREX rates, Types of FOREX rates, Different quotations in FOREX Rates-
Direct & Indirect quotes, Ask & Bid Price, Cross Rates, Spot Rate, Forward rates, Settlements,
Arbitrage in Foreign exchange markets,

Module-4: Foreign Exchange Risk and Management 16 Hours

Introduction- Meaning of Foreign exchange exposure - Different kinds of exposures-
Transaction exposure – Meaning and Management (problems also) - Translation Exposure -
Meaning and Management (theory only) -Economic Exposure – Meaning and Management
(Theory only) - Political Exposure – Meaning and Management (theory only) -Interest Rate
Exposure- Meaning and Management (Theory only)

Module-05:Forecasting Foreign Exchange Rate 14 Hours

Measuring Exchange Rate Movements, Concept of Appreciation, Depreciation and
Devaluation of Currencies, Exchange Rate Equilibrium, Factors Effecting Foreign Exchange
Rate, Forecasting Exchange Rates, International Parity Relationship: Interest Rate Parity,
Purchasing Power Parity & Fisher Effects.

Course Outcomes
1. Demonstrate the application in relation to concepts of International Finance and forex
market in business expansion.
2. Calculate and criticize the BOP statement of a given country.
3. Examine the fluctuations of forex market and usage of arbitrary tools accordingly.
4. Sketch the application of hedging tools in forex market operations.
5. Compare & forecast Foreign Exchange Rate based on International Parity theories.

Reference Books:
1. Eun, C. S., & Resnick, B. G. (2010). International Financial Mgmt (7th ed.) Tata
McGraw-Hill Education.
2. Sharan, V. (2012). International Financial Management (6th ed.). PHI Learning.
3. Shapiro, Alan. C (2008). Multinational Financial Management (8th ed.). Wiley India.
4. Madhu, Vij. (2010). International Financial Management (3rd ed.). Excel Books.
5. Srinivasan, S.P., & Janakiram, B. (2005). International Financial Management (1st
ed.). Dreamtech Press.

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 Module - 1: Introduction to International Finance

Structure

1.1: Introduction ................................................................................................................. 1

1.2: Meaning of International Financial Management ....................................................... 2
1.3: The environment of an MNC ...................................................................................... 3
1.4: Agency Problem .......................................................................................................... 3
1.5: Modes of Entering the International Business ............................................................ 4
1.6: Differences between International and Domestic Financial Management.................. 8
1.7: Scope of International Finance .................................................................................... 9
1.8: Reasons for Growth ................................................................................................... 10
1.9: Features of International Finance .............................................................................. 10
1.10: Measuring Exchange Rate Movements ................................................................. 11
1.11: Exchange Rate Equilibrium ................................................................................... 11
1.12: Factors Affecting Foreign Exchange Rate Forecasting Exchange Rates .............. 14
1.13: Summary ................................................................................................................ 15
1.14: Terminal Questions................................................................................................ 16
1.15: Suggested Readings / Reference Books: ............................................................... 16

Learning Objectives

• To understand the meaning of a multi-national corporation

• To understand the meaning of an International Financial environment
• To understand the reasons for the growth of IFM and know the scope of IT

1.1: Introduction

A multinational corporation is a company involved in producing and selling goods and services
in more than one country. It usually consists of a parent company located in its home country
with numerous foreign subsidiaries. As the business expands, the awareness of opportunities
in foreign markets also increases. This ultimately evolves into some of them becoming MNCs

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so that they can enjoy the benefits of International business opportunities. Knowledge of
international finance helps MNCs in the following ways. First, it enables companies and
financial managers to decide how international events will affect the firm and what steps need
to be taken to gain positive developments and insulate them from harmful ones. Second, it
helps the companies to recognize how the firm will be affected by movements in exchange
rates, interest rates, inflation rates and asset values.

The consequences of events affecting the stock markets and interest rates of one country
immediately show up around the world. This is due to the integrated and interdependent
financial environment that exists around the world. Also, money and capital markets have
always been closely linked. All this makes it necessary for every MNC and aspiring manager
to take a close look at the ever-changing and dynamic field of international finance.

1.2: Meaning of International Financial Management

International financial management is defined as the management of the whole gamut of

financial operations relating to the international activities of business organizations. These
activities include the expansion of existing business in foreign countries, decisions of setting
up a plant abroad or participating in investment in another country.

Setting up joint ventures, exporting and importing goods and services, financing subsidiaries
abroad and distributing dividends on the profits earned by a multinational are the activities
which involve international financial transactions.

Though international financial management borrows certain concepts from the financial
management of a corporation limited within a country, it differs widely from the latter in its
scope and content.

At the international level, there is a greater variety of means of financing, higher risk and a
greater number of constraints in operations. All this demands greater innovation and faster
adaptation on the part of the financial manager in general and that of multinationals, in
particular.

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1.3: The environment of an MNC

The international financial system consists of following segments;

1. Regulatory framework: Comprising the Government the International Monetary
system.
2. Financial institutions and markets: consists of international banks and other
multinational financial institutions that participate in the international money and
capital markets. The foreign exchange market consists of international banking, foreign
exchange dealers and 24hr trading at organised exchanges around the world where
currency future options and derivatives are regularly traded.
3. Host country environment: consists of the economic, political and socio-economic
systems including people’s cultural values and aspirations.

1.4: Agency Problem

Financial executives in multinational corporations many times have to make decisions that
conflict with the objective of maximising the shareholder's wealth. It has been observed that
as foreign operations of the firm expand and diversify, managers of these foreign operations
become more concerned with their respective subsidiaries and are tempted to make decisions
that maximize the value of their respective subsidiaries. These managers tend to operate
independently of the MNC parent and view their subsidiaries as single, separate units.
The decisions that these managers take will not necessarily coincide with the overall
objectives of the parent MNC. Thus, when a conflict of goals occurs between managers and
shareholders, it is referred to as the Agency Problem.

Strategies to prevent conflict

➢ MNCs can reward the financial managers according to their contribution to the
MNC as a whole regularly.
➢ MNCs can fire managers who do not take into account the goal of the parent
company or probably give them fewer rewards/ compensation.

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1.5: Modes of Entering the International Business

A. Non-Equity Mode

1. Exporting: It is one of the traditional modes that involve the trading of goods and
services between countries. When goods and services belonging to one country are sold
outside its domestic borders, it is referred to as exporting. Exporting can be direct or
indirect. Direct Exporting is constituted when the producing firm participates in trading
goods and services across the borders of the domestic country.

Indirect exporting may take the form of an export agent acting as a representative of the
home country. These agents may represent the overseas purchasers for which they
charge a commission. The common forms of Indirect exporting are Export Management
Companies (EMC), Export Trading Companies (ETC), Piggy bank exporters,
International trading companies, etc.

2. Turnkey Contracts: These are contracts entered into by parties for the usage of
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 technology, management expertise, etc. Here, the foreign entity will plan and develop
the entire operation, instead of building the project stage by stage. The contractors who
are specialized in building and erecting plants in a particular line of the industry will
build the project with their expert team. Once the project is complete, the developers
will run a trial of the project. Following the trial, they will turn the project over to the
purchaser only if it is fully operational. Once the project is passed on to the purchaser,
the contractor may arrange to provide technical assistance and training to the local
personnel by experts for effective usage.

Such contracts are more popular in construction projects, building residential houses,
etc. Those opting for turnkey contracts will be at an advantage as they get sufficient
time for seeking and arranging financial help.

3. Licensing: Licencing can be defined as the permission granted by competent authority

to exercise a certain privilege that, without such authorization, would constitute an
illegal act, a Trespass or a Tort. The certificate or the document itself confers permission
to engage in otherwise proscribed conduct.

Licensing refers to an agreement in which one party sells the right to access and makes
use of the intellectual property such as patents, trademarks, or technology etc., to which
they will not have access without such agreement. The party offering the license will
be termed as licensor and the party making use of the license is the licensee. The
licensor may charge a specified amount as a fee called licensing fee, which is calculated
as a percentage of the sale price. The licensor enters into international business by
permitting a company outside its domestic borders to use its trade name, etc.

4. Franchising: Franchising refers to an arrangement in which the parent company

(Franchiser), issues a grant to another company (Franchisee), the right to carry on
business in a specified way. The grant may be about marketing goods, services, or the
use of technology, etc. as per certain specifications.

Franchising is a form of licensing in which the franchisee is entitled to obtain goodwill

and a carefully controlled marketing strategy. The franchiser will have to provide the
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 necessary support connected with the availability of raw materials, marketing and other
such related assistance to the franchisee.

5. Contract Manufacturing: This refers to an arrangement wherein domestic companies

enter into a contract with a foreign company for manufacturing and producing goods,
reserving all rights of marketing the same products.

The domestic company will indicate its requirements for the products, as per customer
specification, keeping in mind the particulars such as features, functioning, etc. of the
products. The company will then outsource the manufacturing of the same to the
manufacturer company. Such contracts are usually entered into by industries such as
food manufacturing, aerospace, medical, defence, etc.

The firms undertake to produce the goods under the brand of another firm and are
manufactured, usually according to customer specifications. Since the products are
manufactured under the label of another firm, such contracts are also termed Private
label manufacturing.

Some examples of Contract manufacturing are Flextronics Corporation manufacturing

Ericsson mobile phones, Flextronics Corporation producing Xbox game machines for
Microsoft, etc.

6. Management Contracts: These are contracts between a domestic company and a

foreign company or its government, in which the foreign entity agrees to manage the
entire operation of the project for a certain time.

In this arrangement, the operational control of a firm is vested in another firm, usually,
a foreign company, which performs some specific managerial functions, for which they
charge a fee.

When a domestic company lacks expertise in a particular field of its operations, such
shortfall is met by the management company. The management company can assist the
domestic company in performing the activities such as accounting, management of
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 personnel, technical assistance, training and development, etc.

Management contracts are more reliable and are less prone to risks. Hence, it can be
considered as an alternate method for Foreign Direct Investment (FDI).

7. Foreign Direct Investment: It is an arrangement which involves investing directly into

the affairs or the business of a firm in one country, by a firm of another country, usually
a foreign entity.

Such an agreement can be entered into either by purchasing a substantial part or whole
of a company in that country or by diversification of business by extending its current
operations in that country. It may take the form of Mergers and Acquisitions, plough-
back of earned profits from cross-country operations, Special Economic Zones (SEZ),
infrastructure subsidies, etc.

The most popular examples of FDI are Vodafone, Coca-Cola, Metlife, etc.

B. Equity Mode

1. Wholly-owned Subsidy: When a company has 100% equity ownership of another

company, say a foreign company, it is said to be wholly owned by the company having
such ownership. The company holding the ownership is called the parent company and
the other company is called the subsidiary company, which is the minority shareholder.
It provides easy entry into the market.

2. Joint venture: When two or more firms join together to create a new business entity
that is legally separated and distinct from its parent, it involves shared ownership,
provides strength in terms of required capital and helps the company share the risk in
foreign markets.

3. Merger and Acquisition: A merger is a voluntary and permanent combination of

business whereby one or more firms integrate their operation and identities with those
of another and henceforth, work under a common name and in the interest of the newly
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 formed amalgamations.

Here, the company gets immediate ownership and control over the acquired firm
factories, employee technology, brand name and distribution network, formulates
international strategy and generates more revenue.

4. Strategic alliance: A strategic alliance is an agreement between two or more parties to

pursue a set of agreed-upon objectives needed while remaining an independent
organization. This form of cooperation lies between mergers and acquisitions. It is the
collaboration that aims for synergy where each partner hopes that the benefits from the
alliance will be greater than those from individual effort. It often involves the transfer
of technology access to knowledge and expertise.

1.6: Differences between International and Domestic Financial

Management

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1.7: Scope of International Finance

Three conceptually distinct but interrelated parts are identifiable in international finance:

1. International Financial Economics: Concerned with causes and effects of financial

flows among nations-application of macroeconomic theory and policy to the global
economy.
2. International Financial Management: Concerned with how individual economic
units, especially MNCs, cope with the complex financial environment of international
business. Focuses on issues most relevant for making a sound business decision in a
global economy.
3. International Financial Markets: Concerned with international financial/investment
instruments, foreign exchange markets, international banking, international securities
markets, financial derivatives, etc.
4. Estimating Financial Requirements: The fundamental responsibility of the
international finance manager is to estimate the short and long-term financial
requirements of the business. To determine this, the finance manager has to prepare a
financial plan for the present as well as the future, based on the past financial data of
the business. This includes estimating the amount required for purchasing fixed assets
as well as the working capital.
5. Deciding Capital Structure: The capital structure refers to the kind and proportion
of different securities for raising the required funds. After deciding the amount of
funds required, it's time to decide which type of securities should be raised. It may be
wise to finance the fixed assets via long-term debts and current assets via short-term
debts.
6. Selecting a Source of Finance: After preparing the capital structure, the appropriate
source of finance needs to be determined. Various sources from which finance can be
raised can include share capital, debentures, financial institutions, commercial banks,
public deposits or equity, etc. If finance is required for the short term then a bank,
public deposits, and financial institutions are appropriate. On the other hand, if finance
is required for the long term, share capital and debentures might be useful.

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1.8: Reasons for Growth

There are several reasons for the growth of international financial management. International
trade has increased at a greater pace. A large number of enterprises of all sizes are involved
in international operations, besides their domestic operations. More particularly, the process
of economic reforms and globalization gained momentum as well as has acquired a certain
urgency and irreversibility.

Change in the political system in Eastern Europe towards greater participation in the global
economy, emphasis on privatization by the world bank and IMF, and willingness on the part
of the developing economies to open up for competition, are some of the factors that have
increased the international economic activity.

1.9: Features of International Finance

International finance is a distinct field of study and certain features set it apart from other
fields. The important features of international finance are discussed below:

a) Foreign Exchange Risk: An understanding of foreign exchange risk is essential for

managers and investors in the modern-day environment of unforeseen changes in
foreign exchange rates. When different national currencies are exchanged for each
other, there is a definite risk of volatility in foreign exchange rates. The present
international monetary system set-up is characterized by a mix of floating and
managed exchange rate policies adopted by each nation keeping in view its interest.
This variability of exchange rates is widely regarded as the most serious international
financial problem facing corporate managers and policymakers.
b) Political Risk: Political risk ranges from the risk of loss (/or gain) from unforeseen
government actions or other events of a political character such as acts of terrorism to
outright expropriation of assets held by foreigners. MNCs must assess the political
risk not only in countries where it is currently doing their business but also where it
expects to establish their subsidiaries.
c) Expanded Opportunity Sets: When firms go global, they also tend to benefit from
expanded opportunities which are available now. They can raise funds in capital
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 markets where the cost of capital is the lowest. In addition, firms can also gain from
greater economies of scale when they operate on a global basis.
d) Market Imperfections: There are profound differences among nation’s laws, tax
systems, business practices and general cultural environment. Imperfections in world
financial markets tend to restrict the extent to which investors can diversify their
portfolios. Though there are risks and costs in coping with market imperfections, they
also offer managers of international firms abundant opportunities.

1.10: Measuring Exchange Rate Movements

An exchange rate measures the value of one currency in units of another currency. As economic
conditions change, exchange rates can change substantially. A decline in a currency’s value is
often referred to as depreciation. When the British Pound depreciates against the US Dollar,
this means that the US dollar is strengthening relative to the Pound. This increase in a currency
value is often referred to as appreciation.

When spot rates of two specific points in time are compared, the spot rate as of the more recent
is denoted as S and the spot rate as of the earlier date is denoted as St-1.

The percentage change in the value of a foreign currency is computed as

𝑺 − 𝑺𝒕−𝟏
𝑺𝒕−𝟏
A positive percentage change represents the appreciation of the foreign currency, while a
negative percentage change represents depreciation.

1.11: Exchange Rate Equilibrium

While it is easy to measure the percentage change in the value of a currency, it is more difficult
to explain why the value changed or to forecast how it may change in the future. To achieve
either of these objectives, the concept of an equilibrium exchange rate has to be understood.
Like any other product sold in markets, the price of a currency is determined by the demand
and supply mechanism.
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Let’s say there are only two “countries” in the world: the US and the EU. There exists a market
for US dollars in the world. There is a certain amount of dollars that Europeans want and a
certain number of dollars that Americans want to make available to Europeans. The “price” in
this market is the nominal exchange rate – if the exchange rate is high, Europeans want less,
and Americans want to make more available because they will get more for it. Where supply
equals demand we get the equilibrium exchange rate and quantity of dollars bought and sold in
the foreign exchange market.

As the demand and supply of dollars in the foreign exchange market move around, so does
the exchange rate. If either demand rises (shift right) or supply falls (shift back), the nominal
exchange rate appreciates (e goes up). If either demand falls (shift left) or supply rises (shift
out), the nominal exchange rate depreciates (e goes down)

What leads to changes in demand and supply?

a) Changes in trade
i. The supply of dollars is determined by US demand for imports from the EU.
ii. The demand for dollars is determined by EU demand for US exports.

Example: If the EU loses interest in buying US goods, then the demand for US
exports will fall, as will the demand for US dollars in the foreign exchange market,
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 and the dollar will depreciate. The Europeans need fewer dollars because they are
buying fewer American goods.

b) Speculation / foreign exchange traders

i. Some people buy and sell currencies to make a profit – if they can buy a currency
when the exchange rate is low and sell the currency when the exchange rate is
high, they will make money.
ii. Speculators guess as to what the exchange rate will be in the future and buy and
sell according to that guess, either demanding more or fewer dollars or
supplying more or fewer dollars.

Example: If speculators think that the exchange rate of the dollar will be less next
week, they will try and sell their dollars now. This increases the supply of dollars
in the foreign exchange market and the dollar will depreciate.

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1.12: Factors Affecting Foreign Exchange Rate Forecasting
Exchange Rates

a. Differentials in Inflation: As a general rule, a country with a consistently lower

inflation rate exhibits a rising currency value, as its purchasing power increases
relative to other currencies. Those countries with higher inflation typically see
depreciation in their currency concerning the currencies of their trading partners.
This is also usually accompanied by higher interest rates.
b. Differentials in Interest Rates: Interest rates, inflation and exchange rates are all
highly correlated. By manipulating interest rates, central banks exert influence
over both inflation and exchange rates, and changing interest rates impact
inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract
foreign capital and cause the exchange rate to rise. The impact of higher interest
rates is mitigated, however, if inflation in the country is much higher than in
others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest rates tend
to decrease the exchange rate.
c. Current-Account Deficits: The current account is the balance of trade between
a country and its trading partners, reflecting all payments between countries for
goods, services, interest and dividends. A deficit in the current account shows the
country is spending more on foreign trade than it is earning, and that it is
borrowing capital from foreign sources to make up the deficit. In other words, the
country requires more foreign currency than it receives through sales of exports,
and it supplies more of its currency than foreigners demand for its products. The
excess demand for foreign currency lowers the country’s exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign assets
are too expensive to generate sales for domestic interests.
d. Public Debt: Countries will engage in large-scale deficit financing to pay for
public sector projects and governmental funding. While such activity stimulates
the domestic economy, nations with large public deficits and debts are less
attractive to foreign investors. A large debt encourages inflation, and if inflation
is high, the debt will be serviced and ultimately paid off with cheaper real dollars
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 in the future.
e. Terms of Trade: A ratio comparing export prices to import prices, the terms of
trade are related to current accounts and the balance of payments. If the price of a
country’s exports rises by a greater rate than that of its imports, its terms of trade
have favourably improved. Increasing terms of trade show greater demand for the
country’s exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country’s currency (and an increase in the
currency’s value). If the price of exports rises by a smaller rate than that of its
imports, the currency’s value will decrease concerning its trading partners.
f. Political Stability and Economic Performance: Foreign investors inevitably
seek out stable countries with strong economic performance in which to invest
their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk.
Political turmoil, for example, can cause a loss of confidence in a currency and a
movement of capital to the currencies of more stable countries.

1.13: Summary
▪ An MNC is a company involved in producing and selling goods and services in more
than one country.
▪ The environment of an MNC consists of an International financial system, the foreign
exchange market and the host country’s environment.
▪ When a conflict of goals occurs between managers and shareholders, it is referred to
as the Agency Problem.
▪ IFM may be defined as the management of financial operations relating to
international activities of business organizations.
▪ The scope of IFM consists of international financial economics, international financial
management and international financial markets.
▪ The features of IFM include foreign exchange risk, political risk, expanded
opportunity sets and market imperfections.
▪ A decline in a currency’s value is often referred to as depreciation.
▪ An increase in a currency value is often referred to as appreciation.
▪ Like any other product sold in markets, the price of a currency is determined by the
demand and supply mechanism.
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 ▪ The supply and demand of currency also depend on the imports and exports of a
particular country.
▪ Factors affecting foreign exchange rate forecasting exchange rates are- Differentials
in Inflation, Differentials in Interest Rates, Current-Account Deficits, Public Debt,
Terms of Trade, Political Stability and Economic Performance.

1.14: Terminal Questions

2 Mark Questions
1. What do you mean by a multinational corporation?
2. What do you mean by Agency Problem?
3. Define International Financial Management.
4. What do you mean by appreciation and depreciation of the value of a currency?
5. List any four factors influencing forecasting exchange rate.

5 Mark and 14 Mark Questions

1. Explain the scope of International Finance.
2. Explain the differences between IFM & FM.
3. Explain the features of International Finance.
4. Explain the environment of MNCs.
5. Explain the reasons for the growth of International Finance.
6. Briefly explain the factors influencing forecasting exchange rate.

1.15: Suggested Readings / Reference Books:

1. Eun, C. S., & Resnick, B. G. (2010). International Financial Mgmt (7th ed.) Tata
McGraw-Hill Education.
2. Sharan, V. (2012). International Financial Management (6th ed.). PHI Learning.
3. Shapiro, Alan. C (2008). Multinational Financial Management (8th ed.). Wiley India.
4. Madhu, Vij. (2010). International Financial Management (3rd ed.). Excel Books.
5. Srinivasan, S.P., & Janakiram, B. (2005). International Financial Management (1st
ed.). Dreamtech Press.

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 Module - 2: International Monetary System and BOP

Structure

2.1: Introduction to International Monetary System ........................................................ 17

2.2: Evolution of the International Monetary System ...................................................... 18
2.2.1: Bimetallism (Prior to 1875) ..................................................................................... 18
2.2.2: The Gold Standard, 1876 – 1913 ............................................................................. 19
2.2.3: Inter-War Years, 1914 – 1944 .................................................................................. 19
2.2.4: The Bretton Woods System 1945 – 1973 ................................................................. 20
2.2.5: Exchange Rate Regime Since 1973 ......................................................................... 22
2.3: Introduction to International Financial Institutions ................................................... 23
2.3.1: World Bank .............................................................................................................. 23
2.4: The International Monetary Fund (IMF) ................................................................... 24
2.5: The World Trade Organization (WTO) .................................................................... 25
2.6: WTO Agreements: .................................................................................................... 25
2.7: International Finance Corporation (IFC)................................................................... 26
2.8: Balance of Payment ................................................................................................... 27
2.9: Summary ................................................................................................................... 34
2.10: Terminal Questions................................................................................................ 35
2.11: Suggested Readings / Reference Books: ............................................................... 39

Learning Objectives

• To understand the International Monetary System

• To understand what Balance of Payments means and how to
arrive at the deficit or surplus balance

2.1: Introduction to International Monetary System

International transactions and the resulting problems of balance of payments need to be solved
so that international operations do not suffer. Adequate finances are to be arranged
particularly for less developed/ developing countries so that international transactions take
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 place smoothly. In the context of international trade, the problems that crop up are related to:
(a) Liquidity
(b) Adjustment
(c) Stability

Liquidity is necessary to finance the transactions that are done on a cash basis. Adjustment is
needed to bridge the gap that emanates because of the imbalance between demand and supply
at existing exchange rates. Similarly, stability is necessary with the intent to limit the degree
of uncertainty in international business decisions.

The international monetary system addresses itself to provide mechanisms to solve the above
problems.

The international monetary system consists of elements such as laws, rules, agreements,
institutions, mechanisms and procedures which affect foreign exchange rates, Balance of
Payments adjustments, international trade and capital flows. This system will continue to
evolve in the future as the international business and political environment of the world
economy continues to change. The international monetary system plays a crucial role in the
financial management of a multinational business and the economic and financial policies of
each country.

2.2: Evolution of the International Monetary System

The evolution of the International Monetary System can be analysed in five stages as follows:
1. Bimetallism
2. The Gold Standard 1876 – 1913
3. The Inter-War Years 1914 – 1944
4. The Bretton Wood System 1945- 1973
5. Flexible Exchange Rate Regime since 1973

2.2.1: Bimetallism (Prior to 1875)

Gold and silver are used as international means of payment and the exchange rate among
currencies was determined by either their gold or silver content. The exchange ratio between
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two metals was officially fixed; therefore only more abundant metal was used, driving the more
scarce metal out of circulation

In other words, a “double standard” in the sense that both gold and silver were used as money.
Some countries were on the gold standard, some on the silver standard and some on both. Both
gold and silver were used as international means of payment and the exchange rates among
currencies were determined by either their gold or silver contents.

2.2.2: The Gold Standard, 1876 – 1913

The fundamental principle of the classical gold standard was that each country should set a par
value for its currency in terms of gold and try to maintain this value. Thus, each country had to
establish the rate at which its currency could be converted to the weight of gold. Also, under
the gold standard, the exchange rate between any two currencies was determined by their gold
content.

Example: The United Kingdom pledged to buy or sell an ounce of gold for 4.247 pounds
sterling, thereby establishing the pound for value or official price in terms of gold. The United
States agreed to buy or sell an ounce of gold to a par value of $ 20.67. The stated amount of
gold making £ 4.247 = 01 ounce of gold =$ 20.67

This implied a fixed exchange rate between the pound and the dollar of £1
= $ 4.867i.e., = $ 20.67 / £ 4.247

2.2.3: Inter-War Years, 1914 – 1944

The gold standard in the international monetary system worked until World War 1 interrupted
trade and disturbed the stability of exchange rates for currencies of major countries. The role
of Great Britain as the world’s major creditor nation came to an end after World War 1. The
US began to assume the role of the leading creditor nation.

➢ Countries began to recover from the war and stabilize their economies. The USA
returned to the gold standard in 1919 and UK in 1925.
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 ➢ The UK had experienced considerably more inflation than the USA and because the
UK had liquidated most of its foreign investments in financing the war, This resulted
in unemployment and economic stagnation in Britain.
➢ The pound's overvaluation was not the only major problem of the restored gold
standard. Other problems included the failure of the US to act responsibly, as there
was a general decrease in the ability and willingness of nations to rely on gold standard
adjustments.
➢ The US dollar was devalued from $ 20.67/ ounce of gold to $ 35.00/ounce of gold
(great depression) In 1934, the US returned to a modified gold standard which was
known as the gold exchange standard (the US traded gold only with foreign central
banks)
➢ Thus, the inter-war period was characterised by half-hearted attempts and failure to
restore the gold standard, economic and political instabilities, widely fluctuating
exchange rates, bank failures ( due to the great depression and stock market crash) and
financial crisis.

2.2.4: The Bretton Woods System 1945 – 1973

The depression of the 1930s, followed by another war, has vastly diminished commercial trade,
the international exchange of currencies and cross-border lending and borrowing. Revival of
the system was necessary and the reconstruction of the post-war financial system began with
the Bretton Woods Agreement that emerged from the International Monetary and Financial
Conference of the United and associated nations in July 1944 at Bretton Woods, New
Hampshire.

The agreement established a dollar-based international monetary system and created two new
institutions: The International Monetary Fund (IMF) and the International Bank for
Reconstruction and Development (World Bank). The basic role of the IMF would be to help
countries with the balance of payments and exchange rate problems while the World Bank
would help countries with post-war reconstruction and general economic development.

Thus, the main points of the post-war system evolving from the Bretton Woods Conference
were as follows:
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 ➢ A new institution, the International Monetary Fund (IMF), would be established in
Washington DC. Its purpose would be to lend foreign exchange to any member whose
supply of foreign exchange has become scarce. This lending would not be automatic
but would be conditional on the member’s pursuit of economic policies consistent
with the other points of the agreement, a determination that would be made by the
IMF.
➢ The US dollar (and de facto, the British pound) would be designated as reserve
currencies, and other nations would maintain their foreign exchange reserves
principally in the form of dollars or pounds.
➢ Each fund member would establish a par value for its currency and maintain the
exchange rate for its currency within one per cent of par value. In practice, since the
principle reserve currency would be the US dollar, this meant that the other countries
would peg their currencies to the US dollar, and, once convertibility was restored,
would buy and sell US dollars to keep market exchange rates within the 1% band
value around the par value. The United States, meanwhile, separately agreed to buy
gold from or sell gold to foreign official monetary authorities at a $35 per ounce
settlement of international financial transactions. The US dollar was thus pegged to
gold and any other currency pegged to the dollar was indirectly pegged to gold at a
price determined by its par value.
➢ A fund member could change its par value only with fund approval and only of the
country’s balance of payments was in “fundamental disequilibrium” The meaning of
fundamental disequilibrium was left unspecified but everyone understood that par
value changes were not to be used as a matter of course to adjust economic imbalances.
➢ After a post-war transition period, currencies were to become convertible. That meant,
to anyone who was not a lawyer, currencies could be freely bought and sold for other
foreign currencies. Restrictions were to be removed and, hopefully, eliminated. So, to
keep market exchange rates within 1 per cent of par value, central banks and exchange
authorities would have to build up a stock of dollar reserves with which to intervene
in the foreign exchange market.
➢ The fund would get gold and currencies to lend through “subscription.” That is,
countries would have to make a payment (subscription) of gold and currency to the
IMF to become a member. Subscription quotas were assigned according to a member
country’s size and currency. Those with bigger quotas had to pay more but also got
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 more voting rights regarding fund decisions.
The gold pool was used to sell gold to maintain its price at 435 per ounce. In return, the US
was expected to improve its external trade.

But since the US could not reduce its trade deficit, some of the European countries started
demanding again for conversion of their dollar holdings into gold. Finally, the “gold pool”
arrangement broke down. Eventually, a series of devaluations and speculations led to the
breaking down of the fixed rate system of Bretton Woods.

On 15th August 1971, the President of the US suspended the system of convertibility of gold
and dollar. For some time, the system of fixed rates with an adjustment margin of ± 2.5% was
tried but did not work. Finally, the fixed rate system was abandoned and the floating rate system
came into effect.

In December 1971, the Smithsonian Agreement was signed in Washington; its major features
were:
- Devaluation of the dollar and reevaluation of other currencies; gold passed from
$ 35 per ounce to $ 38;
- New fluctuation margins: from ± 1 % to ±2.25%;
- Non – convertibility of the dollar.

In 1977 and 1978, in the wake of inflation in the US, the dollar further depreciated. The Federal
Reserve practised a strict monetary policy. Between 1980 and 1985, the dollar appreciated
Now, the members of G-7 meet from time to time to coordinate the policies so that exchange
rate stability can be maintained. But, this coordination is not always successful. Nevertheless,
their meeting regularly has an effect of avoiding protectionist tendencies on the part of any one
or more of them.

2.2.5: Exchange Rate Regime Since 1973

The committee appointed by the IMF suggested four options, in the wake of the collapse of the
Bretton Woods system of exchange rates. These suggestions were accepted by the IMF and
incorporated into the text of the second amendment to the articles of agreement. These
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suggestions include (i) Floating Rate System, (ii) Pegging of Currency, (iii) Crawling Peg (vi)
Target Zone Arrangement.
i. Floating Rate system: Marketing forces determine the exchange rate of
currencies under a floating rate system.
ii. Pegging of Currency: Under the system, a developing country pegs its currency
either to a strong currency or to a currency of a country with which it has a large
share of trade. The pegging system provides for a fixed exchange rate between
the two currencies. However, the exchange rates float to other currencies.
iii. Crawling Peg: Crawling pegs is a hybrid of a fixed rate and a floating rate. The
exchange rate of a currency with which it is pegged is stable in the short run, but
it changes gradually over some time to reflect the changes in the market. This
system has the advantages of stability and flexibility.
iv. Target Zone Arrangement: Under this system, the exchange rates are fixed to
the currencies of the countries of a particular zone and the exchange rates float to
the countries outside the zones.
For example, the Eastern Caribbean currency union, Central African Economic
and Monetary community, and Western African Economic and Monetary union.

2.3: Introduction to International Financial Institutions

2.3.1: World Bank

The World Bank (WB) is an international organization which provides facilities related to
“finance, advice and research to developing nations” to bolster their economic development. It
plays a stellar role in providing financial and technical assistance to developing countries across
the globe. It is a unique financial institution that provides partnerships to reduce poverty and
support economic development. It is composed of two institutions namely the International
Bank for Reconstruction and Development (IBRD) and the International Development
Association (IDA). However, there are five institutions within the larger World Bank group.
They are the following:

The World Bank Group consists of five organizations:

1. The International Bank for Reconstruction and Development: The International
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 Bank for Reconstruction and Development (IBRD) lends to governments of middle-
income and creditworthy low-income countries.
2. The International Development Association: The International Development
Association (IDA) provides interest-free loans — called credits — and grants to
governments of the poorest countries. It is called the soft loan window of the World
Bank. Together, IBRD and IDA make up the World Bank.
3. The International Finance Corporation: The International Finance Corporation
(IFC) is the largest global development institution focused exclusively on the private
sector. It helps developing countries achieve sustainable growth by financing
investment, mobilizing capital in international financial markets, and providing
advisory services to businesses and governments.
4. The Multilateral Investment Guarantee Agency: The Multilateral Investment
Guarantee Agency (MIGA) was created in 1988 to promote foreign direct investment
into developing countries to support economic growth, reduce poverty, and improve
people’s lives. MIGA fulfils this mandate by offering political risk insurance
(guarantees) to investors and lenders.
5. The International Centre for Settlement of Investment Disputes: The
International Centre for Settlement of Investment Disputes (ICSID) provides
international facilities for the conciliation and arbitration of investment disputes.

2.4: The International Monetary Fund (IMF)

The International Monetary Fund (IMF) is an international organization that aims to promote
global economic growth and financial stability meant to encourage international trade and
reduce poverty. It is working to foster global monetary cooperation, secure financial stability,
facilitate international trade, and promote high employment and sustainable economic growth.
The primary purpose of the IMF is to ensure the stability of the international system- the system
of exchange rates and international payments. Although the IMF is an agency of the United
Nations, it has its charter, structure and financing arrangements. The IMF not only works with
its 187 members, but it also collaborates with the World Bank, World Trade Organization and
agencies of the United Nations. To become a member of the IMF, countries must apply and be
accepted by the other members. Because membership of the World Bank is conditional on
being a member of the IMF, the World Bank also has 187 members. These members govern
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the World Bank through a Board of Governors. Apart from working with developing countries
on individual projects, the World Bank also works with various international institutions, along
with professional and academic bodies.

2.5: The World Trade Organization (WTO)

In international economic relations, the most significant event to occur in recent times has been
the establishment of the World Trade Organization (WTO) in 1995. The WTO replaced GATT
(General Agreement on Tariffs and Trade) formalised in 1947. The former GATT was not an
organisation. Rather it was a merely legal arrangement. The GATT structure had the following
weaknesses:
• It lacked institutional structure. GATT by itself was only a set of rules and multilateral
agreements.
• It covered only trade in goods. It didn’t cover trade-in services, Intellectual Property
Rights etc. Its main focus was on the textiles and agriculture sector.
• A strong Dispute Resolution Mechanism was absent.
• By developing countries, it was seen as a body meant for promoting the interests of
the western world. This was because the Geneva Treaty of 1946, where GATT was
signed had no representation from some newly independent states and socialist states.
GATT was signed by only 23 countries (including India).

To iron out these flaws, the WTO was born in 1995 as a result of the Uruguay round of
negotiations (1986-94). This new organisation was set up as a permanent body and is designed
to play the role of a watchdog in the spheres of trade in goods, trade in services, foreign
investment, intellectual property rights etc. It oversees the operation of the rules-based
multilateral trading system. Its main function is to monitor and enforce trade rules in the global
economy.

2.6: WTO Agreements:

1. Agreement on Agriculture- This provides a framework for the long-term reform of
agricultural trade and domestic policies to introduce increased market orientation in
agricultural trade. It provides for commitments in the area of market access, domestic
support and export subsidies. Domestic support entails three types of subsidies- A)
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 Amber box subsidies- They are most directly linked to production levels and are trade-
distorting. B) Blue box subsidies- These are production-limiting programmes that still
distort trade. C) Green box subsidies- They are permitted as they are non-trade
distorting. They are heavily used by the USA and EU.
2. Agreement on trade in textiles and clothing (Multi-Fibre Arrangement) -
The MFA was an international trade agreement on textiles and clothing that was
active from 1974 till 2004. It was phased out in 2005. The agreement imposed quotas
on the amount that developing countries could export in the form of yarn, fabric and
clothing to developed countries. Under the MFA, the United States and the European
Union restricted imports from developing countries to protect their domestic
industries. Under the agreement, each country was assigned a quota or quantities of a
specific item which could be exported to the U.S. and EU.
3. Agreement on market access
4. Agreement on TRIMs- The Agreement on Trade-Related Investment Measures
(TRIMs) calls for introducing national treatment of foreign investments and the
removal of quantitative restrictions.
5. Agreement on TRIPs (Trade Related Intellectual Property Rights)
6. The General Agreement on Trade in Services (GATS)- It provides a multilateral
framework of principles and services which should govern trade in services under
conditions of transparency and progressive liberalisation.

2.7: International Finance Corporation (IFC)

The International Finance Corporation (IFC) provides financing for private-enterprise

investment in developing countries around the world, through both loans and direct
investments. Affiliated with the World Bank, it also provides advisory services to encourage
the development of private enterprise in nations that might be lacking the necessary
infrastructure or liquidity for businesses to secure financing.

How the International Finance Corporation (IFC) Works

The IFC was established in 1956 as a member of the World Bank Group, focused on investing
in economic development. It claims to be the largest global development institution focused on
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the private sector in developing countries. The IFC says it also seeks to ensure that private
enterprises in developing nations have access to markets and financing.
The IFC's most recent stated goals include the development of sustainable agriculture,
expanding small businesses' access to microfinance, supporting infrastructure improvements,
as well as promoting climate, health, and education policies. The IFC is governed by its 184
member countries and is headquartered in Washington, D.C.

2.8: Balance of Payment

Balance of payments (BOP) records commercial, financial and economic flows between the
residents of a given country and those of the rest of the world during a certain time, generally
a year. In the context of Balance of Payment, the resident of a country means any individual,
business organization, government agency or any other institution legally domiciled in the
country concerned; it does not necessarily mean a citizen. The Balance of Payment is the
statistical record of a country’s international transactions over a certain period presented in the
form of double-entry bookkeeping.

Balance of Payment Statement

A BOP statement is kept in the form of sources (credits) and uses (debits) of funds. This record
enables us to know whether the country has/had a net surplus or deficit during the referred
period. If a country receives more funds than it spends, it has a surplus of a BOP. If
expenditures by the residents exceed the receipts, the country has a deficit of BOP.

The major sources of funds for a country are:

• Exports of goods and services.
• Sale of existing foreign financial assets
• Foreign loans/borrowings, etc.

Likewise, the major uses are:

• Import of goods and services
• Purchase of foreign financial assets
• Foreign lendings
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 Sources increase the external purchasing power of a country and their uses decrease its
purchasing power.

A BOP statement is divided into several intermediate accounts. The three major segments are:
1. Current Account
2. Capital Account
3. Official Reserves

1. Current Account: This is a record of trade in goods and services among countries. The
current account can be further divided into three parts:

a) Goods Account: This is a record of the trade in goods which is composed of

exports (selling merchandise to foreigners) and imports (buying merchandise
from abroad). Exports are a source of funds and result in a decrease in real assets.
On the other hand, imports are the use of funds and result in the acquisition of real
assets.

b) Services Account: The trade-in services (also called Invisibles) include interest,
dividends, tourism/travel expenses and financial charges etc. Interest and
dividends measure the services that the country’s capital renders abroad. Payment
coming from tourists measures the services that the country’s shops and hotels
provide to foreigners who visit the country. Receipts obtained by servicing
foreigners on these counts constitute a source of funds when the country’s
residents receive the services from foreign – owned assets, utilization of funds.

c) Unilateral Transfers: These consist of remittances by migrants, gifts, donations

and subsidies received from abroad. Remittances so received are sources,
remittances made in the forms of gifts/ donations etc. by immigration cause
utilization of funds.

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 2. Capital Account: Capital Account is divided into Foreign Direct Investment (FDI),
Portfolio investment and short-term capital flows. FDIs are for relatively long periods and
portfolio investments have a maturity of more than a year; short-term capital flows mature in
less than one year.

3. Official reserves: The monetary authority of a country, usually the central bank, owns
international reserves. These reserves are composed of gold, and convertible currencies like
US Dollars, Deutschmark, Japanese Yen, and SDRL (special drawing rights).

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 Meaning of Deficit and Surplus in the Balance of Payment
• Several concepts of balance have evolved -
- Trade Balance: This is the balance on the merchandise trade account.
- Balance on Goods and Services: This is the balance between exports and
imports of goods and services.
- Current Account Balance: This is the net balance on the entire current
account.

BOP deficit or surplus refers to a deficit or surplus in the current account. That is, if the
exports are more, there will be a surplus and vice versa.

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Proforma of Balance of Payment Statement

A. Current Accounts Amount Amount

1. Goods Account
Exports XXX
Less: Imports XXX
Balance on Goods Account XXXX

2. Services Account
Receipts (Ex: interest, dividends, tourism receipts and
financial charges) XXX
Less: Payments (Ex: interest, dividends, tourism payments
and financial charges) XXX
Balance on services Account XXXX

3. Unilateral Transfers
Gifts, donations, subsidies received XXX
Less: Gifts, donations, subsidies made XXX
Balance on Unilateral Transfers XXXX
Total Current Account = (1 + 2 + 3) XXXX

B. Capital Account

4. FDI
Direct investment by foreigners XXX
Less: Direct investment made abroad XXX
Balance on FDI XXXX

5. Portfolio Investment
Foreign investment in the securities by forigners in home
country XXX
Less: Investment in securities abroad XXX
Balance on Portfolio Investment XXXX

6. Short-term capital flows

Foreign claim on the country XXX
Less: Short-term claim on foreigners XXX
Balance on short-term capital account XXXX
Total Capital Account = (4 + 5 + 6) XXXX

C. Official Reserves
Decrease/ Increase in International Reserve XXXX

Surplus (Positive) / Deficit (Negative) = (A + B + C) XXXX

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 Illustration 1
You are required to find out the overall balance, showing clearly all the sub-balances from
the following data:
1. UC corporation of USA invests in India Rs. 3,00,000 to modernize its Indian
subsidiary.
2. A tourist from Egypt buys souvenirs worth Rs.3,000 to carry with him. He also
pays hotel and travel bills of Rs.5,000 to Delhi Tourist Agency.
3. The Indian subsidiary of UC Corporation remits, as usual, Rs.5,000 as dividends
to its parent company in the USA.
4. This Indian subsidiary of UC Corporation sells a part of its production in other
Asian Countries for Rs.1,00,000.
5. The Indian Subsidiary of UC corporation borrows a sum of Rs. 2,00,000 (to be
paid back in a year) from the Germany money market to resolve its urgent
liquidity problem.
6. An Indian company buys a machine for Rs.1,00,000 from Japan and 60% payment
is made immediately; the remaining amount is to be paid after 3 years.
7. An Indian subsidiary of a French company borrows Rs.50,000 from the Indian
public to invest in its modernization programme.

Solution
Sources and Uses of Funds

Sl. No. Sources Uses Nature

1. 3,00,000 Direct Foreign Investment

2.(a) 3,000 Goods Exported
(b) 5,000 Services (invisible) rendered
3. 5,000 Dividends Paid
4. 1,00,000 Goods Exported
5. 2,00,000 Short-term borrowings
6.(a) 40,000 1,00,000 Equipment imported
(b) Increase in a claim on India (Portfolio)
6,48,000 1,05,000

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 A. Current Account
Goods Account
Exports: Rs.1,03,000 (+)
Imports: Rs.1,00,000 (-)
Balance: Rs. 3,000 (+)

Invisible Account
Payments Received: Rs. 5,000 (+)
Payments Made: Rs. 5,000(-)
Balance: NIL
Current Account Balance: Rs.3,000 (+)

B. Capital Account
FDI
Inflow: Rs. 3,00,000 (+)
Outflow: NIL
Balance: Rs. 3,00,000 (+)

Portfolio Investment
Inflow: Rs. 40,000 (+)
Outflow: NIL
Balance: Rs. 40,000 (+)

Long term Capital

Balance: Rs. 3,40,000 (+) (FDI + Portfolio)
Short-term capital Account Inflow: Rs. 2,00,000 (+)
Outflow: NIL
Balance: Rs. 2,00,000 (+)

Capital Accounts
Balance: Rs. 5,40,000 (+)
Overall Balance: Rs. 5,43,000 (+)
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 There is a net surplus of Rs.5,43,000 in the balance of payments. This means, there will be an
increase in reserves by this amount.

Note: Transaction No. 7 did not enter into the BOP statement since this transaction does not
involve any foreign country. The entire transaction has taken place in Indian rupees within
India.

2.9: Summary
▪ The foreign exchange market (forex, FX, or currency market) is a global, worldwide
decentralized financial market for trading currencies.
▪ The markets in which participants can buy, sell, exchange and speculate on currencies.
Foreign exchange markets are made up of banks, commercial companies, central banks,
investment management firms, hedge funds, and retail forex brokers and investors. The
forex market is considered to be the largest financial market in the world.
▪ Because the currency markets are large and liquid, they are believed to be the most
efficient financial markets. It is important to realize that the foreign exchange market is
not a single exchange, but is constructed of a global network of computers that connects
participants from all parts of the world.
▪ The foreign exchange market is unique because of its liquidity; its geographical
dispersion and its continuous operation.
▪ The structure of the forex market is majorly divided into retail and the whole market.
▪ The major participants in the foreign exchange markets are commercial banks; foreign
exchange brokers and other authorized dealers, and the monetary authorities.
▪ It is necessary to understand that commercial banks operate at the retail level for
individual exporters and corporations as well as at wholesale levels in the inter – bank
market.
▪ Balance of Payment (BOP) accounts are an accounting record of all monetary
transactions between a country and the rest of the world.
▪ The BOP accounts summarize international transactions for a specific period, usually a
year, and are prepared in a single currency, typically the domestic currency of the country
concerned.
▪ Sources of funds for a nation, such as exports or the receipts of loans and investments,
are recorded as positive or surplus items. Uses of funds, such as for imports or to invest
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 in foreign countries, are recorded as negative or deficit items.
▪ A BOP statement is divided into three major segments Current Account, Capital Account,
Official Reserves.
▪ The current account is one of the two primary components of the balance of payments,
the other being the capital account. The current account is the sum of the balance of trade
(exports minus imports of goods and services), net factor income (such as interest and
dividends) and net transfer payments (such as foreign aid).
▪ The capital account reflects the net change in national ownership of assets.
▪ Official reserves: The monetary authority of a country, usually the central bank, owns
international reserves. These reserves are composed of gold, and convertible currencies
like US Dollars, Deutschmark, Japanese Yen, and SDRL (special drawing rights).

2.10: Terminal Questions

Self-Assessment Questions
Fill in the blanks
1. …………….. is a market where foreign currencies are bought and sold.
2. ……………. grants licenses for shops, hotels or firms to deal in currency
exchange transactions.
3. ………………supervises monitors and controls the foreign exchange market
and tries to stabilize the exchange rates.
4. ……………….records commercial, financial and economic flows between the
residents of a given country and those of the rest of the world during a certain
period, generally a year.
5. If a country receives more funds than it spends, it has …………….. of BOP. If
expenditure by the residents exceeds than the receipts, the country has a
………………of BOP.
6. ……………..is divided into Foreign Direct Investment (FDI), Portfolio
investment and Short-term capital flows

Section A - 2 mark questions

1. What is the international monetary system?
2. What do you understand by the term Balance of Payment?
For Private Circulation only ~ 35 ~
 3. What does capital account in the BOP statement denote?
4. What is the official reserve?
5. List the three main components in a BOP statement.

Section B - 4 marks questions

1. Write a note on Gold Standard.
2. “International trade and investment would not have been possible in the absence
of FEM”. Explain the statement in light of the function performed by it.
3. Write a note on the BOP statement.

Section C - 10 marks questions

1. Explain in detail the inter-war period.
2. Explain the International Monetary Systems.
3. Explain the structure of the Balance of Payment statement.
4. Write a note on the Balance of Payment.

Practical Problems

Problem -1
Record the following transactions and prepare the balance of payment statement
a) A US firm export $1,000 worth of goods to be paid in six months
b) A US resident visits London and spends $ 400 on hotels, meals and so on.
c) The US government gives a US bank balance of $ 200 to the government of a
developing nation as part of the US aid programme
d) A US resident purchases foreign stock for $800 and pays for it by increasing the
foreign bank balance in the US.
e) A foreign investor purchases $600 of United States treasury bills and pays by
drawing down his bank balances in the United State by an equal amount of money

Problem -2
Given below is a series of transactions between country A and country B. Assume the point of
view of country A and A’s Currency is the dollar ($). Do the following
1. Indicate the accounts to be debited and credited in each transaction
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 2. Enter the transactions in the appropriate T account
3. Prepare the balance of payment for country A, Assume that all the short-term capital
movements are compensating.

Transactions
1. a) A exports goods to B for $1,000. B’s importers sign a bill of exchange for the goods
they import from A.
b) A’s exports discount the bill of exchange with their bank which in turn keeps bills
until maturity (Assume a 10% discount).
c) on the maturity of the bill A’s bank receives payment for the bill in B’s currency.
A’s bank deposits B’s currency in B’s bank. The interest accrued on the bill is $.
2. A imports goods from B for $ 800 and A’s importers pay B’s exporters for the $800
with a loan in B’s currency which they get from A’s bank.
3. A resident of country A, Mr X goes on vacation to country B. He spend s all the money
he had with him, $5,000 for services received while on his vacation in country B.
4. Mr X is lucky however because on the last day of his vacation he finds in the street a
purse with $100 in B’s currency. He brings the money home and declares his finding
to customs authorities.
5. Another residence of A who migrated from B a few years ago decides to send $ 100
to his family. His father used this money to buy a bond from another citizen of A.
6. A businessman of A. Mr Y decided to build a subsidiary plant in B. Therefore he
shipped to B all necessary materials for this purpose which cost $ 50,000.
7. Mr Y very soon finds out that he needs another $20,000 for the completion of the
plant. Thus he issues a bond on the parent company for this amount and sells them to
citizens of B
8. Mr Y makes $10,000 profit during the first year of operation which Mr Y uses to
enlarge his business in B. A’s citizens are very impressed by the successful operation
of Mr Y’s plant in B. Therefore A’s citizen buys from B’s citizen half of the bond
issued by Mr Y.
9. A resident of B Mr Z migrates to A. His only property is $ 1,000 in B country which
he carries with him to A and his house in B which he rents to his friend for $100 a
month. The house is worth $8,000. No rent payment however has been received.

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 10. Mr Z decided to sell his house to his friend for $ 8,000. The payment is arranged as
follows $4,000 in cash and $ 4,000 in five years. Mr Z deposits this money with his
old bank in B.
11. Mr Z however thinks he should give back to the church of this village $1,000 therefore
$1,000 is transferred from Mr Z’s account in B’s bank to the account of the church
12. B is a producer of gold. During the period for which the balance of payments is
completed, B produces $1 million worth of gold. Half of this is consumed at home.
However, 20% is sold to A’s central bank and 10% is exported to A for industrial use.
For the amount of gold exported to A. B accepts a deposit with the central bank of
country A.
13. A citizen of A, Mr M who migrated there from B a long time ago finds out that he has
inherits the property of his uncle. The property consists of a farm worth $ 2,000 and a
deposit of $ 1,000 in the bank.
14. Mr M keeps the money with B bank but he buys a designer dress for $ 200 which he
sends to his sister in B as a gift. The dress is purchased in A with A’s currency.
15. Finally, Mr M sells the farm for $2,000. He uses the proceeds and his deposit in B
bank to buy bonds issued by B government.
16. Mr M makes a gift to his brother in B. This gift consists of a watch which costs $500
and a cheque for $100. The watch is purchased in country A with A’s currency.

Students Practice Practical Problems

1. The following transactions (expressed in US $ billions) take place during a year. Calculate
the US Balance of Payment.
a. The United States exports $300 of goods and receives payment.
b. The Unites States imports $225 of goods and pays for them.
c. The US pays $15 to a foreigner in dividends for investing in the US.
d. American tourist spends $30 overseas using travel checks drawn from US bank.
e. Americans buy foreign stocks for $60.

2. Prepare a BOP statement for France from the following data:

a. France exports goods worth FF₹5,000.
b. France imports goods worth FF ₹4,000.
c. Expenditure of Foreign tourists in France: FF₹ 2,500.
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 d. France makes interest and dividend payments to foreigners: FF₹ 2,000.
e. A French working in the US sends a cheque to his wife in Paris worth FF₹ 500.
f. A Bangladeshi immigrant working in France remits money in his account in
Dacca: FF₹ 1,000.
g. France telecom invests in India: FF₹ 4,500.
h. IBM invests in France: FF₹ 2,000.
i. A French resident buys a German treasury bond: FF₹ 300.
j. A Swiss resident buys a French treasury bond: FF₹ 5,000.
k. A short-term loan advanced by BNP to a British resident: FF₹ 4,000.
l. France borrows FF₹ 3,800 for the short term.

3. The following data are given:

a. An exporter sells watches to Russia for ₹. 5,00,000. The exporter accepts ₹.
50,000 in cash and the remaining as a one-year Bill of Exchange.
b. Rohan, an Indian, goes to Sri Lanka on vacation with ₹ Rs. 2,000. He spent ₹.
1,000 on services received and bought souvenirs for ₹.900 to bring with him.
c. An Indian company imports cloth worth ₹.5,000 from Nepal.
d. Karim of Bangladesh emigrates to India with ₹.1,000.
e. Karim finds a job and sends ₹.1,500 to his family in Bangladesh.
f. An exporter, Madan, sells spare parts worth ₹.25,000 to Colombia and receives
payment on delivery.
g. A US exporter sells to India process equipment for ₹. 1,50,000.

2.11: Suggested Readings / Reference Books:

1. Eun, C. S., & Resnick, B. G. (2010). International Financial Mgmt (7th ed.) Tata
McGraw-Hill Education.
2. Sharan, V. (2012). International Financial Management (6th ed.). PHI Learning.
3. Shapiro, Alan. C (2008). Multinational Financial Management (8th ed.). Wiley India.
4. Madhu, Vij. (2010). International Financial Management (3rd ed.). Excel Books.
5. Srinivasan, S.P., & Janakiram, B. (2005). International Financial Management (1st
ed.). Dreamtech Press.

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 Module - 3: Forex Rates
Structure

3.1: Define Foreign Exchange Market ............................................................................. 41

3.2: Features of the Foreign Exchange Market ................................................................ 41
3.3: Functions of Foreign Exchange Market .................................................................... 41
3.4: Players of the Foreign Exchange Market .................................................................. 42
3.5: Types of Foreign Exchange Market .......................................................................... 42
3.6: FEMA and RBI Regulations ..................................................................................... 43
3.6.1: The main Features of FEMA regulations are: ....................................................... 44
3.7: Introduction to FOREX ............................................................................................. 45
3.7.1: Rates/Quotations ...................................................................................................... 46
A) Direct and Indirect quotes ................................................................................. 46
B) Ask and Bid Price............................................................................................... 47
C) Cross Rates ........................................................................................................ 48
D) Spot Rate ............................................................................................................ 49
3.8: Forward Markets ....................................................................................................... 50
3.8.1: Premiums and Discounts in the Forward Market .................................................. 50
3.8.2: Quotations in Forward Market ................................................................................ 51
3.9: Settlements ................................................................................................................ 52
3.10: Arbitrage in Foreign Exchange Markets ............................................................... 54
3.11: Arbitrage in case of the forward market (or Covered Interest Arbitrage) ............. 56
3.12: Summary ................................................................................................................ 57
3.13: Terminal Questions................................................................................................ 57
3.14: Students Practice Practical Problems .................................................................... 60
3.15: Suggested Readings / Reference Books: ............................................................... 63

Learning Objectives
• To understand the dynamics of foreign exchange markets
• To understand the exchange rate behaviour

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3.1: Define Foreign Exchange Market

The foreign exchange market is over a counter (OTC) global marketplace that determines the
exchange rate for currencies around the world. This foreign exchange market is also known as
Forex, FX, or even the currency market. The participants engaged in this market can buy, sell,
exchange, and speculate on the currencies.

These foreign exchange markets are consisting of banks, forex dealers, commercial companies,
central banks, investment management firms, hedge funds, retail forex dealers, and investors.
In our prevailing section, we will widen our discussion on the ‘Foreign Exchange Market’.

3.2: Features of the Foreign Exchange Market

This kind of exchange market does have characteristics of its own, which are required to be
identified. The features of the Foreign Exchange Market are as follows:

1. High Liquidity: The foreign exchange market is the most easily liquefiable financial
market in the whole world. This involves the trading of various currencies worldwide.
The traders in this market are free to buy or sell the currencies anytime as per their own
choice.
2. Market Transparency: There is much clarity in this market. The traders in the foreign
exchange market have full access to all market data and information. This will help to
monitor different countries’ currency price fluctuations through the real-time portfolio.
3. Dynamic Market: The foreign exchange market is a dynamic market structure. In these
markets, the currency values change every second and hour.
4. Operates 24 Hours: The Foreign exchange markets function 24 hours a day. This
provides the traders with the possibility to trade at any time.

3.3: Functions of Foreign Exchange Market

The various functions of the Foreign Exchange Market are as follows:

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 • Transfer Function: The basic and most obvious function of the foreign exchange
market is to transfer funds or foreign currencies from one country to another for settling
their payments. The market converts one’s currency to another.
• Credit Function: The FOREX provides short-term credit to the importers to facilitate
the smooth flow of goods and services from various countries. The importer can use his
credit to finance foreign purchases.
• Hedging Function: The third function of a foreign exchange market is to hedge foreign
exchange risks. The parties in the foreign exchange are often afraid of the fluctuations
in the exchange rates, which means the price of one currency in terms of another
currency. This might result in a gain or loss to the party concerned.

3.4: Players of the Foreign Exchange Market

The Players in a foreign exchange market are as follows:

• Central Bank: The central bank takes care of the exchange rate of the currency of their
respective country to ensure that the fluctuations happen within the desired limit and
this participant keeps control over the money supply in the market.
• Commercial Banks: Commercial banks are the channel of forex transactions, which
facilitates international trade and exchange with its customers. Commercial banks also
provide foreign investments.
• Traditional Users: The traditional users consist of foreign tourists, the companies who
carry out business operations across the globe.
• Traders and Speculators: The traders and the speculators are the opportunity seekers
who look forward to making a profit through trading on short-term market trends.
• Brokers: Brokers are considered to be the financial experts who act as a sure
intermediary between the dealers and the investors by providing the best quotations.

3.5: Types of Foreign Exchange Market

The Foreign Exchange Market has its varieties. We will know about the types of these markets
in the section below:

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The Major Foreign Exchange Markets

1. Spot Market: In this market, the quickest transaction of currency occurs. This foreign
exchange market provides immediate payment to the buyers and the sellers as per the
current exchange rate. The spot market accounts for almost one-third of all the currency
exchange, and trades which usually take one or two days to settle the transactions.

2. Forward Market: In the forward market, there are two parties which can be either two
companies, two individuals, or government nodal agencies. In this type of market, there
is an agreement to do a trade at some future date, at a defined price and quantity.

3. Future Markets: The future markets come with solutions to several problems that are
being encountered in the forward markets. Future markets work on similar lines and
basic philosophies as the forward markets.

4. Option Market: An option is a contract that allows (but is not as such required) an
investor to buy or sell an instrument that is underlying like a security, ETF, or even
index at a determined price over a definite period. Buying and selling ‘options’ are done
in this type of market.

5. Swap Market: A swap is a type of derivative contract through which two

parties exchange cash flows or liabilities from two different financial instruments. Most
swaps involve these cash flows based on a principal amount.

3.6: FEMA and RBI Regulations

FEMA is a regulatory mechanism that enables the Reserve Bank of India to pass regulations
and the Central Government to pass rules relating to foreign exchange in tune with the Foreign
Trade policy of India.

FEMA served to make transactions for external trade easier – transactions involving current
accounts for external trade no longer required RBI’s permission. The deals in Foreign
Exchange were to be ‘managed’ instead of ‘regulated’.
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 3.6.1: The main Features of FEMA regulations are:

• Activities such as payments made to any person outside India or receipts from them,
along with deals in foreign exchange and foreign security are restricted. It is FEMA that
gives the central government the power to impose the restrictions.
• Free transactions on the current account are subject to reasonable restrictions that may
be imposed.
• Without the general or specific permission of FEMA, MA restricts the transactions
involving a foreign exchange or foreign security and payments from outside the country
to India – the transactions should be made only through an authorized person.
• Deals in foreign exchange under the current account by an authorized person can be
restricted by the Central Government, based on public interest generally.
• Although selling or drawing of foreign exchange is done through an authorized person,
the RBI is empowered by this Act to subject the capital account transactions to several
restrictions.
• Residents of India will be permitted to carry out transactions in foreign exchange,
foreign security or to own or hold immovable property abroad if the currency, security
or property was owned or acquired when he/she was living outside India, or when it
was inherited by him/her from someone living outside India.
Generally, FEMA and RBI regulations are quite complex to understand and implement
and any noncompliance with exchange control regulations leads to a huge penalty.
Therefore, it is very important to take the advice of professional and expert firms
dealing with such matters on regular basis.

In this regard, we provide our services relating to FEMA and RBI regulations as under:
1. FEMA regulations interpretation, advisory and compliance
2. RBI regulations interpretation, advisory and compliance
3. Advisory relating to registration and closure of Branch Office, wholly-owned
subsidiary company, liaison office, project office and Joint Ventures in India from
FEMA and RBI regulations.
4. Assistance in obtaining approval from the Department of Industrial Policy &
Promotion, Foreign Investment Facilitation Portal

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 5. Advising on Foreign Direct Investment, External Commercial Borrowings under
Foreign Exchange Regulations
6. Assistance in preparation and filing of returns/forms/information/documents with
RB like FCGPR, FCTRS, FLA etc
7. Advisory and compliance relating to Overseas Direct Investment (ODI)
8. Assistance in obtaining RBI approval for making payments against restricted current
account transactions
9. Advisory services under Foreign Investment Policy, telecom laws, land-related laws,
etc.
10. Assistance in obtaining other regulatory approvals, licenses,
clarifications/dispensations

3.7: Introduction to FOREX

The network of dealers and other participants, which provide the exchange of currency and the
opportunity to hedge against foreign exchange risk, is known as the foreign exchange market.

The foreign exchange rate is the price of one unit of currency in terms of another currency.
For example, how many rupees are required to buy one computer is the price of a computer in
terms of rupees. Similarly how many rupees are required to buy one US $ is the price of $ in
terms of rupees.

In other words, the price of the Rupee, in terms of US $ is the exchange rate at which the rupee
can be converted into US$ and vice-a-versa.

So foreign exchange rate/quotation is the price of a currency expressed in terms of another

currency, i.e., the amount of currency required to buy one unit of another currency.

In the foreign exchange market, the price of one currency may be quoted in terms of several
currencies. However, most of the currencies are traded in terms of US $. It is important to
realize that every price or exchange rate is relative.

For example, if US $ is worth Rs.43, then it also implies that Re.1 is worth $ 1÷43. All foreign
For Private Circulation only ~ 45 ~
exchange rates in this way are related to each other in a reciprocal way. In other words, the
value of $/Re is just the reciprocal of the value of Re/$.

Quotations in the foreign exchange market are generally made in terms of local currency or the
domestic currency per unit of a foreign currency. For example, the exchange rates of the Rupee
in India maybe quoted in terms of $, say Re./$ = Rs.43/$. It means that one $ is worth Rs.43.

A change in the price of one currency implies, therefore, a change in the price of the other
currency that appears in the quote.

For example, if the price of the Rupee against $ moves from Rs.43/$ to Rs 42.50/$, one can
say that the Rupee has appreciated relative to the $ by Re.0.50. This is the same as saying that
$ has depreciated relative to the rupee.

3.7.1: Rates/Quotations

In the foreign exchange market, the rates /quotations maybe of different types. The quotations
maybe classified as:

A) Direct and Indirect quotes

A direct quote indicates the number of units of the domestic currency required to buy one unit
of the foreign currency.

That is in Mumbai, the typical exchange rate quote indicates the number of Rupees needed to
buy one unit of a foreign currency, e.g., Re. Per $, or Re. Per DM etc.

An indirect quote indicates the number of units of foreign currency that can be expressed for
one unit of the domestic currency. For example, in New York, the rates may be given as £ per
$ or francs per $ etc. The direct and Indirect quotes are related to each other in an inverse
relationship, i.e., an indirect quote is the inverse of the direct quote. So

Indirect quote = 1÷Direct quote

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 In international transactions, both direct and indirect quotes are useful.

For example, if the direct quote of DM in the U.S. is DM/$ =DM1.5037 and an American
importer has to pay DM 1000 to a German firm, then how many $ will be required by the
American importer?

In this case, the quote for $/DM maybe obtained as the inverse of DM/$, I.E., 1÷1.5037 =
0.665. So, he will require $0.665× 1000= $665 to pay for the German firm.

So, a direct quote is the number of domestic currency units required to buy one unit of foreign
currency whereas an indirect quote is the number of foreign currency units required to buy
one unit of the domestic currency.

B) Ask and Bid Price

Generally, in the spot exchange market, two-way spot rates are quoted.

The Ask price is the rate at which the foreign exchange dealer “asks” its customers to pay in
local currency in exchange for foreign currency. In other words, the asking price is the selling
rate or the offer rate and refers to the rate at which the foreign currency can be purchased from
the dealer.

The bid price is the rate at which the dealer is ready to buy the foreign currency in exchange
for the domestic currency. It is also called as buying rate.

The dealer sells the foreign currency for more than what they are ready to pay for buying it.
Normally, the direct ask price is greater than the direct bid price and the difference between
the two is known as Ask-Bid Spread.

The ask-bid spread depends upon the breadth and depth of the market for that currency and
the volatility of the currency. In case, there is a large volume of transactions and the trading
is continuous in any currency, the spread is small and may range between 0.1% to 0.5%. The
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 spread is much higher for infrequently traded securities. This spread compensates the dealer
for holding the risky foreign currency and for providing the service of connecting the
currencies. The Bid spread is usually stated as a percentage cost of transacting in the foreign
exchange market and maybe computed as follows:

𝑨𝒔𝒌 𝒑𝒓𝒊𝒄𝒆 − 𝑩𝒊𝒅 𝒑𝒓𝒊𝒄𝒆

𝑺𝒑𝒓𝒆𝒂𝒅 𝒊𝒏 % = ∗ 𝟏𝟎𝟎
𝑨𝒔𝒌 𝒑𝒓𝒊𝒄𝒆

For example, if the ask price of $/£ is $1.7029, then the % spread may be ascertained as
follows:

1.7046 − 1.7029
𝑆𝑝𝑟𝑒𝑎𝑑 𝑖𝑛 % = ∗ 100
1.7046

This can be interpreted as that the dealer is ready to sell £ @ 1.7046 and is ready to buy £@$
1.0729.

In this transaction, he would be making a profit of 0.1% of the Ask price. In the case of a
direct quote, the spread maybe defined as -

Spread= Ask price - Bid price

Similarly, in the case of an indirect quote, the spread is -

Spread = Bid price - Ask price

C) Cross Rates
The cross rate is the exchange rate based on the cross-product of two other exchange rates.
The exchange rate between two currencies based on the rate of these two currencies in terms
of a third currency is known as a cross rate.

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 For example, an American trader gives the following quotations in New York: $0.60/DM and
$1.80/£, then the cross rates DM/£ or £/DM may be ascertained as follows:

D) Spot Rate

Currencies in the foreign exchange market maybe traded for spot delivery or postponed
delivery.

A spot exchange rate is a rate at which currencies are traded for delivery on the same day or at
the most within two days.

For example, An Indian importer may need US $ to pay for the shipment that has just arrived.
He will have to purchase the $ in the market to make payment for the import. The rate at which
he will buy the US$ in the market is known as the spot exchange rate. He will make the payment
in terms of Re and gets in turn the US $ which will be paid to the foreign exporter.

The spot exchange rate, for a currency, is the current rate at which one currency can be
immediately converted into another currency.

In most cases, the spot exchange rates are set by demand and supply forces in the foreign
exchange market.
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3.8: Forward Markets

The forward rate is a rate quoted by foreign exchange traders for the purchase of sale of foreign
exchange in the future. The forward exchange rate is set and agreed upon by the parties and
remains fixed for the contract period regardless of the fluctuations in the spot exchange rate in
future.

For example, An Indian Firm buys electronics from a British firm with a payment of £
10,00,000 in 90 days. The Indian importer requires £ in future to make the payment. Suppose
the present of £ is Rs.68. Over the next 90 days the £ may rise or decline against Rupee. The
importer can agree to £ 10,00,000 at a rate say Rs. 68.10 after 90 days. According to the forward
contract, the seller will give £ 10,00,000 to the Indian importer, who in turn, will pay Rs.68.10
×10,00,000=6,80,10,000 Rs. This amount of £ 10,00,000 can now be used to pay for the import.

In this way, the importer has made certain his payment obligation in terms of Re., to be made
90 days hence.

Thus, the importer has offset his short position in £ by going long in the forward market, i.e.,
by buying £ in the forward market.

3.8.1: Premiums and Discounts in the Forward Market

In the foreign exchange market, the forward rates are quoted at a premium or discount to the
current spot rate.

A foreign currency is said to be selling at a premium if its forward rate in terms of domestic
currency is higher than the spot rate.
A foreign currency is said to be selling at a discount if its forward rate in terms of domestic
currency is lower than the spot rate.

The difference between the spot rate and the forward rate is also called as forward spot
differential.

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 𝑨𝒏𝒏𝒖𝒂𝒍𝒊𝒛𝒆𝒅 % 𝒐𝒇 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑷𝒓𝒆𝒎𝒊𝒖𝒎 𝒐𝒓 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕
𝑭𝑹 − 𝑺𝑹 𝟑𝟔𝟎
= ∗ ∗ 𝟏𝟎𝟎
𝑺𝑹 𝑭𝑻𝑷 (𝒊𝒏 𝒅𝒂𝒚𝒔)

Whereas:
𝐹𝑅 = 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑅𝑎𝑡𝑒
𝑆𝑅 = 𝑆𝑜𝑝𝑡 𝑅𝑎𝑡𝑒
𝐹𝑇𝑃 = 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑝𝑒𝑟𝑖𝑜𝑑

For example, if the forward rate, F, is Rs.42.53/$ and the spot rate, S, is Rs.42.50/$, and n =
1 month, then the % per annum premium on $ is:

42.53 − 42.50 360

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑜𝑟 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = ∗ ∗ 100 = 0.847%
42.50 30

In case, the forward rate is less, then the % per annum discount may be calculated in the same
way. For example, if the forward rate is Rs.42.46/$, then the % per annum discount on $ is:

42.46 − 42.50 360

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑜𝑟 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = ∗ ∗ 100 = 1.129%
42.50 30

Regarding two currencies, a forward premium on one currency implies a forward discount on
the other. In the above case, the rupee is at a discount when the forward rate is Rs.42.33 and
it is at a premium when the forward rate is Rs.42.46.

3.8.2: Quotations in Forward Market

In the forward exchange market, there may be two types of quotations. The rates can be made
in terms of the amount of local currency at which the dealer will buy and sell a unit of foreign
currency. This is called the outright rate and is generally used by dealers in dealing with
customers.

The forward rates can also be quoted in terms of points of difference i.e., the discount of
premium from the spot rate and which is generally used in inter-bank transactions. To find out
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the outright forward rate, when the forward premium or discount is given in terms of points,
the points are added/deducted to the spot price depending upon whether the currency has a
forward premium or a forward discount. The adjusted rate is the outright forward rate.

The points are added to the spot price if the foreign currency is trading at a forward premium;
the points are subtracted from the spot price if the foreign currency is trading at a forward
discount.
For example, the spot rate for Rs./$ is Rs.45.6321/Rs.4.6380. The forward rates for a different
period in terms of swap points are:

1 Month 2 Months 3 Months

30/25 40/35 25/35

These rates can be interpreted like this. In the spot market, the dealer is bidding to buy $ @ Rs.
45.6321 per dollar and is selling (offering) $ @ Rs.45.6380. The former is the bid price and the
latter is the ask price. The difference between the two is the spread (i.e., profit) of the seller.
The forward rates for different periods are given in points which can be converted into outright
rates as follows:

Bid Price Ask Price Spread

Spot Rs.45.6321/$ Rs.45.6380 $.0059
1 Month Rs.45.6291/$ Rs.45.6355 $.0064
3 Months Rs.45.6281/$ Rs.45.6345 $.0064
6 Months Rs.45.6346/$ Rs.45.6415 $.0069
Note:
The traders know well whether the quotes in points represent a premium or a discount on the
spot rate. This can be determined mechanically. If the first forward quote (the bid or buying
figure) is smaller than the second forward quote (the offer or the asking or selling price), then
there is a premium. In such a situation, points are added to the spot price. Conversely, if the
first quote is greater than the second, then it is a discount.

3.9: Settlements

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Value Date: A settlement of any transaction takes place by transfers of deposits between the
two parties. The day on which these transactions are effected is called the settlement date or
the value date.

Settlement location: To affect the transfers, banks in the countries of the two currencies
involved must be open for business. The relevant countries are called settlement locations.

Dealing locations: The location of the two banks involved in the trade is dealing locations,
which need not be the same as the settlement locations.

Classification of transactions based on the value date

Where T represents the current day when trading takes place and n represents the number of
days.
a. Cash – Cash rate or Ready rate is the rate when the exchange of currencies takes
place on the date of the deal itself. There is no delay in payment at all, therefore
represented by T + 0. When the delivery is made on the day the contract is booked,
it is called a Telegraphic Transfer or Cash or Value – day Deal.
b. Tom – It stands for tomorrow rate, which indicates that the exchange of currencies
takes place on the next working day after the date of the deal, and is therefore
represented by T+ 1.
c. Spot – When the exchange of currencies takes place on the second day after the
date of the deal (T+2), it is called as spot rate. The spot rate is the rate quoted for
current foreign – currency transactions. It applies to interbank transactions that

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 require delivery of the purchased currency within two business days in exchange
for immediate cash payment for that currency.
For e. g. a London bank sells yen against the dollar to a Paris bank on Monday,
1st march, the London bank will turn over the yen deposit in Japan to the Paris
bank on Wednesday and the Paris bank will turn over the $ deposit in the US to
the London bank on the same day i. e. 3rd march, Wednesday. If the 3rd of march
is a holiday in any bank in the dealing location or settlement location deposit will
take place on the next business day.
d. Forward – The forward rate is a contractual rate between a foreign
– exchange trader and the trader’s client for delivery of foreign currency sometime
in the future. Here, the rate of a transaction is fixed on the transaction date for
transactions in future. Standard forward contract maturities are 1,2,3,6, 9, and 12
months.
E.g. 1 month forward purchase of pounds against dollars on 1st Jan. Value date
has arrived as follows:
The value date for the spot transaction: is 3rd Jan. Value date for the forward
transaction:
3rd Jan + 1 calendar month = 3rd Feb
If the 3rd Feb. is a holiday in any bank in the dealing location or settlement
location deposit will take place on the next business date. But this must not take
you for next month, for e. g. if the value date is Feb 28 is value date and it is
ineligible you cannot shift it to 1st March it must be rolled back to Feb 27.

3.10: Arbitrage in Foreign Exchange Markets

Arbitrage is the simultaneous taking of positions in two or more markets to exploit a

discrepancy between the prices of assets in the different markets. It is different from
speculation. The speculator seeks profits from a change in price level while the arbitrageur
seeks profits from a discrepancy in price levels in two markets.

Concerning the foreign exchange market, the term arbitrage refers to the purchase of a currency
at the centre where it is cheaper and selling it at another centre where it is costlier to make a
profit.
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As the foreign exchange market is efficient, the foreign exchange quotes in two different
centres must be in line. However, in case the rates are not the same then there exists a difference
in prices of the same currency at two different centres and it gives rise to arbitrage opportunities
to make a profit.

A dealer can make a profit by buying at the centre where the currency is cheaper and selling it
at another centre where the currency is dearer. Such a buy-sell opportunity will involve no
investment of funds and no risk-bearing by the dealer but will provide a profit opportunity,
called the arbitrage profit.

The process of arbitrage may be described as consisting of simultaneous selling and buying of
the same currency in two different centres to make a risk-less profit. This type of arbitrage may
be called a simple arbitrage or geographical arbitrage. It helps to eliminate the exchange rate
differentials across two centres for the same currency.

Consider a situation, where the following rates are quoted in New York and Frankfurt for the
transactions between DM and $:

New York - $.DM = $ 0.419

Frankfurt – DM/$ = Dm 2.367

The New York price quoted as $/DM implies a DM/$, i.e., the price equal to its inverse and is
DM2.386 [i.e., 1/(0.419)]. So, in New York, the DM/$ rate is 2.386, while in Frankfurt, the
rate is 2.367. This discrepancy indicates that an arbitrage opportunity exists. Since a trader
receives more DM per $ in New York than in Frankfurt, DM is cheaper in New York. To
exploit this price differential, a trader can enter into an arbitrage transaction by buying DM in
New York and simultaneously selling DM in Frankfurt and thereby making profits. These
transactions represent the exploitation of arbitrage opportunities.

When arbitrage continues, the exchange rates between two currencies will soon arrive at the
equilibrium level. The demand and supply forces would help to reach the equilibrium level.

Another type of arbitrage opportunity, known as triangular arbitrage, exists when three
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currencies and their centres are involved. The triangular arbitrage helps equilibrium exchange
rates across the world.

3.11: Arbitrage in case of the forward market (or Covered Interest

Arbitrage)

The difference in interest rates in the two countries may attract investors to invest in a high-
interest-rate currency.

The rule is that if the interest rate differential is greater than the premium or discount, place the
money in the currency that has a higher rate of interest or vice versa.

For example, interest rates in countries A and B are 12% and 7%, respectively. The spot rate
and the forward rate are Y1.750 and Y1.680 for one unit of currency X. In this case, the forward
discount on currency Y ( or forward premium on X) is:

1.68 − 1.75 360

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑜𝑟 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = ∗ ∗ 100 = −4%
1.75 360

So, the net income in the currency X is 8% (i.e., 12% - 4%) whereas the net income in currency
Y is 7% only. So the covered interest differential is in the favour of country X and the funds
will flow from country Y to country X. The movement of funds to take advantage of covered
interest differential is known as Covered Interest Arbitrage.

Suppose an investor in country Y wants to take arbitrage benefit by investing Y.50,00,000. He

can take the following steps:
1. Borrow Y 50,00,000 in country Y @7% interest.
2. Convert Y 50,00,000 into X@ Y1.75=X 1. So, the investor would have X
28,57,142.86. Invest this money in country X@ 12% p.a.
3. This lending would mature to X 32,00,000 (i.e., X 28,57,142.86
×1.12) in one year. So he should immediately sell X 32,00,000 @ Y 1.68 in the
1-year forward contract.
4. After 1 year, when he receives X 32,00,000 from investment, he should deliver in
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 the forward contract and receive Y 53,76,000
5. He should repay the original loan of Y 50,00,000 together with interest @ 7%i.e.,
a total of Y 53,50,00,000.
6. He will gain by Y 26,000. (Y 53,76,000-Y 53,50,000) in one year.

3.12: Summary

▪ The foreign exchange market is the network of dealers and other participants engaged
in the exchange of currencies.
▪ The market may be the spot where transactions for immediate delivery are undertaken
or maybe forward where the delivery takes place in future.
▪ The foreign exchange rate is the price of one unit of a currency in terms of another
currency.
▪ In the foreign exchange market, the rates may be direct/ indirect, spot/ forward, or
ask/bid.
▪ The difference between spot and forward is known as a forward premium or forward
discount.
▪ The difference between the ask and bid is known as the spread and is the profit for the
dealers.
▪ A cross rate is the exchange rate between two currencies based on their rates with other
common currencies.
▪ Arbitrage is a simultaneous taking of two actions in two different markets to make a
profit.
▪ Arbitrage can be bilateral where only two currencies are involved or may be triangular
where arbitrage profit is made with three currencies.
▪ The movement of funds to take benefit of interest rate differential is known as covered
interest arbitrage.

3.13: Terminal Questions

Section A - 2 Mark Questions

1. What is Foreign Exchange Rate?
2. What is a direct quote?
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 3. What is an Indirect Quote?
4. What is the Ask price?
5. What is the Bid price?
6. What is Cross Rate?
7. What is Spot Rate?
8. What is Forward Rate?
9. What is Forward premium?
10. What is a Forward discount?
11. What is the outright rate?
12. What is Cash settlement?
13. What is a TOM settlement?
14. What is Arbitrage?

Section B – 4 Mark & 10 Mark Questions

1. Explain the various kinds of rates or quotes in foreign exchange markets.
2. Explain the various kind of settlements in foreign exchange markets.
3. Explain with help of an example what are forward premium and forward
discounts.

Section C – Problems

Problem -1
Covert the following rates into outright rates and indicate their spreads.
Spot 1-Month 3- Month 6-Months
₹/$ 35.6300/25 20/25 25/35 30/40
₹/£ 55.2200/35 40/30 50/35 55/42
₹/DM 23.9000/30 30/25 40/60 45/65

Problem -2
Suppose the rate quoted as follows in Paris
$ 1.5537 – 50 for Pound sterling and $0.1982-98 for French Franc. What is the direct quote for
the Pound sterling in Paris?

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Problem -3
If the $: Yen spot rate is $ 1 =Yen 110 and interest rates in Tokyo and New York are 3 and 4.5
per cent respectively, what is the expected dollar-yen exchange rate one year hence?

Problem -4
Find cross rates from the following information
a) $/£ = 1.5240, ¥/£ = 235.20, ¥/$ =?
b) €/£ = 2.5150, €/T = 205.80, T/£ =?

Problem -5
Find cross rates from the following information
a) $/£ = 1.5537/59, €/$ = 0.1982/92, €/£ =?
b) $/£ = 2.0015/30, $/SFR = 0.6965/70, £/SFR =?

Problem -6
Dutch Mark spot was quoted at $0.4/DM in New York, the price of Pound Sterling was quoted
at $1.8/£

a) What would you expect the price of Pound to be in Germany?

b) If the Pound were quoted in Frank Fort at DM 4.40/£. What would you do to profit from
the above situation?

Problem -7
An American firm purchases $ 4000 worth of perfume (₣ 20000) from a French firm, the
American distributor must make the payment in 90 days in French Franc the following
quotations and expectations exists for the French FrancSpot rate = $ 0.2000,
90-day forward rate = $ 0.2200,
Interest rate in US = 15 % p.a
Interest rate in France = 10 % p.a

What is the premium on the forward French Franc? What is the interest rate differential
between France and the US? Is there an incentive for covered interest arbitrage?
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Problem -8
Given the following date calculate any arbitrage possibility is available
Spot rate: $ 1 = Rs 44.0030
6 months forward rate: $1 = Rs 45.0010
Annualized interest rate on 6 months Rupees = 12 %
Annualized interest rate on 6 months Dollars = 8 %

3.14: Students Practice Practical Problems

Problem -1
French franc could be purchased in the foreign exchange market for 20 US cents today. If the
franc appreciates 10 per cent tomorrow against the dollar, how many francs would a dollar buy
tomorrow?
Ans: 1$ = FF 4.545

Problem -2
Consider the following bid-ask prices Rs.40-Rs40.50/US$. Find the bid-ask spread percentage.
1. Find out the bid rate if the ask rate is Rs.40.53/US$ and the bid-ask spread is 1.23%.
2. A dealer in Delhi gives the following quotations
1US$= Rs.43.300- Rs.43.7300
1 £ = Rs.69.9200 – Rs.71.3100
Calculate the spread % for US$ and £
3. Find out the forward rate differential if the spot rate of US$ is Rs.45 and the one-
month forward rate is Rs.45.80.
4. Find out the one-month forward rate of US$ if the spot rate is Rs.45 and the forward
premium is 12%.
5. In New York, the spot rate for currency X is $ .9968 and the 1-month and 6 months
forward rates are $ .9984 and $ .9998 respectively. Which currency is at a premium
and which is the % annualized premium?

Ans: 1 Month = 1.9265 and 6 Months= 0.602%

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Problem -3
Convert the following rates into outright rates and indicate their spreads.

Spot 1-Month 3-Months 6-Months

Rs/$ 38.6300/25 40/30 50/35 55/42
Rs/£ 58.2200/35 30/25 40/60 45/65
Rs/DM 21.9000/35 20/25 25/35 30/40

Problem -4
Find out the rate between INR and $ if the exchange rate between INR and £ is Rs.50 and
between $ and £ is $1.6.
Ans: Rs. 31.25

Problem -5
Suppose the rates are quoted as follows in Paris.
$ 1.5537-50 for pound sterling and $0.1982-98 for French franc. What is the direct
quote for the Pound sterling in Paris?

Ans: FFr 7.7763-8456

Problem -6
Direct spot quotes of DM and FF respectively are:
DM=$0.3300/12 FF=$0.1160/70
Calculate:
• Bid-ask % spread on DM and FF
• Direct quote for DM in FF at Paris

Problem -7
A French company has shipped goods to an American importer under a letter of credit
arrangement, which calls for payment at the end of 90 days. The invoice is for $ 1,24,000.
Presently, the exchange rate is FF 5.70/$. If the French francs were to strengthen by 5% by the
end of 90 days, what be the transactions gain or loss in French? If it were to weaken by 5%,
what would happen? Make calculations in francs per $.
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Ans: Gain/loss if FF strengthen – FF 35,340, If FF weakens – FF 35,340

Problem -8
The following spot rates are observed in the foreign currency market:
Currency Rate Per
U.S.$
U.K. £ 00.62
Netherlands Guilder 01.90
Sweden Krona 06.40
Switzerland Franc 01.50
Italy Lira 1,300.00
Japan Yen 140.00
Compute the following:
i) U.K. £ that can be acquired for $ 1,000. ( Ans: £ 620)
ii) $ that 50 Dutch Guilders will buy. (Ans: $ 26.32)
iii) Swedish Krona can be acquired for $ 40. (Ans: Krona 256)
iv) Dollars that 2000 Swiss francs can buy. (Ans: $1,333.33)
v) Italian Lira that can be acquired for $20.( Ans: Lira 26,000)
vi) Dollars that 1,000 Japanese yen will buy. (Ans: $7.14)

Problem – 9
Find the possible arbitrage gain from the following data, and make necessary assumptions.
Rs 40.10000/US$ (Spot)
Rs 40.4000/US$(3-months Forward)
Interest rate ( 3 months) Rs. 11.5% p.a.
US $ 8% p.a.

Ans: Gain = $1.11

Problem -10
Given the following data
Spot rate: Rs 35.0020= $1
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 6 months forward rate: Rs 35.9010 =$1
The annualized interest rate on a 6-month rupee: 12% p.a Annualized interest rate on a
6-month dollar: 7% p.a. Work out the arbitrage possibilities.

Ans: Gain

Problem -11
Given the following data
Spot rate: Can $ 0.665/DM
3 months forward rate: Can$ 0.670/DM Annualized interest rate on 3-months DM: 7%
p.a Annualized interest rate on 3 months Can$ 9%p.a Work out the arbitrage
possibilities

Ans: Gain

Problem -12
Given the following data
Spot rate: FF6.00/$
6 months forward rate: FF6.0020/$ Annualized interest rate on 6-months $: 7% p.a
Annualized interest rate on 6 months FF:9%p.a Work out the arbitrage possibilities.
Ans: Gain

3.15: Suggested Readings / Reference Books:

1. Eun, C. S., & Resnick, B. G. (2010). International Financial Mgmt (7th ed.) Tata
McGraw-Hill Education.
2. Sharan, V. (2012). International Financial Management (6th ed.). PHI Learning.
3. Shapiro, Alan. C (2008). Multinational Financial Management (8th ed.). Wiley India.
4. Madhu, Vij. (2010). International Financial Management (3rd ed.). Excel Books.
5. Srinivasan, S.P., & Janakiram, B. (2005). International Financial Management (1st
ed.). Dreamtech Press.

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 Module - 4: Foreign Exchange Risk and its Management

Structure

4.1: Introduction ............................................................................................................... 64

4.2: Meaning of Foreign Exchange Exposure .................................................................. 65
4.3: Types of Foreign Exchange Exposure ...................................................................... 66
4.3.1: Transaction Exposure .............................................................................................. 66
4.3.2: Translation Exposure............................................................................................... 74
4.3.3: Economic Exposure ................................................................................................. 76
4.3.4: Political Exposure .................................................................................................... 79
4.3.5: Interest Rate Exposure ............................................................................................. 82
4.4: Summary ................................................................................................................... 83
4.5: Terminal Questions ................................................................................................... 84
4.6: Practical Problems ..................................................................................................... 86
4.7: Students Practice Practical Problems ........................................................................ 87
4.8: Suggested Readings / Reference Books: ................................................................... 89

Learning Objectives

• To understand the meaning of foreign exchange exposure

• To understand the different types of foreign exchange exposure
• To understand how to manage foreign exchange risk

4.1: Introduction

Foreign exchange risk is linked to unexpected fluctuations in the value of currencies. The risk
level depends on whether the fluctuations can be predicted. These short-term and long-term
fluctuations have a direct impact on the profitability and competitiveness of the business. This
chapter provides an overview of the foreign exchange risks faced by MNCs. A very important
dimension of international finance is exposure management, and therefore MNCs are
developing techniques and strategies for foreign exchange management. It becomes necessary
to understand the types of exposure and different techniques used.
For Private Circulation only ~ 64 ~
4.2: Meaning of Foreign Exchange Exposure

The foreign exchange rates are subject to change from time to time. Some of the variations may
be unanticipated and have nothing to do with the fundamentals. A business firm dealing in
import and export has to often deal with the foreign exchange rates and market. Normally, such
a firm always has exposure to such exchange risk which may arise due to changes in exchange
rates. Foreign exchange exposure is present whenever a firm’s transactions or current assets
and current liabilities are denominated in terms of currency other than domestic currency. In
case a firm owns assets or has projects that create cash flows in a foreign currency, then a
change in the exchange rate can affect the value of these assets and projects. However, if the
cash flows are expressed locally, then this type of exchange risk will not be present.

The incurrence of foreign exchange risk can be explained like this. An American firm agrees
to buy a car from another firm in New York for a price of $7,000 payable on the delivery of
the car which is expected in 60 days from today. The car is delivered on the specified date and
the buyer will make the payment as required. In this case, the buyer knew the exact $ amount
to be paid under the contract right from the day when the contract was written. There was no
uncertainty about the value of the contract. However, suppose an Indian firm enters into a
contract with a U.S. supplier to buy a car for $7,000 payable at the time of delivery which is to
take place after 60 days. In the case, the Indian importer will have to pay $7,000 at the time of
delivery of the car.

For this purpose, he will have to buy from the market $7,000 at the then prevailing rates. Today,
at the time of entering into the contract, he is sure of the value in terms of $ but not in terms of
the rupee. The Indian firm is not certain what its future rupee outflow would be 60 days hence.
This uncertainty gives rise to exchange rate risk. In case, the value of Re. declines over 60 days
then the payment liability in terms of Re. will increase, though the liability in terms of $ is
fixed.

There are two terms, foreign exchange risk and foreign exposure, which are quite often used
interchangeably. However, foreign exchange risk refers to the variability of the domestic
currency value of foreign currency-denominated assets or liabilities. On the other hand, foreign
exchange exposure refers to the sensitivity of the change in the real domestic currency value
For Private Circulation only ~ 65 ~
of the assets or liabilities due to a change in exchange rates. The exposure deals with the real
change in the value of assets, liabilities or operating income, i.e., it is inflation adjusted.
However, in the present discussion, the two terms, risk and exposures, have been used
interchangeably.

The fluctuations in foreign exchange rates expose the firm (dealing in international business)
to foreign risk. The process of managing financial affairs to minimize the detrimental effects
of fluctuations in exchange rates may be called Foreign Exchange Exposure Management or
Foreign Exchange Risk Management. Foreign exchange risk management helps a firm in
coping up with the possibility of loss arising out of the uncovered position where the exchange
rate fluctuates or the currency involved is devalued.

While dealing with foreign exchange risk management, a financial manager may be faced with
questions namely,
(a) What are the types of risk to which a firm may be exposed as a result of fluctuating
exchange rates?
(b) How the risk can be minimized?

4.3: Types of Foreign Exchange Exposure

There are five types of foreign exchange exposure: Transaction exposure, Translation
exposure, Economic exposure, Political exposure ans Interest rate exposure.

4.3.1: Transaction Exposure

Transaction Exposure: The Case of Ericsson

Ericsson, the Swedish telecommunications giant, has the largest total customer base in the
telecommunications industry in the world. Ericsson has been working in international
markets since the 1880s. Worldwide, four out of ten mobile calls are handled by Ericsson
equipment. Ericsson reported total income from sales in 2000 as SEK 273 billion (USD 29
billion). Ericsson reports in Swedish Krona (SEK) but operates in more than 140 countries.

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 Foreign currency-denominated assets, liabilities, sales and purchases, together with a large
cost base in Sweden, resulting in substantial foreign exchange exposures.

An analysis of net transaction exposures for the whole company, including revenues and
costs by currency, shows a major net revenue exposure in EUR, but a more balanced position
for USD. A +/-10% change in the SEK/ EUR or SEK/USD exchange rate would have an
approximate impact of +/- SEK 3.0 billion, while a +/-SEK 0.3 billion respectively before
any hedging effects are considered.

Ericsson would from this perspective benefit from Swedish participation in the European
Monetary Union with currency conversion to EUR. The unfavourable effects of the weaker
EUR during 2000 were more than offset by hedging activities, and by positive developments
in several of the currencies in which Ericsson also has a net revenue exposure (such as JPY,
GBP, THB, and others).

Ericsson hedges transaction exposure using forward contracts and options. Ericsson reported
a loss of SEK 508 million (USD 53.8 million) associated with its hedging activities during
the year 2000. Source: Ericsson Annual Report 2000.

Whenever there is a commitment to pay foreign currency or the possibility to receive foreign
currency at a future date, any movement in the exchange rate will affect the domestic value of
the transaction. The following situation gives rise to transaction exposure:
• Trade transactions with foreign countries when billing is done in
foreign currencies like exports and imports.
• Banking and financial transactions are done in foreign currencies
like lending and borrowing or equity participation, etc.

Example: U.S. firm borrows in U.K. pounds, owes £1m in one year, and faces transaction
exposure since the cash flows are fixed in a foreign currency.

Transaction risk is critical to an MNC due to the high variability in exchange rates. Firms
frequently enter into financial and commercial contracts denominated in foreign currencies and
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management of transaction exposure has become an important function of international
financial management.

Management of Transaction Exposure

The technique of hedging transaction exposure are grouped into two major divisions –

A. Financial Hedging
1. Forward market hedge
2. Money market hedge
3. Option market hedge
4. Future market hedge

B. Operational Hedging
1. Choice of currency invoicing
2. Leads and lags
3. Indexation clauses in contracts
4. Netting

A. Financial Hedging

The basic role in the forward market hedge is that foreign currency payables (short position)
should be hedged by a matching (long position) buying in the same currency in the forward,
and the receivable position (long) should be matched with selling (short position) in the same
currency in the forward market. A forward market hedge is to match the liability of the assets
position against the offsetting position in the forward market, i.e., a net asset position is covered
by liability in the forward market; and a liability position is covered by the asset position in the
forward market. After taking a forward market hedge, there would be no open position
concerning the movement of exchange rates. For example, an Indian firm has a liability of
£3,000 payable in 30 days.

The firm may take the following steps to cover its liability position:
Step I: Buy a forward contract today to purchase £3,000 in 30 days. Say, the 30 days
the forward rate is Rs.70.25 per £.
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 Step II: On the 30th day, pay the banker Rs.2,10,750, (i.e., 3,000 × 70.25) and collect
£3,000. Use these £ to pay the supplier.

By the use of the forward contract, the Indian firm knows now the exact worth of the future
payment, i.e., Rs. 2,10,750. The exchange risk in £ is eliminated by the net assets position in
the forward market.

1. Futures Market Hedge: Futures contract is another type of hedge available

against the exchange rate risk. A futures contract is a contract to buy or sell a
stated foreign currency at a specified price at some future specified date. It is
important to note here that this is a contract that requires its holder to buy or sell
the asset, regardless of what happens to its value during the interim period. The
importance of a future contract is that it can be used by the financial manager to
lock-in the foreign currency conversion into domestic currency or vice-a-versa.
Futures are a standardized contract in terms of quality and date; the hedging with
futures may not exactly match the transaction exposure in size and maturity.
The features can be used particularly, in cases where the forward exchange rates
are not available for the required period and the forward market hedge cannot be
accomplished. In the case of futures, the firm can hedge its exchange risk exposure
by selling or buying foreign currency futures contracts. The rule for futures market
hedge can be stated as follows: If the transaction leaves the firm long on a foreign
currency, it should sell the futures contract and if the transaction leaves the firm
short, it should buy the futures contract.

2. Money Market Hedging: The money market hedge involves the mixing of
money market and foreign exchange market transactions. The money market
hedge involves borrowing in one currency and converting the proceeds into
another currency. It involves taking advantage of the disequilibrium position
between money and the foreign exchange market. This disequilibrium exists in
the form of a difference between the internal rate differential and the exchange
premium/discount in the forward exchange market.

3. Options Market Hedge: An option contract gives a right to the option holder to
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 buy or not to buy, or to sell a started quantity to foreign currency at a specified
exchange rate at a specific date of the call option (to buy or not to buy) to a put
option (to sell or not to sell). Options contracts can help a firm which is not very
sure whether foreign currency inflow/outflow would or not. The firm can use
currency options to hedge against transaction exposure by locking the exchange
rates and using such rates only to its advantage.

The financial hedging techniques can be easily understood with the help of a case study:
Boeing Corporation, a U.S. MNC, exports a 747 to British Airways; the invoice is for £10m,
payable in one year. Int. rates and FX rates are:
U.S. interest rate (one year) = 6.10%
U.K. interest rate (one year) = 9.00%
S = $1.50/£
FR/STRIKE PRICE = $1.46/£ (one-year forward rate)

a. Forward Hedge And Future Market Hedge: A most direct and popular way to
hedge currency risk is a currency forward contract, sell the £10m forward at $1.46/£
for a guaranteed receipt of $14.6m (£10m x $1.46/£), regardless of what happens to
the spot rate.

If £ depreciates to $1.40 (what Boeing is worried about), they only receive $14m for
the order (selling £10m at the spot rate), but the profit on the forward contract is
$0.60m to make up the difference and Boeing nets $14.6m. If £ appreciates to $1.50,
Boeing will receive $15m for the order but will lose $0.4m on the forward contract,
for a net of $14.6m. No matter what happens to the Spot rate, Boeing will net $14.6m
with a currency forward hedge and will lock in an ex-rate of $1.46/£.

b. Money Market Hedge: Another strategy for Boeing: Borrow for 1 year in the U.K.
in British Pounds @ 9%, with a £10m payoff, convert BPs to USDs at the spot rate,
invest in the US @ 6.10%, and use the £10m receivable from British Airways in one
year to pay off the BP loan in the U.K. and keep the USDs from the payoff in the U.S.
money market.

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 Steps:
1. Borrow in UK: £10m / 1.09 = £9,174,312 today for one year
@ 9%, pay back £10m in one year
2. Convert the pounds into dollars today @S=$1.50/BP, for
$13,761,468 (£9,174,312 x $1.50/£)
3. Invest $13,761,468 in the U.S. @ 6.1%
4. Collect £10m in one year from British Airways in the UK and pay off the
loan in the U.K. (pay back £10m)
5. Receive the dollar proceeds of the investment in the U.S. of $14,600,918.

c. Options Market Hedge: Eliminates ALL currency risk, even any favourable
exchange rate changes that can increase profits by raising revenues in the home
currency when the foreign currency appreciates for AR or lowering costs in the home
currency when the dollar appreciates for AP.

A currency option is a contract giving the right, not the obligation, to buy or sell a
specific quantity of one foreign currency in exchange for another at a fixed price;
called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces
the uncertainty of exchange rate changes and limits the losses of open currency
positions. Options are particularly suited as a hedging tool for contingent cash flows,
as is the case in bidding processes. Call Options are used if the risk is an upward trend
in price (of the currency), while Put Options are used if the risk is a downward trend.

Take the example of RIL which needs to purchase crude oil in USD in 6 months, if
RIL buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to
buy a specified amount of dollars at a fixed rate on the specified date, there are two
scenarios. If the exchange rate movement is favourable i.e the dollar depreciates, then
RIL can buy them at the spot rate as they have become cheaper. In the other case, if
the dollar appreciates compared to today’s spot rate, RIL can exercise the option to
purchase it at the agreed strike price. In either case RIL benefits by paying the lower
price to purchase the dollar.

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 B. Operational Hedging

1. Choice of the Currency of Invoicing: To avoid the exchange rate risk, many
companies try to invoice their exports in the national currency and try to pay for
their supplies in the national currency. This way an exporter knows exactly how
much he is going to receive and how much he has to pay as an importer.
Example: If Boeing can invoice in USD, then it has eliminated currency risk for
itself and shifted it to British Airways. Now if S = $1.50/£, British Airways has
$15m (accounts payable) and Boeing has $15m (accounts receivables).

2. Leads and Lags: This technique consists of accelerating or delaying receipts or

payments in foreign exchange as warranted by the positive/expected position of
exchange rates.

The principle involved is rather simple:

If depreciation of the national currency is anticipated, importing enterprises like
to clear their dues expeditiously in foreign currencies; exporting prefer to delay
the receipt from their debtors abroad. The converse will hold if an appreciation of
the national currency is anticipated; importing enterprise delay their payments to
foreigners while exporting ones will attempt to get paid at the earliest.

3. Indexation clauses in contracts: Indexation clauses written into the international

purchase and sales contracts aim at contractually preventing the practical details
of sharing the transactions’ risk of exchange between the purchaser and the seller
in the hypothesis where a variation in the exchange rate of the currency chosen by
the parties would intervene.

a) Clause for adapting prices proportional to fluctuations in the exchange rate:

From the contract being signed, the seller fixes the value of the goods in its
currency. If the rate of the invoicing currency in the contract increases, the
price of the export is increased for the purchaser based on the new exchange
rate. Therefore the risk of exchange is completely supported by the latter.
b) “Tunnel” indexation clause: The company can introduce a tunnel,
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 stipulating that an appreciation or depreciation would be taken into account
only beyond a certain level, say higher than 4 or 5 per cent.
c) Indexation clause for a currency or basket of currencies: The contracting
parties tie the amount to be paid to a third currency or basket of currencies
such as the SDR. This clause passes on the risk of exchange to the two
parties in the contract.
d) Divided risk clause: The divided risk clause makes the two parties support
a part of the exchange risk. For example, the contract anticipates that a part
of the variation in rate occurring between the invoicing date and the
payment date will be divided by the exporter up to the limit of half, with the
importer supporting the other half.
e) Multicurrency clauses: Multicurrency clauses or multiple exchange
clauses enable the amount of the contract to be drawn up in many currencies
and it is only when payment is due that one of the parties in the contract (the
purchaser or seller) chooses the currency for payment. For example, a
French exporter may like to settle in US dollars if the rate is FFr 5/US$.
And he may choose to settle in pound sterling if the dollar rate is FFr
4.80/US$.

4. Netting: Settlement of mutual obligations between two parties (called bilateral

netting) or with a third party acting as a clearing house (called multilateral netting)
where the net difference (not the gross amounts) is carried forward. Netting is a
common practice in trading foreign exchange, futures, and options.
An enterprise may reduce its exchange risk by making and receiving payments in
the same currency. The exposure position in that case is simply on the net balance.
Bilateral Netting: Netting is bilateral when two companies have trade relations
and do buy and sell reciprocally. For example, a parent company sells semi-
finished products to its foreign subsidiary and then repurchases the finished
product from the latter.

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 With netting, movements of funds to be done will look like this as shown below:
On the other hand, if the two companies take recourse to the net, fund movement
will be as shown below

4.3.2: Translation Exposure

Transaction Exposure: The Case of Ericsson

Ericsson has many subsidiaries operating outside Sweden. The value in SEK of Ericsson’s
foreign investments is exposed to exchange rate fluctuations. Translation exposure in foreign
subsidiaries is hedged within a policy established by the Board:
➢ Monetary net in companies translated using the temporal method (translation effects
in investment affecting the income statement) is hedged to 100%.
➢ Equity in companies translated using the current method (translation effects reported
directly in stockholders’ equity in the balance sheet) is hedged selectively up to 20%
of the total equity.
➢ The translation differences reported in equity, during the year 2000, were SEK 2.0
billion, mainly due to a weaker SEK. Source: Ericsson Annual Report 2000.

This results from direct (joint ventures) or indirect investments (portfolio participation) in
foreign countries. When the balance sheet is consolidated, the value of the assets expressed
in the national currency varies as a function of the variation of the currency of the country
where the investment was made. If at the time of consolidation, the exchange rate is different
from what it was at the time of investment, there would be a difference in consolidation. The
accounting practices in this regard vary from country to country and even within a country
from company to company.

There is a great responsibility to manage the assets and liabilities with the fluctuation of
foreign exchange rates in such a way that the profits and cash flow levels stick to budgeted
levels as far as possible.

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 Management of Translation Exposure
Management of translation exposure which has been developed in various countries of four
types:
a) The current rate method
b) The monetary/non-monetary method
c) The temporal method
d) The current/non-current method

a) Current Rate Method

The current rate method is the simplest and the most popular all over the world. Under this
method:
1. All balance sheet and income statement items are translated at the current rate of
exchange, except for stockholder’s equity (which is transferred at the historical
rate).
2. Income statement items including depreciation and cost of goods sold are
transferred at either the actual exchange rate on the date on which they have
incurred or at the weighted average rate for the period.
3. Dividends paid are translated at the exchange rate prevailing on the date the
payment was made.
4. The gains and losses caused by translation adjustment are transferred to a separate
account called Cumulative Translation Adjustment (CTA) and help in balancing
the Balance sheet.

b) Monetary / Non- Monetary Method

The monetary and non-monetary method differentiates monetary and non- monetary items.
1. Monetary items are those that represent a claim to receive or an obligation to pay
a fixed amount of foreign currency unit, e.g., cash, accounts receivables, current
liabilities, accounts payable and long-term debt.
2. Non-monetary items are those items that do not represent a claim to receive or an
obligation to pay a fixed amount of foreign currency items, e.g., inventory, fixed
assets, long term investments.
3. All monetary items are translated at the current rate while non- monetary items
are translated at historical rates.
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 4. Income statement items are translated at the average exchange rate for the period,
except for items such as depreciation and cost of goods sold that are considered
non-monetary items.

c) Temporal Method
This method is the modified version of the monetary/ non- monetary method. The only
difference is that the temporal method inventory is usually translated at the historical rate but
it can be translated at the current rate if the inventory is shown in the balance sheet at market
value. In the monetary/non- monetary method inventory is always translated at the historical
rate. The income statement items are normally translated at an average exchange rate for the
period. However, the cost of goods sold and depreciation are translated at historical rates.

d) Current/ Non-Current Method

This is the oldest approach. Under this method, the current assets and current liabilities of
foreign affiliates are translated into the home country at the current exchange rate while the
non-current assets and liabilities are translated at historical rates.
In the balance sheet, exposure to gains and losses from fluctuating currency values is
determined by the net of current assets less current liabilities. Items in the income statement
are translated at the average exchange rate for the period.

4.3.3: Economic Exposure

In an open economy, the strength of currencies of competitors due to relative costs and prices
in each country which, in turn, have a bearing on the exchange rate and the structure of the
business itself gives rise to economic exposure which may put companies at a competitive
disadvantage. Though this is not a direct foreign exchange risk exposure, the underlying
economic factors may become a risk factor.

Thus economic exposure refers to the change in expected cash flows as a result of an
unexpected change in exchange rates. For example, a British exporter who operates in the
Indian market can increase his market share merely by reducing the Indian prices of his
products if the Indian rupee becomes strong against the UK pound. Conversely, if the Indian
rupee weakens against the British pound, the Indian company which is a potential competitor
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 to the British company can make a profit indirectly from the currency losses of the British
company. Thus, even though the Indian company is not directly exporting, competition in the
business can be generated on account of the strength of the currency of competitors.

Management of Economic Exposure

Management of economic exposure can be broadly classified into two major ways:
1. Marketing initiatives
2. Production initiatives

Marketing Strategies for managing economic Exposure

i. Market Selection: A major strategic consideration for a firm is what market to sell in
and the relative marketing support to devote to each market. For example, firms may
decide to pull out of markets that have become unprofitable due to real exchange rate
changes, and more aggressively pursue market share or expand into new markets when
the real exchange rate depreciates. These decisions depend, among other things, on
the fixed costs associated with establishing or increasing market share. Market
selection and market segmentation provide the basic parameters within which a
company can adjust its marketing mix over time. They are primarily medium and
longer-term decisions and may not be feasible strategies to react to exchange rate
exposure in the short run. For shorter-run marketing reactions to exchange rate
exposure, the firm may have to turn to price or promotional policies.

ii. Pricing Policies: As we saw previously, in response to changes in real exchange rates,
a firm has to decide market share versus profit margin. This involves the pass-through
decision concerning the foreign currency price of foreign sales. Of course, such a
decision should be made by setting the price that maximizes dollar profits for the firm;
however, since the world is stochastic, this is not always a clear choice. The decision
on how to adjust the foreign currency price in response to exchange rate changes will
depend upon how long the real exchange rate change is expected to persist, the extent
of economies of scale that occur from maintaining a large quantity of production, the
cost structure of expanding output, the price elasticity of demand, and the likelihood
of attracting competition if high unit profitability is apparent.

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 The longer the exchange rate change is expected to persist, the greater the price
elasticity of demand, the greater the economies of scale and the greater the possibility
of attracting competition, the greater will be the incentive to lower home currency
price and expand demand in light of a home currency depreciation and to keep home
currency price fixed and maintain demand in light of a home currency appreciation.
However, in deciding to change prices, the firm should take into account the impact
on cash flows not just today but in the future as well, as once a customer is lost, he
may be lost for a long period making it difficult for a firm to regain market share.

iii. Promotional Strategies: An essential issue in any marketing program is the size of
the promotional budget for advertising, selling and merchandising. These budgets
should explicitly build in exchange rate impacts. An example is European ski areas in
the mid-1980s. When the dollar was strong, they found that they obtained larger
returns on advertising in the U.S. for ski vacations in the Alps as the costs compared
to the Rocky Mountains have fallen due to the currency movements.

Production Strategies for Managing Operating Exposure

The adjustment discussed so far attempts to alter the home currency value of foreign currency
values. But, sometimes, the exchange rate moves so much that pricing or other marketing
strategies do not save the product.

Product sourcing and plant location are the principles variables that companies manipulate to
manage competitive risks that cannot be managed through marketing changes alone.
i. Diversifying Operations: One possibility for dealing with the impact of exchange
rate exposure on the firm’s cash flows is to have the firm diversify into activities with
offsetting exposures to the exchange rate. For example, combine the production and
exporting of a manufactured good with an importing operation that imports
competitive consumer goods from foreign producers. This creates a natural operating
hedge that keeps total dollar cash flows steadily in light of real exchange rate
movements. While the benefits of this strategy are obvious, it has some potential
drawbacks: it may lead the firm to enter into activities in which it has no apparent
comparative advantage resulting in an inefficient source of resources, or the firm may
view the two activities as complementary and allow cross-subsidization to occur for
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 long periods and not consider the economic viability of each operation on its own.

ii. Diversifying Sources of Inputs: For firms wishing to stick to their knitting, the goal
of a production strategy should be to reduce operating costs. The most flexible way to
do this in light of a real home currency appreciation is to purchase more components
from overseas. As long the inputs are not priced in a globally integrated market the
appreciation should lower the dollar cost of the inputs and thus total production costs.
For the longer term, the firm may wish to consider the option of designing new local
facilities that provide added flexibility in making substitutions among various sources
of inputs, either form domestic sources or foreign sources. However, this strategy does
not bode well for the concept of good supplier relations, and potential costs associated
with constantly switching suppliers need to be taken into consideration when
evaluating this strategy.

iii. Plant Location: The most obvious way to be able to take advantage of relative cost
changes due to real currency movements is to have production costs based on a
different currency by actually having production capacity in different countries. The
simplest response is to move production to your competitor's market. Then any
relative cost advantage he may gain from exchange rate changes also accrues to you
as well. Alternatively, placing a plant in a third country based upon the intensity of
certain inputs to production (i.e., labour, raw materials) may make more sense;
however one needs to think about the correlations between the third country exchange
rate and the foreign competitor’s exchange rate to evaluate the hedge value of such a
decision.

iv. Raising Productivity: Raising productivity through closing inefficient plants,

automating heavily and negotiating wage and benefit cutbacks and work rule
concessions is another alternative to manage economic exposure. Employee
motivation can also be used to heighten productivity and improve product quality.

4.3.4: Political Exposure

Political risk is the risk that results from political changes or instability in a country. It hurts
the working of foreign enterprises located in that country as well as on financial and
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 commercial operations carried out in such a country. Political risk can be broadly classified
into the following three categories:
• Country risk
• Sector risk
• Project risk

Management of Political Risk

Political Risk Management by a Multinational

Risk management by a multinational enterprise is required at three stages:
• Before an investment is made in a foreign country
• During the life of the investment
• While negotiating for indemnity in case there has been an attack
on the investment through nationalization

Management of Political Risk before the Investment

Given the significance of political risk, the investor must assess the nature and extent of
political risk. While studying investment risk in foreign countries, it has been observed that
the following approaches are adopted:
a. Dichotomic decisions: To invest or not to invest aboard. Some countries are
considered rightly or wrongly to be risky and a firm would not invest there.
b. Assigning a risk premium: Since risk is difficult to quantify, it is necessary to
be taken it into account. Therefore, there is a practice relatively widespread in
multinational enterprises to assign risk premiums to foreign investments.
c. Sensitivity analysis: this analysis brings to the fore the major factors influencing
cash flows (inflows and outflows) of the project.

To avoid litigation, investing companies try to incorporate several points in contracts

regarding conditions concerning access to the local capital market, taxation applicable to the
company, right to import raw material and semi-finished products, and right to export to other
foreign countries, right of capital transfer, interest, dividends, rents, conditions of local
participation, insurance and guarantees.

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 Management of Political Risk during Life of the Investment
If the enterprise anticipates an aggravation of the risk, it should try to adapt to the risk and
integrate it into its decision process. It may adopt the following approaches for the purpose:
• Not to localize the whole production process in the same country.
• To integrate local products
• To have recourse to debt
• Plough back the funds generated by the subsidiary rather than bringing new
capital from the parent company
• To increase the number of local employees
• To have other local alternative sources of supplies
• To establish a joint venture with a local enterprise

Alternatively, a company may have recourse to external guarantees to protect itself. There
exist in many countries public and private insurances to cover these risks. In several countries,
public authorities have established specialized organizations to insuring the risk inherent in
foreign operations. For instance, in England, this is done by ECGD (Export Credit Guarantee
Department). EXIM Bank in the USA, Ministry of International Trade and Industry (MITI).

Management of Political Risk after Nationalization

Nationalization of foreign subsidiaries causes the following problems:
• Determination of the amount of compensation
• Modalities of payment of indemnities
• Proceedings before courts or the International Centre for Settlement of Investment
Disputes (ICID), the institution created in 1966, which is a part of the World Bank.

Political Risk Management by Exporting Organization

To cover themselves against payment defaults, exporting companies may take recourse to
several internal or external means:
(i) Internal means: The enterprise may reduce its exposure to the country of risk by
reducing its exports to such a country and exploring the possibilities of sales in
less risk-prone countries; such a measure is preventive. The enterprise may
consider increasing the margin on the products that it exports towards the risk
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 country. However, the possibility of adding a risk premium to the price of
products, to a marked extent, depends on the state of competition in the country.
(ii) External means: The enterprise may also take recourse to external means by
transferring the risk to an other organization, say to a bank asking them to furnish
a confirmed and irrevocable documentary credit. And the bank will get a
commission for offering its services. Another method of transferring the risk is to
sell credits to specialized organizations/ invoicing companies.

4.3.5: Interest Rate Exposure

Interest rate exposure relates to exposure a company has to the interest rate risk. Interest rate
risk can be defined as ‘the amount of financial loss a company or individual could incur as a
result of adverse changes in interest rates’. A company having financial transactions in more
than one country is exposed to the adverse interest rate changes of multiple countries. Thus,
efficient management of this interest rate exposure is vital for the sound financial health of the
company. The two main areas of concern should be the borrowings and cash investments made.

Example: If a company owns bond A worth Rs. 1,000 with a 2.5% rate they are paid Rs. 25 per
year on the bond. If interest rates rise, and bond B (a bond with similar characteristics such as
credit quality and maturity) can be purchased for Rs.1, 000 with a 5% rate (Rs. 50/year
payment), then the price of bond A will decrease.
Why will the price of bond A decrease? Because Rs.1, 000 will now buy a bond that pays
Rs.50/year. A reasonable price for bond A is now $500.

Management of Interest Rate Exposure

a) Interest rate swap: A method for changing the interest rate you earn/pay on an agreed
amount for a specified period. An agreement between two parties (known as
counterparties) where one stream of future interest payments is exchanged for another
based on a specified principal amount. Interest rate swaps often exchange a fixed
payment for a floating payment that is linked to an interest rate (most often the
LIBOR). A company will typically use interest rate swaps to limit or manage exposure
to fluctuations in interest rates, or to obtain a marginally lower interest rate than it
would have been able to get without the swap.
b) Cross-currency swap: An exchange of principal and interest payments in separate
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 currencies. A currency swap is a foreign- exchange agreement between two parties to
exchange aspects (namely the principal and/or interest payments) of a loan in one
currency for equivalent aspects of an equal in net present value loan in another
currency.
c) Forward rate agreement: Two parties fix the interest rate that will apply to a loan or
deposit.
d) Interest rate caps: The seller and borrower agree to limit the borrower’s floating
interest rate to a specified level for some time. Limits to the interest rate on an
adjustable-rate loan - are frequently associated with a mortgage. There are several
different types of interest rate cap structures including initial, periodic and lifetime
interest rate cap structures. The initial cap is a value that limits by what amount the
interest can adjust at the mortgage’s first interest rate adjustment date. The period cap
is a value that limits by what amount the interest rate can adjust at each subsequent
adjustment date. The lifetime cap limits the total amount by which the interest rate can
adjust over the life of the mortgage.

4.4: Summary

▪ There are mainly five types of exposure- Translation Exposure, Transaction

Exposure, Economic Exposure, Political Exposure and Interest Rate Exposure and
managing each type of exposure is very important.
▪ Transaction exposure: The risk, faced by companies involved in international trade,
is those currency exchange rates will change after the companies have already
entered into financial obligations. Such exposure to fluctuating exchange rates can
lead to major losses for firms.
▪ Management of Transaction Exposure: The following techniques can be used to
manage the Financial Hedging-Forward market hedge, Money market hedge, and
Options market hedge. Operational Hedging-Choice of currency invoicing, Leads
and lags, Indexation clauses in contracts and Netting.
▪ Translation Exposure: The risk that a company’s equities, assets, liabilities or
income will change in value as a result of exchange rate changes. This occurs when
a firm denominates a portion of its equities, assets, liabilities or income in a foreign
currency.
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 ▪ Management of Translation Exposure can be done through the Current rate method,
the Monetary/Non-monetary method, the Temporal method, and the Current/Non-
current method.
▪ Economic exposure: Economic exposure is the risk that a change in the economy in
one of the countries will negatively impact its investments or operations.
▪ Management of Economic Exposure can be done by using two strategies they are
Marketing initiatives and Production initiatives.
▪ Political Exposure: Political risk is the risk that results from political changes or
instability in a country.
▪ Management of Political exposure can be understood by differentiating the risk of
multinationals as well as exporters and also studying the strategies adopted by them.
▪ Interest rate exposure: Interest rate exposure relates to exposure a company has to
the interest rate risk.
▪ Management of Interest rate exposure can be understood by using techniques like
Interest rate swaps, Cross-currency swaps, Forward rate agreements and Interest rate
caps.

4.5: Terminal Questions

Self-Assessment Questions
Fill in the blanks:
1. ___________ is present whenever a firm’s transactions or current assets and current
liabilities are denominated in terms of currency other than domestic currency.
2. Trade transaction with foreign countries when billing is done in foreign currencies
like exports and imports is an example of ___________.
3. Settlement of mutual obligations between two parties (called bilateral netting) or with
a third party acting as a clearing house (called multilateral netting) where the net
difference (not the gross amounts) is carried forward is called ___________.
4. ___________refers to the change in expected cash flows as a result of an unexpected
change in exchange rates.
5. ___________is the risk that results from political changes or instability in a country
6. The amount of financial loss a company or individual could incur as a result of adverse
changes in interest rates is called ___________.
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 7. An agreement between two parties (known as counterparties) where one stream of
future interest payments is exchanged for another based on a specified principal
amount is called ___________.

[Ans: 1. Foreign exchange exposure, 2. Transaction Exposure, 3. Netting, 4. Economic

exposure, 5. Political risk, 6. Interest rate exposure, 7. Interest rate swaps

Section A - 2 mark questions

1. What do you mean by foreign exchange exposure?
2. Mention the five types of foreign exchange exposure.
3. What is transaction exposure?
4. What is netting?
5. What is translation exposure?
6. Define monetary/non-monetary method of translation exposure.
7. What is the temporal method of translation exposure?
8. What is economic exposure?
9. What do you mean by political exposure?
10. List the strategies that can be used to manage political exposure.
11. What are interest rate swaps?
12. What is cross currency swaps?

Section B - 5 mark questions

1. Explain the technique of financial hedging in transaction exposure.
2. Explain the monetary/ non-monetary method of translation
exposure.
3. What are the strategies adopted to manage economic exposure?
4. How do exporters manage the political exposure of a country?
5. Write a note on interest rate exposure and its management.

Section C - 14 mark questions

1. Write a note on the management of transaction exposure.
2. What is translation exposure and how can it be managed?
3. What are the marketing and production strategies used in managing economic
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 exposure?
4. Define political exposure and briefly explain how can it be managed.

4.6: Practical Problems

Problem -1
A French importer named Charles is to receive DM 1.0 million in 6 months. The exchange
rates are quoted as follows:
Spot: FFr 3.3876/DM
6-months forward: FFr 3.3368/DM
(a) There is a fear of the depreciation of DM shortly. What should Charles do?
(b) What would you suggest to Charles in case an appreciation of DM is likely to take
place?
Ans: Depreciation of DM as indicated by fwd rate= FFr 50,800.

Problem -2
A German exporter sells some machinery to an American company, for which he would receive
payment of US$ 1 million in 3 months. What can he do with the following data? The exchange
rates are as follows:
Spot DM 1.4810/US$
3-months forward DM1.4700/US$
Ans: cost of covering risk in the forward market is DM 11,000

Problem -3
An Indian company C& Co. imports equipment worth $1.0 million and is to pay after 3
months. On the day of the contract, the rates are:
Spot: Rs.35.00/$
3-months forward: Rs.36.25/$
(c) There is an anticipation of a further fall of the rupee. What can C& Co. do?
(d) What should C&Co. do if it knows with a high probability that, in 3- months, a
dollar will settle at Rs.36.00/$
Ans: Net cost of covering the payables in the fwd market=Rs.1.25 million

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Problem -4
A French importer has to pay 10,000 US$ in three months. The exchange rates are being quoted
as follows:
Spot: FFr5.60/US$
3-months forward: FFr5.80/US$
What can he do to cover the exposure?
Ans: Gain is FFr 60,000

Problem -5
A company ABC&Co. has its receivables of DM 1.0 million due in 3 months. The rupee tends
to appreciate. The current rate is Rs.24.2020/DM. The company would like to hedge in the
options market. The data are as follows:
Strike price: Rs 23.50/DM; Premium: 2%
Which type of option is involved? How is this option to be used?
Ans: Loss without hedging= Rs.1,692,000.

4.7: Students Practice Practical Problems

Problem - 1
An exporter has sold to a French company goods worth FF 5 million. He is to receive this sum
in 3 months. he fears a mild depreciation of FF and therefore wants to cover himself in the
options market. The deal is as follows:
Premium 3%
Exercise price: Rs.6.75/FF
Spot rate: Rs.7/FF
Which type of option is to be used? How to use the option?

Problem -2
A French importer bought equipment from a US firm for US$ 1 million on 1st March in the
current year to be paid for in 3 months. The importer fears an appreciation of the US $. He
decides to cover himself in the options market. What are the possibilities?
The data are:
For Private Circulation only ~ 87 ~
 Exchange rate: FFr5.00/US$ or US$0.20/FFr Strike price: FFr 5.05/US$
Maturity date:1st June Premium:3%
Ans: If US $ appreciates his net price would be 5.20 FFr./US$ If US$ depreciates, his net
price would be FFr4.90/US$

Problem -3
An importer has to pay $1.5 million to a US company in June of the current year. To guard
against the possible appreciation of the $, he buys an option by paying a 2.5% premium on
the current price. The spot rate is Rs.35.20/$. The strike price is fixed at Rs.37/$.
Which option has to be bought? Explain how it has to be used.

Problem -4
An Indian exporting firm, ABC&Co. would like to cover itself against a likely depreciation
of the pound sterling. The following data is given:
Receivables of ABC&Co. £ 5,00,000
Spot rate: Rs.56.00/£
Payment date:3-months
3 months interest rate: India: 12% per annum UK: 5% per annum
What should the exporter do?
Ans: Net gain of Rs.4,83,941

Problem -5
A French exporter has to receive FF 1 million in 3 months from an Indian company. the
following data is available:
Spot exchange rate: Rs.6.8022/FF
3 month Interest rate FF-8% p.a India – 12% p.a
What are the steps involved in covering his risk in the money market

Problem -6
A UK importer has to pay $ 1,00,000 in a month. He fears an appreciation of the dollar. What
can he do with the knowledge of the following data?
1-month interest rate: US$: 4%
UK£: 5%
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 Spot rate: $ 1.5537/£
Ans: cost of coverage in the Money market is £53.81

Problem -7
A French importer has to pay $ 10000 in a month. He fears an appreciation of the dollar. What
can he do with the knowledge of the following data? 1 month interest rate: US$: 6%, FF: 8%,
Spot rate: FF5.6/$

4.8: Suggested Readings / Reference Books:

1. Eun, C. S., & Resnick, B. G. (2010). International Financial Mgmt (7th ed.) Tata
McGraw-Hill Education.
2. Sharan, V. (2012). International Financial Management (6th ed.). PHI Learning.
3. Shapiro, Alan. C (2008). Multinational Financial Management (8th ed.). Wiley India.
4. Madhu, Vij. (2010). International Financial Management (3rd ed.). Excel Books.
5. Srinivasan, S.P., & Janakiram, B. (2005). International Financial Management (1st
ed.). Dreamtech Press.

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 Module - 5: Forecasting Foreign Exchange Rate

Structure

5.1: Measuring Exchange Rate Movements ..................................................................... 90

5.2: Depreciation, Devaluation, Revaluation, Appreciation ............................................ 91
5.2.1: Devaluation of a currency ....................................................................................... 91
5.2.2: Depreciation of a currency ...................................................................................... 93
5.2.3: Revaluation............................................................................................................... 95
5.2.4: Currency Appreciation ............................................................................................. 96
5.3: Exchange Rate Equilibrium ...................................................................................... 97
5.4: Factors Affecting Foreign Exchange Rate Forecasting Exchange Rates ................ 100
5.5: International Parity Relationship ............................................................................. 101
5.5.1: Purchasing Power Parity (PPP) ............................................................................ 102
5.5.2: Interest Rate Parity Theory .................................................................................... 105
5.5.3: International Fisher Effect .................................................................................... 106
5.6: Summary ................................................................................................................. 108
5.7: Terminal Questions ................................................................................................. 109
5.8: Practical Problems ................................................................................................... 110
5.9: Students Practice Practical Problems ...................................................................... 111
5.10: Suggested Readings / Reference Books: ............................................................. 111

Learning Objectives

• To understand the exchange rate movements

• Understanding the exchange rate theories

5.1: Measuring Exchange Rate Movements

An exchange rate measures the value of one currency in units of another currency. As economic
conditions change, exchange rates can change substantially. A decline in a currency’s value is
often referred to as Depreciation.

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When the British pound depreciates against the US dollar, this means that the US dollar
strengthens relative to the pound. This increase in a currency value is often referred to as
Appreciation.

When spot rates of two specific points in time are compared, the spot rate as of the more recent
is denoted as S and the spot rate as of the earlier date is denoted as St-1. The percentage change
in the value of a foreign currency is computed as

𝑺 − 𝑺𝒕−𝟏
𝑺𝒕−𝟏

A positive percentage change represents the appreciation of the foreign currency, while a
negative percentage change represents depreciation.

5.2: Depreciation, Devaluation, Revaluation, Appreciation

5.2.1: Devaluation of a currency

The devaluation of a currency is associated with countries having a fixed exchange rate regime.
Under the fixed rate regime, the central bank or the government decides the value of the
currency concerning other foreign currencies. The central bank or the government purchases
or sells its currencies to maintain the exchange rate. When the government or the central bank
reduces the value of its currency, then it is known as the devaluation of the currency. Under
this, the value of the domestic currency is deliberately reduced in terms of other foreign
currencies.

For example, in 1966 when India was following the fixed exchange rate regime, the Indian
Rupee was devalued by 36 %.

Reasons and objectives of currency devaluation

• To increase Exports: countries go for a currency devaluation to boost their exports

in the international market. Devaluation of currency makes its goods cheaper

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 compared to its International competitors. For example, recently China devalued its
currency to make its goods less expensive in the international market. This was aimed
to make its goods more competitive in the global market and to increase its overall
exports. This can also increase the economic growth rate of the country due to higher
exports and an increase in the aggregate demand and the economy.
• Competitive devaluation (race to the bottom): if one country devalues its currency
other countries are also incentivized to devalue their currency to maintain their
competitiveness and the international export market. This situation can lead to tit-for-
tat currency wars which are also known as the “race to the bottom”. Competitive
devaluation can lead to a rise in unchecked inflation.
• To reduce trade deficits: currency devaluation makes a country's exports cheaper,
while imports become more expensive. This leads to an increase in exports and a
decrease in imports. This situation favours the improved balance of payment and
reduces trade deficits. Countries facing consistent trade deficits go for a currency
devaluation to correct their balance of payment and reduced their deficits. However,
the devaluation of currency also increases the debt burden of foreign-denominated
external loans.
• To reduce the sovereign debt burden: countries may opt for currency devaluation
and weak currency policy to reduce the government-issued sovereign debt burden. If
the debt payments are fixed, devaluation of currency will make the domestic currency
weaker and will ultimately make the payments less expensive over time. For example,
if a country's domestic currency is devalued to 80% of its initial value, the $10 million
debt payment will be reduced to work only $8 million now. However, this policy fails
if the country holds a large amount of foreign external loans as they will become
relatively more costly.

Disadvantages of currency devaluation

• Inflation: it can lead to an increase in the inflation rate as essential imports such as
oil etc will become more expensive. It can also lead to demand-pull inflation.
• It reduces the purchasing power of the country’s citizens and foreign goods and
foreign tours become expensive for them.

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 • Large and quick devaluation of currency may reduce the faith of international
investors in the domestic economy. Foreign investors would be less interested in
holding the government debt as devaluation reduces the value of their holdings.
• Devaluation of currency negatively impacts the corporates and individuals who hold
debt in foreign currency.

5.2.2: Depreciation of a currency

Depreciation of a currency is a phenomenon associated with countries with floating exchange

rate regimes. In the floating exchange rate regimes, the value of a country's currency is
determined by the market forces of demand and supply. The exchange rate of the currency
changes on daily basis as per the demand and supply of that currency for foreign currencies. A
currency depreciates concerning foreign currency when the supply of currency in the market
increases while its demand falls.

Reasons responsible for currency devaluation

• The decline in exports: the decline in a country's overall exports leads to a decline
in export revenues. This reduces the demand for the country's currency and leads to
its depreciation.
• The large increase in imports: a large increase in the demand for imported goods
and services can lead to a trade deficit. An increase in the current account deficit can
lead to a net outflow of the currency which can weaken the exchange rate leading to
currency depreciation.
• Monetary policy of Central Bank: if the central bank reduces its policy interest
rates it can lead to the outflow of hot money such as foreign portfolio investment etc.
This can lead to the depreciation of the domestic currency.
• Open market operations of the central bank: if the Central bank undertakes open
market operations to buy foreign currency and gold etc it can lead to the depreciation
of the domestic currency. RBI undertakes open market operations in case of rapid
appreciation or depreciation of the rupee and to reduce volatility in the foreign
exchange market.

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Devaluation vs depreciation

Both devaluation and depreciation lead to a decline in the value of the domestic currency.
However, there are certain differences between them.
• Devaluation is the official reduction in the value of a currency, while depreciation
refers to an unofficial decline in the currency’s value.
• Devaluation is the phenomenon associated with a fixed exchange rate regime.
Whereas, depreciation of a currency is associated with the floating or managed
floating exchange rate regime.
• Devaluation of the currency is done purposely by the central bank or the government.
Whereas the market forces of demand and supply are responsible for the depreciation
of a currency.
• The impact of currency devaluation is for the short term, while the depreciation of
currency can affect the economy for a longer time.
• Devaluation of currency is done occasionally by the central bank, whereas
depreciation and appreciation of currency occur daily.

Impact of currency devaluation and depreciation

• Impact on the property: the impact of devaluation and depreciation on the value of
a property is similar. The value of domestic property for the country’s citizens does
not change much. However, the existing foreign investors may lose money as the
value of existing property in that country would be now lesser in foreign currency.
• Impact on foreign investment: Foreign investors may get attracted to invest in
domestic assets such as the housing market etc because depreciation and devaluation
make it cheaper for foreigners to buy local real estate. However, too frequent
devaluations of currency in the fixed exchange rate regimes can negatively impact
foreign investment due to speculations about the economic instability of the domestic
economy.
• Impact on exports and imports: in both devaluation and depreciation, the impact
on exports and imports is similar. Exports become cheaper in the international market
which increases demand. Imports become expensive and the overall imports reduce.

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 • Aggregate demand: devaluation and depreciation would increase the consumption
of domestic goods at the cost of imported goods leading to an increase in the
economic growth rate.
• Inflation: depreciation and devaluation of currency can have a similar impact on the
inflation rate. An increase in the cost of imports can lead to cost-push inflation,
whereas an increase in domestic demand can lead to demand-pull inflation.
• Fall in the real wages: depreciation and devaluation-induced inflation can lead to a
fall in the real wages if the nominal wages are not increased in response to the increase
in the inflation rate.
• Impact on the exchange rate and the current account balance of
payments: depreciation and devaluation improve the current account balance of
payments due to a relative increase in exports for imports.
• Long-term impacts: the long-term impacts of devaluation and depreciation differ.
The depreciation of the domestic currency in a floating exchange rate regime, can
increase its exports, boost spending and can make the economy look better for foreign
investors. This can increase the flow of foreign investment which can cancel out some
of the effects of depreciation. However, this is not possible in a fixed-rate economy
as only the government or Central bank changes the exchange rates.

5.2.3: Revaluation

Revaluation refers to an upward adjustment to the country's official exchange rate relative to
either price of gold or any other foreign currency. Revaluation increases the value of the
domestic currency for the foreign currency. Revaluation is a feature of the fixed exchange rate
regime, where the exchange rate is determined by the central bank or the government.
Revaluation is the opposite of devaluation, which is a downward adjustment.

Example: suppose 10 units of any currency is equal to $1 of US currency. After revaluation,

the government may change the value of its currency such that 8 units of its currency are now
equal to $1 of US currency.

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Reasons for currency Revaluation

• Current account surplus: the government can go for currency revaluation for
reducing the current account surplus. This happens for economies where exports are
higher than imports.
• To manage inflation: the government may go for currency revaluation to manage
that inflation rate. Revaluation can lead to either higher inflation or even lower
inflation. Currency revaluation can make imports cheaper which can reduce the
inflation rate in the domestic economy.
• Changes in the interest rates of other countries and changes in the global
economic environment can also lead to currency revaluation to manage its impact
on the domestic economy.

5.2.4: Currency Appreciation

Currency appreciation refers to the increase in the value of one currency for other foreign
currencies. Currency appreciation is the unofficial increase in the value of any currency. It is a
feature associated with floating or managed floating exchange rate regimes. Appreciation of a
currency takes place when the supply of the currency is lesser than its demand in the foreign
exchange market.

Causes of currency appreciation

• Increase in the policy interest rate by the central bank: if the central bank
increases the policy interest rate, it would make the investors attractive to invest in
government bonds and domestic securities which can lead to an inflow of foreign
investment in the form of hot money. This can lead to the appreciation of the domestic
currency.
• Current account surplus: current account surplus can cause an inflow of foreign
exchange in the economy leading to appreciation in the exchange rate of the domestic
currency.
• Increase in exports: increase in exports can increase the demand for the domestic
currency leading to its appreciation for foreign currencies.
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 • Intervention by the central bank through open market operations: buying
domestic currency from the foreign exchange market by the central bank can lead to
an appreciation of the domestic currency.
• Higher economic growth can increase foreign investment in the economy which can
cause appreciation in the exchange rate.

Appreciation versus revaluation

Both appreciation and revaluation have similar impacts but they have some differences.
Appreciation of a currency associated with a floating or managed floating exchange rate
system. Whereas the revaluation of a currency is associated with the fixed exchange rate
regime.

Impacts of appreciation and revaluation of a currency

• Exports: Appreciation and revaluation of currency make the exports less competitive
in the international market. This leads to a decrease in the country's exports.
• Imports: The imports become cheaper and thus there is an overall increase and the
imports.
• Remittances: The value of the remittances coming from abroad decreases in the
domestic currency.
• Balance of Payment (BOP): Successive appreciation of domestic currency can
make the BOP adverse.
• Inflation: The overall inflation can decrease because the imports would become
cheaper.

5.3: Exchange Rate Equilibrium

While it is easy to measure the percentage change in the value of a currency, it is more difficult
to explain why the value changed or to forecast how it may change in the future. To achieve
either of these objectives, the concept of an equilibrium exchange rate has to be understood.
Like any other product sold in markets, the price of a currency is determined by the demand
and supply mechanism.
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Let’s say there are only two “countries” in the world: the US and the EU. There exists a market
for US dollars in the world. There is a certain amount of dollars that Europeans want and a
certain number of dollars that Americans want to make available to Europeans. The “price” in
this market is the nominal exchange rate – if the exchange rate is high, Europeans want less,
and Americans want to make more available because they will get more for it. Where supply
equals demand we get the equilibrium exchange rate and quantity of dollars bought and sold in
the foreign exchange market.

As the demand and supply of dollars in the foreign exchange market move around, so does
the exchange rate. If either demand rises (shift right) or supply falls (shift back), the nominal
exchange rate appreciates (e goes up). If either demand falls (shift left) or supply rises (shift
out), the nominal exchange rate depreciates (e goes down)

What leads to changes in demand and supply?

c) Changes in trade
iii. The supply of dollars is determined by US demand for imports from the EU.
iv. The demand for dollars is determined by EU demand for US exports.

Example: If the EU loses interest in buying US goods, then the demand for US
exports will fall, as will the demand for US dollars in the foreign exchange market,
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 and the dollar will depreciate. The Europeans need fewer dollars because they are
buying fewer American goods.

d) Speculation / foreign exchange traders

iii. Some people buy and sell currencies to make a profit – if they can buy a currency
when the exchange rate is low and sell the currency when the exchange rate is
high, they will make money.
iv. Speculators guess as to what the exchange rate will be in the future and buy and
sell according to that guess, either demanding more or fewer dollars or
supplying more or fewer dollars.

Example: If speculators think that the exchange rate of the dollar will be less next
week, they will try and sell their dollars now. This increases the supply of dollars
in the foreign exchange market and the dollar will depreciate.

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5.4: Factors Affecting Foreign Exchange Rate Forecasting
Exchange Rates

g. Differentials in Inflation: As a general rule, a country with a consistently lower

inflation rate exhibits a rising currency value, as its purchasing power increases
relative to other currencies. Those countries with higher inflation typically see
depreciation in their currency concerning the currencies of their trading partners.
This is also usually accompanied by higher interest rates.
h. Differentials in Interest Rates: Interest rates, inflation and exchange rates are all
highly correlated. By manipulating interest rates, central banks exert influence
over both inflation and exchange rates, and changing interest rates impact
inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract
foreign capital and cause the exchange rate to rise. The impact of higher interest
rates is mitigated, however, if inflation in the country is much higher than in
others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest rates tend
to decrease the exchange rate.
i. Current-Account Deficits: The current account is the balance of trade between
a country and its trading partners, reflecting all payments between countries for
goods, services, interest and dividends. A deficit in the current account shows the
country is spending more on foreign trade than it is earning, and that it is
borrowing capital from foreign sources to make up the deficit. In other words, the
country requires more foreign currency than it receives through sales of exports,
and it supplies more of its currency than foreigners demand for its products. The
excess demand for foreign currency lowers the country’s exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign assets
are too expensive to generate sales for domestic interests.
j. Public Debt: Countries will engage in large-scale deficit financing to pay for
public sector projects and governmental funding. While such activity stimulates
the domestic economy, nations with large public deficits and debts are less
attractive to foreign investors. A large debt encourages inflation, and if inflation
is high, the debt will be serviced and ultimately paid off with cheaper real dollars
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 in the future.
k. Terms of Trade: A ratio comparing export prices to import prices, the terms of
trade are related to current accounts and the balance of payments. If the price of a
country’s exports rises by a greater rate than that of its imports, its terms of trade
have favourably improved. Increasing terms of trade show greater demand for the
country’s exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country’s currency (and an increase in the
currency’s value). If the price of exports rises by a smaller rate than that of its
imports, the currency’s value will decrease concerning its trading partners.
l. Political Stability and Economic Performance: Foreign investors inevitably
seek out stable countries with strong economic performance in which to invest
their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk.
Political turmoil, for example, can cause a loss of confidence in a currency and a
movement of capital to the currencies of more stable countries.

5.5: International Parity Relationship

The phenomenon of exchange rate movements is an important issue in international finance.

Forecasters with the most impressive records frequently go wrong in their calculations by
substantial margins. However, many times poor forecasting is due to unforeseeable events.

Are changes in exchange rates predictable? How does inflation affect exchange rates? How are
interest rates related to exchange rates? What is the proper exchange rate in theory? For an
answer to these fundamental issues, it is essential to understand the different theories of
exchange rate determination.

The three theories of exchange rate determination are:

a. Purchasing Power Parity (PPP), links spot exchange rates to nations’ price
levels.
b. The Interest Rate Parity (IRP), links spot exchange rates, forward exchange
rates and nominal interest rates.
c. The International Fisher Effect (IFE) links exchange rates to nations’ nominal
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 interest rate levels.

5.5.1: Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is a condition between countries where an amount of money
has the same purchasing power in different countries. The prices of the goods between the
countries would only reflect the exchange rates. The concept is based on the law of one price,
where in the absence of transaction costs and official trade barriers, identical goods will have
the same price in different markets when the prices are expressed in the same currency.

In other words, the purchasing power of a currency is determined by the number of goods and
services that can be purchased with one unit of that currency.

For example, a chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00 in
a U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both
chocolate bars cost US$1.00.)

Likewise, if the rate of inflation is different in two countries, the floating exchange rate should
accordingly vary to reflect that difference. Let us consider two countries, A and B. The rate
of inflation in country A is higher than that in country B. as a result, imports from country A
increase since the prices of foreign goods tend to be lower. Similarly, exports from the country
will decrease since the prices of its goods appear to be higher for foreigners. In consequence,
the currency of country A will depreciate for that of country B.

We can analyze the PPP theory with an Example:

In period 1, a hypothetical consumer spends DM 100 to buy a certain quantity of goods and
services. Alternatively, the same quantity can be bought for FFr. So the parity holds such that
Let S1 denote the spot rate between DM and FFr

𝐷𝑀 100 𝐷𝑀 0.33
𝑆1 = =
𝐹𝐹𝑟 300 𝐹𝐹𝑟

Let us say, to buy the same quantity of goods and services in period 2, we spend either DM

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 110 or FFr 360. So, the resultant relationship is

𝐷𝑀 110 𝐷𝑀 0.3055
𝑆2 = =
𝐹𝐹𝑟 360 𝐹𝐹𝑟

We see that Deutsche Mark has appreciated against French Franc. This is because of the rate
of inflation.

In Germany, the rate of inflation is 10% and in France, the rate of inflation is 20%. We can
also find the exchange rate in period 2 by applying the formula
S2= S1 X [(1 + rDM ) / (1 + rFFr )]
= 1/3 or 0.33 X (1.1 /1.2)
= DM 0.3055 / FFr

Assumptions of PPP:
1. The financial markets are perfectly liquid, transparent and free with no controls, taxes,
transaction costs etc.
2. Goods markets are perfect, with the international shipment of goods able to take place
freely, instantaneously and without any cost.
3. There are single-consumption goods common to everyone.
4. The same commodities appear in the same proportions in each country’s consumption
basket.

Absolute PPP:

Purchasing power parity in its absolute version states that price levels should be the same
worldwide when expressed in the common currency. A unit of home currency should have the
same purchasing power worldwide. This theory is the application of the law of one price to
national price levels or else arbitrage opportunities would exist. However, absolute PPP ignores
the effects of transportation costs, tariffs quotas and other restrictions and product
differentiations in free trade.

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Formula:

𝟏 + 𝒊𝑯𝑪 𝒕
𝒆 𝒕 = 𝒆𝟎 ∗ [ ]
𝟏 + 𝒊𝑭𝑪

Relative PPP:
The relative version of PPP states that the exchange rate between the home currency and
foreign currency will adjust to reflect changes in the price levels of the two countries. Ex: - If
inflation in India is 10 % and in the US is 3% then the rupee value of the USD must rise by
about 7 % to equalize the Rupee price of goods in both countries.

Formula:

𝟏
𝟏 + 𝒊𝑭𝑪 𝒕
𝒆𝒕 = 𝒆𝒕 ∗ [ ]
𝟏 + 𝒊𝑯𝑪

Whereas:
𝒆𝒕 = 𝑆𝑝𝑜𝑡 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑡𝑖𝑚𝑒 𝑡 (𝑜𝑟) 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
𝒆𝒕 𝟏 = 𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒
𝒆𝟎 = 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 ℎ𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑓𝑜𝑟 𝐼 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝒊𝑯𝑪 = 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑠 𝑜𝑓 ℎ𝑜𝑚𝑒 𝑐𝑜𝑢𝑛𝑡𝑟𝑦
𝒊𝑭𝑪 = 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑠 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑜𝑢𝑛𝑡𝑟𝑦
𝒕 = 𝑇𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

Note: - THE ABOVE FORMULA WORKS FOR DIRECT QUOTE.

In case of an indirect quote the formula shall be

𝟏 + 𝒊𝑭𝑪 𝒕
𝒆 𝒕 = 𝒆𝟎 ∗ [ ]
𝟏 + 𝒊𝑯𝑪

𝟏
𝟏 + 𝒊𝑯𝑪 𝒕
𝒆𝒕 = 𝒆𝒕 ∗ [ ]
𝟏 + 𝒊𝑭𝑪

For Private Circulation only ~ 104 ~

Criticism of PPP Theory:
1. Neglect of the demand/supply approach: The theory fails to explain the demand for
as well as the supply of foreign exchange. The PPP Theory proves to be unsatisfactory
due to this negligence. Because in actual practice, the exchange rate is determined
according to the market forces such as the demand for and supply of foreign currency.
2. Unrealistic Approach: Since the PPP Theory uses price indices which itself proves
to be unrealistic. The reason for this is that the quality of goods and services included
in the indices differs from nation to nation. Thus, any comparison without due
significance for the quality proves to be unrealistic.
3. Unrealistic Assumptions: It is yet another valid criticism that the PPP Theory is
based on unrealistic assumptions such as the absence of transport cost. Also, it
wrongly assumes that there is an absence of any barriers to international trade.
4. Neglects Impact of International Capital Flow: The PPP Theory neglects the
impact of international capital movements on the foreign exchange market.
International capital flows may cause fluctuations in the existing exchange rate.
5. Rare Occurrence: According to critics, the PPP Theory is in contrast to the practical
approach. Because the rate of exchange between any two currencies based on the
domestic price ratios is a very rare occurrence.
The PPP Theory can be considered an ideal theory to determine exchange rates in
specific situations, such as high inflation or monetary disturbances.

5.5.2: Interest Rate Parity Theory

A theory in which the interest rate differential between two countries is equal to the differential
between the forward exchange rate and the spot exchange rate. According to this theory, when
one makes two fixed investments in two different currencies, the return on both investments is
the same even though interest rates may be different. Interest Rate Parity plays an essential role
in foreign exchange markets, connecting interest rates, spot exchange rates and foreign
exchange rates.

Example:
Let us consider investing € 1000 for 1 year. We’ll consider two investment cases viz:
Case I: Domestic Investment
For Private Circulation only ~ 105 ~
In the U.S., consider the spot exchange rate of $1.2245/€ 1.
So we can exchange our € 1000 @ $1.2245 = $1224.50
Now we can invest $1224.50 @ 3.0% for 1 year which yields $1261.23 at the end of the year.

Case II: Foreign Investment

Likewise, we can invest € 1000 in a foreign European market, say at the rate of 5.0% for 1
year.
But we buy forward 1 year to lock in the future exchange rate at
$1.20117/€ 1 since we need to convert our € 1000 back to the domestic
currency, i.e. the U.S. Dollar.
So € 1000 @ of 5.0% for 1 year = € 1050
Then we can convert € 1050 @ $1.20117 = $1261.228
Thus, in the absence of arbitrage, the Return on Investment (RoI) is the same regardless of
our choice of investment method.
The IRP implies that the exchange rate (forward and spot) differential will be equal to the
interest differential between the two countries i.e, (∆ FRD = ∆ IR)

𝑭𝒕 𝟏 + 𝒓𝑯𝑪 𝒕
=[ ]
𝒆𝟎 𝟏 + 𝒓𝑭𝑪

Whereas:
𝑭𝒕 = 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 ‘𝑡’.
𝒆𝟎 = 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 ℎ𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑓𝑜𝑟 𝐼 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝒓𝑯𝑪 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 ℎ𝑜𝑚𝑒 𝑐𝑜𝑢𝑛𝑡𝑟𝑦
𝒓𝑭𝑪 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑜𝑢𝑛𝑡𝑟𝑦
𝒕 = 𝑇𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

5.5.3: International Fisher Effect

Along with the PPP theory, another major theory in international finance is IFE. It uses the
interest rate rather than inflation rate differentials to explain why exchange rates change over
time, but is closely related to PPP theory because interest rates are often highly correlated
with inflation rates.

For Private Circulation only ~ 106 ~

International Fisher Theory states that estimated changes in the current exchange rate between
any two currencies are directly proportional to the difference between the two countries'
nominal interest rates at a particular time. In other words, IFE theory says that a decrease or
increase in expected inflation in a country will cause a proportionate increase or decrease in
the interest rate of a country. IFE theory believes that

Nominal rate = Expected real interest rate + Expected inflation rate.

The real interest rate shall be adjustable to reflect expected inflation to obtain the nominal
interest rate. According to the Fisher effect, the interest rate(r) is made of two components
a) Real interest rate (a)
b) Expected inflation rate (i)

Therefore
(1 + Nominal interest rate) = (1 + Real interest rate) (1 + Expected inflation rate)
(1 + r) = (1 + a) (1 + i)
(1 + r) = 1 + a + i + ai
r = a + i + ai
However often approximated ‘r’ is calculated as equal to ‘a + i’.

It also assumed that the expected real rate of interest rate is the same in all countries.

Example: If country A’s interest rate is 10% and country B’s interest rate is 5%, country B’s
currency should appreciate roughly 5% compared to country A’s currency. The rationale for
the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate.
This increased amount of inflation should cause the currency in the country with the high-
interest rate to depreciate against a country with lower interest rates.

The International Fisher Theory is calculated by the following formula:

𝟏 + 𝒓𝑯 𝒕
𝒆 𝒕 = 𝒆𝟎 ∗ [ ]
𝟏 + 𝒓𝑭

For Private Circulation only ~ 107 ~

Whereas:
𝒆𝒕 = 𝑆𝑝𝑜𝑡 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑡𝑖𝑚𝑒 𝑡 (𝑜𝑟) 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
𝒆𝟎 = 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 ℎ𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑓𝑜𝑟 𝐼 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝒓𝑯𝑪 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 ℎ𝑜𝑚𝑒 𝑐𝑜𝑢𝑛𝑡𝑟𝑦
𝒓𝑭𝑪 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑜𝑢𝑛𝑡𝑟𝑦
𝒕 = 𝑇𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

“E” represents the % change in the exchange rate “ih” represents the home country's interest
rate “if ” represents the foreign country's interest rate

Criticism of the International Fisher Effect

1. Apart from inflation and interest rate, several other factors affect the exchange rate.
2. Since this theory is based on the PPP theory, if the PPP theory does not hold good
then the IFE theory also will not hold good.

5.6: Summary
▪ A decline in a currency’s value is often referred to as depreciation.
▪ An increase in a currency value is often referred to as appreciation.
▪ Like any other product sold in markets, the price of a currency is determined by the
demand and supply mechanism.
▪ The supply and demand of currency also depend on the imports and exports of a
particular country.
▪ Factors affecting foreign exchange rate forecasting exchange rates are- Differentials
in Inflation, Differentials in Interest Rates, Current-Account Deficits, Public Debt,
Terms of Trade, Political Stability and Economic Performance.
▪ The three theories of exchange rate determination are: Purchasing Power Parity (PPP),
The Interest Rate Parity (IRP), The International Fisher Effect (IFE)
▪ PPP- The purchasing power of a currency is determined by the number of goods and
services that can be purchased with one unit of that currency.
▪ The concept is based on the law of one price, where in the absence of transaction costs
and official trade barriers, identical goods will have the same price in different markets
when the prices are expressed in the same currency.
▪ IRP-A theory in which the interest rate differential between two countries is equal to
For Private Circulation only ~ 108 ~
 the differential between the forward exchange rate and the spot exchange rate.
▪ IFE- International Fisher Theory states that estimated changes in the current exchange
rate between any two currencies are directly proportional to the difference between
the two countries' nominal interest rates at a particular time.
▪ Nominal rate = Expected real interest rate + Expected inflation rate

5.7: Terminal Questions

Self-Assessment Fill in the blanks

1. A decline in a currency’s value is often referred to as ……………………… and an
increase in a currency's value is often referred to as ………………………..
2. Which links the spot exchange rate to a nation’s price levels.
3. Which links spot exchange rates, forward exchange rates and nominal interest rates.
4. Which links exchange rates to a nation’s nominal interest rate levels.

[Ans: 1. depreciation, appreciation; 2. Purchasing Power Parity; 3. The Interest Rate Parity;
4. International Fishers Effect]

Section A - 2 mark questions

1. What do you mean by appreciation and depreciation of the value of a currency?
2. List any four factors influencing the forecasting exchange rate.
3. What does PPP theory state?
4. What is the formula used to determine the forward rate in IRP theory?
5. Define IRP theory.
6. What does the IFE theory state?

Section B - 4 mark questions

1. Briefly explain the factors influencing the forecasting exchange rate.
2. Write a note on PPP theory.
3. What are the criticisms of the PPP theory?
4. Explain briefly the IRP theory.
5. What are international parity theories? Write a note on IFE theory.

For Private Circulation only ~ 109 ~

 Section C - 10 mark questions
1. How do you determine the exchange rate and its equilibrium position?
2. Briefly explain the three international parity theories.

5.8: Practical Problems

Problem -1
Two countries A and B produce only one commodity, say rice. Suppose the price of rice in
country A is CA 2.5 and in country B, CB 3.5.
a) According to the PPP, what should CA: CB spot exchange rate be?
b) Suppose the price of rice over the next year is expected to rise to CA3 and CB4
in countries A and B respectively. What should the one-year CA: CB spot
exchange rate be?
(Ans: 1.4 and 1.33)

Problem -2
Assume that the Canadian dollar’s spot rate is $.85 and that the Canadian and US inflation rates
are similar. Then assume that Canada experiences 4% inflation, while the United States
experiences 3% inflation. According to PPP, what will be the new value of the Canadian dollar
after it adjusts to the inflationary changes?
(Ans: $.8415)

Problem -3
A financial manager of a French company has FF 25 million that she can invest for one year.
She is considering the possibility of either investing in Franc where a one-year investment
yields an interest rate of 9%, or in Germany where a one-year investment produces an interest
rate of 12%. The current exchange rate is DM 3.35/FF. Calculate the one-year forward
exchange rate that will make the financial manager indifferent between investing in France or
Germany.
(Ans: 3.4421)

For Private Circulation only ~ 110 ~

Problem -4
The current spot exchange rate between the US dollar and the Indian rupee is INR 40.11/US$,
and the one-year forward rate is INR 43.52/US$. The expected inflation rate in India is 8.5%.
What is the expected inflation rate in the US?
(Ans: 0%)

5.9: Students Practice Practical Problems

Problem -1
Assume that the Australian dollars spot rate is $0.90 and that the Australian and US one-year
interest rates were initially 6%. Then assume the Australian one-year interest rate increases by
5%, while the US one-year interest rate remains unchanged. Using IRP theory, forecast the
spot rate for one year ahead.
(Ans: $.8595)

Problem -2
In India, the interest rate on a one-year loan is 14.5% and inflation is expected to be 6.5%. The
expected inflation rate in Thailand is 8.5%. What should be the interest rate for one year in
Thailand?
(Ans: 16.65%)

Problem -3
In Jan, the one-year interest rate is 4% on the US dollar and 6% on the pound sterling. The spot
exchange rate is pound 0.4322=$1. If the future spot rate is likely to rise to pound 0.4700, what
would happen to the UK interest rate?
(Ans: 13.095)

5.10: Suggested Readings / Reference Books:

1. Eun, C. S., & Resnick, B. G. (2010). International Financial Mgmt (7th ed.) Tata
McGraw-Hill Education.
2. Sharan, V. (2012). International Financial Management (6th ed.). PHI Learning.
3. Shapiro, Alan. C (2008). Multinational Financial Management (8th ed.). Wiley India.
4. Madhu, Vij. (2010). International Financial Management (3rd ed.). Excel Books.
5. Srinivasan, S.P., & Janakiram, B. (2005). International Financial Management (1st
ed.). Dreamtech Press.
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 MODEL QUESTION PAPER

Subject : International Financial Management

Time: 3 Hours Total Marks: 70

SECTION-A
I. Answer any Eight of the following questions (8x2=16)
a) State the key participants of International Finance Functions
b) What do you mean by a multinational corporation?
c) Distinguish between Current Account and Capital Acount.
d) Explain the term “Statistical Discrepancy” .
e) What are cross rates? Illustrate with examples.
f) What is bid-ask spread? How is it computed?
g) Mention the five types of foreign exchange exposure.
h) Explain the term “Netting “
i) State monetary and non-monetary method of translation exposure.
j) Explain the term “ Cross-currency swap”
k) Give the example of Depreciation and Devaluation of currencies.

SECTION-B
II. Answer any Six of the following questions (6x4=24)
a) Explain the reasons for growth of International Finance.
b) Briefly explain the factors influencing in forecasting exchange rate.
c) Write the significance and importance of Balance of Payment Surplus?
d) Explain the differnet methods of quoting foregin exchanges rates.
e) The dollar-euro exchange rate is $1.5968 = €1.00 and the dollar-yen exchange rate is
¥108.0030 = $1.00.What is the euro-yen (€/¥) cross rate?
f) What are the strategies adopted to manage the economic exposure?
g) Write a note on interest rate exposure and its management
h) Describe IRP theory. Is it sufficient to explain the forward exchange rate?
i) Write the different methods of Purchasing Power Parity and give suitable example.

For Private Circulation only ~ vii ~

 SECTION-C
III. Answer any Three of the following questions (3x10= 30)
a) Explain the differences between IFM & FM

b) From the following information :

1. Convert the following rates into outright rates and indicate their spreads,
2. Calculate premium or discount from the Rupee – Dollar rates.

Spot 1 – month 3 – months 6 – months

Rs. /$ 35.6300 / 25 20 /25 25 /35 30 /40
Rs. / £ (Pound Sterling) 5.2200 / 35 40 /30 50 /35 55 /42
Rs. / Deutschmark (DM) 23.9000 / 30 30 /25 40 / 60 45 /65

c) Descirbe different types of foreign exchnage exposures and explain the techniques
used for management of Translation exposure.

d) An Indian company C& Co. imports equipment worth $1.0 million and is
to pay after 3 months. On the day of the contract, the rates are:
Spot: Rs.35.00/$
3-months forward: Rs.36.25/$
(a) There is an anticipation of a further fall of rupee. What can C& Co. do?
(b) What should C&Co. do if it knows with a high probability that, in 3- months,
dollor will settle at Rs.36.00/$

e) Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for
six months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum
in Germany. Currently, the spot exchange rate is DM1.60 per dollar and the six-month
forward exchange rate is DM1.56 per dollar. The treasurer of IBM does not wish to
bear any exchange risk. Where should he/she invest to maximize the return?

For Private Circulation only ~ viii ~