MMS-semester-3-International-Finance-munotes

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FUNDAMENTALS OF INTERNATIONAL
FINANCE
Unit Structure :
1.0 Objectives
1.1 Introduction to International Finance
1.2 Balance of Payment
1.3 Determinants of demand for and supply of currency
1.4 Exchangerate and factors affecting exchange rate
1.5 Current account deficit
1.6 Balance of trade and their implications on exchange rates
1.7 Summary
1.8 Questions
1.9 References
1.0 OBJECTIVES

 To study and understand International Finance.
 To understand the Balance of Payment and Balance of Trade and their
Impli cations.
 To study the determinants of Demand and Supply of Currency.
 To understand the exchange rate and factors affecting it.
 To understand the Deficit in Current account.
1.1 INTRODUCTION TO INTERNATIONAL FINANCE
International finance, often known as int ernational monetary economics,
has become a crucial component of any study of international economics
in a world where consumption, production, investment, and capital
markets are all globalised. The study of monetary interactions between
two or more count ries is known as international finance. Foreign direct
investment and currency exchange rates are two topics that international
finance primarily examines.
The significance of international finance has grown as a result of increased
globalisation. Instead of narrowly focusing on individual markets,
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2 different countries. Large organisations like the International Finance
Corp. (IFC) and the National Bureau of Economic Study perform res earch
on international finance (NBER). The U.S. Federal Reserve also maintains
a section that studies policies relevant to capital movement, international
trade, and the growth of global markets.
1.2 BALANCE OF PAYMENT

Formally speaking, the balance of pa yments is the double -entry
bookkeeping -presented statistical account of a nation's foreign transactions
during a specific time period. Import and export of commodities and
services as well as overseas investments in companies, bank accounts,
bonds, stocks, and real estate are a few examples of international
transactions. Due to the fact that the balance of payments is recorded over
a specific amount of time (i.e., a quarter or a year).

In the U.S. balance of payments, transactions that result in a receipt from
foreigners are often recorded as credits with a positive sign, whereas
transactions that result in payments to foreigners are typically recorded as
debits with a negative sign. The sale of American goods and services
abroad, as well as goodwill, finan cial claims, and real assets, all result in
credit entries in the country's balance of payments. Contrarily, debit
entries result from purchases made by the United States of products and
services from abroad, goodwill, financial claims, and real
assets.Add itionally, while debit inputs increase the supply of money,
credit entries increase the demand for them. Keep in mind that the supply
(demand) of dollars and foreign exchange are correlated. Every credit in
the account is balanced by a corresponding debit, and vice versa, because
the balance of payments is displayed as a system of double -entry
bookkeeping.

The balance of payments contains a wide range of accounts since it keeps
track of all international transactions a nation makes over a specific time
period. However, the following three major categories can be used to
classify a nation's international transactions:
1. The current account.
2. The capital account.
3. The official reserve account.
The capital account includes all purchases and sales of assets inclu ding
stocks, bonds, bank accounts, real estate, and enterprises, whereas the
current account only includes the export and import of goods and services.
Contrarily, all transactions involving purchases and sales of foreign
reserve assets, such as dollars, f oreign currencies, gold, and Special
Drawing Rights (SDRs), are covered by the official reserve account.
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CURRENT ACCOUNT:

All transactions relating t o products, services, main and secondary
incomes are included in the current account.

 Goods:
It includes general merchandise (items that residents export to or import
from nonresidents), goods for processing (items that residents export or
import across b orders to be processed elsewhere before being re -imported
or exported), repairs on goods (items that residents provide to or receive
from nonresidents on ships, aircraft, etc.), goods procured in ports by
carriers (items like fuel, provisions, stores, and supplies that residents or
nonresident carriers transport through ports), repairs on goods (items that
residents provide (exports and imports of all gold not held as reserve
assets by the authorities). Both imports and exports are recorded using the
fob (f ree on board) method, which values goods at the exporting nation's
border.The difference between the two, known as the goods balance, is
recorded as credits for export receipts and debits for import payments.
When the balance is in excess, export revenues exceed import expenses
(credits exceed debits), and the resulting difference shows up as a positive
or zero sign in the balance of payments. Contrarily, the difference shows
up with a negative sign when the balance is in deficit (credits
 Service s:
It includes travel (goods and services bought by nonresident visitors for
personal and business purposes during their stays of less than a year in a
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4 all modes of transportation , and other distributive and auxiliary services
that are performed by residents for nonresidents and vice versa), and other
services (service transactions with nonresidents not covered under
transportation or travel, such as communication services, constru ction
services, insurance or financial services). Regarding commodities, credits
represent export receipts, debits represent import expenses, and the
difference (Net) represents the service balance's surplus (+) or deficit ( -).
Trade balance is frequently used to refer to the total of the balances on
products and services.

 Primary income:
It displays the revenue flows between residents and non -residents in
exchange for lending labour, money, or other non -produced nonfinancial
assets for a short period of t ime to another business. It consists of
employee compensation (wages, salaries, and additional benefits, such as
social contributions and private insurance policies or pension funds),
investment income (dividends, withdrawals from quasi -corporation
income, reinvested earnings, interest, and investment income attributable
to policyholders in insurance, standardised guarantees, and pension funds),
and other primary income (rents, taxes and subsidies on products and
production).
 Secondary Income:
It displays recent transfers between residents and non -residents that are not
capital transfers and do not result in any direct economic benefit. It
consists of transfers from the government (current taxes on wealth and
income, social contributions and benefits, curre nt international
cooperation, various current transfers, etc.) and transfers from other
industries (workers remittances, insurance premiums, claims on non -life
insurance, and other transfers such as fines and penalties, gifts and
donations, etc.).
For comm odities and services, non -residents inflows are treated as credit
entries, outflows as debit entries, and the discrepancy is what determines
whether the income balance is in surplus or deficit. The current account of
the balance of payments, which displays the number of credits and debits
in the goods, services, and income accounts, is produced by computing the
subtotal up to the secondary income account. The current account balance
(Net) is in surplus when the total of exports and income receivable
exceeds the total of imports and income payable; it is in deficit when the
total of imports and income payable exceeds the total of exports and
income receivable.
CAPITAL ACCOUNT:
The capital account displays credit and debit entries for capital transfers
between residents and non -residents as well as non -produced nonfinancial
assets.
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5  Non-produced, non -financial assets:
It refers to transfers of ownership of natural resources (land, minerals,
forestry, water, fishing, air space, and electromagnetic spectrum); lic ences,
leasing agreements, and other contracts (intangibles like marketable
operating leases, permissions to use natural resources without being
recorded as outright ownership of those resources, permissions to engage
in specific activities, such as some g overnment permits, and entitlements
to certain benefits); and licences, leasing agreements, and other
agreements.
 Capital transfers:
It refers to debt forgiveness, transfers of monies associated with the
purchase or sale of fixed assets, and transfers of ownership of fixed assets.
General government (capital taxes, debt forgiveness, investment awards,
and other capital transfers) and other sectors are the two sectorial
components that make up capital transfers (migrant transfers, debt
forgiveness and other transfers).
Net Lending/Borrowing:
The net lending (surplus) or net borrowing (deficit) by the country
compiling the account with the rest of the world is indicated by the total of
the balances on the current and capital accounts. The amount of financial
assets that are available for lending or required for borrowing to support
all transactions with non -residents is reflected in the balance item net
lending/borrowing, which is why it is reported. Though in reality the
equivalence is hard to achieve, concep tually it is equal to the financial
account's net balance.
Financial Account:
All transactions involving external financial assets and liabilities are
tracked in the financial account. It is organised around five accounts, each
of which is unique based on the kinds of financial assets and liabilities that
were used in the transaction.
1) Direct investment:
It entails cross -border investments and is frequently linked to long -lasting
partnerships when inhabitants of one nation have significant control or
influence over the management of a company with operations in another.
Proof of such relationship is the direct or indirect possession of 10% or
more of the voting rights. Shares, other equities, reinvested earnings, and
debt instruments all fall under the cat egory of direct investment depending
on the instrument used.
2) Portfolio investment:
It covers transactions involving debt and equity securities that aren't
covered by direct investment between residents and non -residents. The
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6 term), and resident sector and counterparty sector are used to categorise
portfolio investments.
3) Financial Derivatives:
It includes financial products that are linked to other financial instruments
and a llow for the trading of certain financial risks on financial markets.
Options, futures, swaps, forward foreign exchange contracts, and credit
derivatives transactions and positions are tracked under this category.
4) Other Investment:
Other than direct inv estment, portfolio investment, financial derivatives,
and reserve assets, it involves positions and transactions. It includes cash
and deposits, loans, insurance, pension plans, and standardised guarantees.
It also includes trade credit and advances, other accounts receivable and
payable, and SDR allocations (SDR holdings are included in reserve
assets).
5) Reserve account:
It consists of external assets that the monetary authorities may easily
access and manage for financing the balance of payments, for in tervening
in exchange markets to influence currency exchange rates, and for other
relevant objectives (such as maintaining confidence in the currency and
the economy, and serving as a basis for foreign borrowing). In addition to
financial derivatives and o ther claims, they also comprise holdings of
special drawing rights (SDRs), foreign currency and deposits, IMF
reserves, securities (including debt and equity securities), special drawing
rights (SDRs), and monetary gold (loans and other financial instrumen ts).
Errors and Omissions:
Errors and omissions in the production of balance -of-payments statements
led to the creation of this item. It is obtained by subtracting the identical
item obtained by adding the current and capital accounts, also known as
net le nding/net borrowing, from the financial account's net balance.Since a
surplus of credits over debits in the current and capital accounts results in
a balancing net acquisition of financial assets or reduction of liabilities
that is shown in the financial a ccount, the net lending or net borrowing
derived from these accounts should, in theory, be equal to the overall
balance on the financial account, it follows that a positive value of (net)
errors and omissions signals that credit entries have been overlooke d.
1.3 DETERMINANTS OF DE MAND FOR AND SUPPLY
OF CURRENCY
The demand for money, which is determined by trade, has an impact on
these relative valuations. A country's currency will be in great demand if
its exports exceed its imports since more people will w ant to buy its
products. According to supply and demand economics, prices increase and
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7 On the other hand, if a nation imports more than it exports, there will be
less of a demand for its currency, wh ich will result in lower pricing.
Currency experiences depreciation, or value loss.
Example:
Imagine that the sole item available is candy bars, and that South Africa
imports more candy bars from the United States than it does from that
country. As a resul t, it must spend more money than was sold in rand. The
demand for dollars exceeds the demand for rands in South Africa.
As a result, the value of the rand decreases. In this case, we'll assume that
the rand may weaken to 15 against the dollar. Currently, a n American
receives 15 rand for every $1 sold. A South African must sell 15 rand in
order to purchase $1.
1.4 EXCHANGE RATE
The price of the domestic currency in relation to another currency is
known as the exchange rate. Comparing different currencies to
demonstrate their relative values is the goal of international exchange. The
rate at which one currency is exchanged for another or the price of one
currency expressed in terms of another currency are two other definitions
of exchange rate. There are two t ypes of exchange rates: fixed and
variable. The country's central bank sets the fixed exchange rate, while the
dynamics of market demand and supply set the floating rate.The majority
of exchange rates are characterised as floating and fluctuate in response to
market supply and demand. Some exchange rates are set or linked to the
value of the currency of a particular nation. Exchange rate fluctuations
have an impact on businesses by altering the cost of supplies imported
from other nations and the demand for their goods among clients abroad.
FACTORS AFFECTING EXCHANGE RATE:
Exchange rates are influenced by many things. Many of these elements
have to do with how the two nations' trading relations. Keep in mind that
exchange rates are based on a comparison of t he currencies of two
different nations. Some of the main factors affecting the exchange rate
between two countries include the ones listed below. The relative
relevance of these factors is up for question, just like it is with many other
aspects of economi cs, therefore take note that they are not listed in any
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1) DIFFERENTIALS IN INFLATION :
A nation with a historically low inflation rate typically has a growing
currency value as its purchasing power rises in relation to other currencies.
Japan, Germany, and Switzerland were among the nations with low
inflation in the second half of the 20th century; the United States and
Canada only subsequently attained this level of low inflation. The
currencies of those nations with higher inflation often depreciate relative
to those of their trading partners. Higher interest rates are typically
accompanied by this as well.
2) DIFFERENTIALS IN INTEREST RATES :
Exchange rates, inflation, and interest rates all have a close relationship.
Central banks control inflation and exchange rates through adjusting
interest rates, which has an effect on both inflation and the value of
currencies. An economy with higher interest rat es provides lenders with a
larger return compared to other nations. As a result, higher interest rates
draw in foreign investment and drive up the value of the currency.
However, the effect of higher interest rates is lessened if inflation in the
nation is significantly higher than in other nations or if other factors
contribute to the depreciation of the currency. Lower interest rates tend to
cause exchange rates to rise, which is the opposite of the link that obtains
for decreasing interest rates.

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9 3) CURRENT ACCOUNT DEFICITS :
The balance of trade between a country and its trading partners, which
includes all payments for goods, services, interest, and dividends, is
known as the current account. A negative current account balance
indicates that a nation borrows money from abroad to cover the deficit,
indicating that it spends more on international trade than it brings in. In
other words, the nation needs more foreign currency than it generates
through export sales, and it produces more of it than foreigne rs are
willing to pay for it. As local goods and services become affordable
enough for foreign customers and foreign assets become too expensive to
produce revenue for domestic interests, the country's exchange rate
declines as a result of the excessive de mand for foreign money.
4) PUBLIC DEBT :
Large -scale deficit financing will be used by nations to pay for public
projects and governmental spending. While this activity boosts the
domestic economy, international investors are less likely to invest in
count ries with huge public deficits and debts. The cause? A large debt
promotes inflation, and if inflation is strong, the loan will eventually be
serviced and repaid with real dollars that are less expensive. In the worst
case, a government may issue currency to partially pay off a big debt, but
expanding the money supply invariably results in inflation.
Additionally, a government must increase the number of securities
available for sale to foreigners in order to lower the price of those assets
if it is unable to finance its deficit through domestic methods (selling
domestic bonds, expanding the money supply). Finally, if foreign
investors think the nation might default on its debts, a high debt may
worry them. If there is a high chance of default, foreigners wi ll be less
eager to purchase securities denominated in that currency. Because of
this, the country's debt rating —as established, for instance, by Moody's or
Standard & Poor's —is a significant factor in determining its exchange
rate.
5) TERMS OF TRADE :
The terms of trade, which compare export prices to import prices, has an
impact on current accounts and the balance of payments. A country's
terms of trade have improved favourably if the price of its exports rises at
a faster rate than the price of its impor ts. Growing terms of commerce
indicate increased demand for the nation's exports. In turn, this leads to a
rise in export earnings, which raises the value of the local currency and
increases demand for it. The value of the currency will fall in comparison
to its trade partners if the price of exports increases at a slower rate than
the price of imports.

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10 6) STRONG ECONOMIC PERFORMANCE :
Foreign investors invariably look for stable nations with robust
economies to place their money in. A nation with such f avourable
characteristics will entice capital away from others thought to carry
greater political and economic risk. For instance, political unrest can
result in a decline in the value of a currency and a capital flight to
currencies in more stable nations .
1.5 CURRENT ACCOUNT DEFICIT

A country's commerce is measured by its current account deficit, which
occurs when the value of the goods and services it purchases exceeds the
value of the exports. Despite making up a relatively tiny portion of the
total cu rrent account, net income, including dividends and interest, and
transfers, such foreign aid, are included in the current account. Similar to
the capital account, the current account is a part of a country's balance of
payments and represents the country's overseas transactions (BOP).

A country that has a current account deficit is one that imports more than
it exports. Developed nations typically have deficits, whereas emerging
economies frequently have surpluses. An economy may benefit from a
current acc ount deficit if external debt is utilized to fund profitable
investments.

By raising the value of its exports in comparison to the value of its
imports, a nation can reduce its existing debt. It can impose import
limitations, such as tariffs or quotas, or it can put a focus on policies that
encourage export, including import substitution, industrialization, or
policies that increase the global competitiveness of indigenous enterprises.
The nation can also utilize monetary policy to lower export costs by
devaluing the domestic currency to increase its value in relation to other
currencies.

Although having a current account deficit does not necessarily mean a
country is spending beyond its means, it can indicate that it is. A nation
can maintain financial st ability while having a current account deficit if it
uses external debt to fund investments that offer higher returns than the
debt's interest rate. However, if a nation's existing debt levels cannot be
paid off with its projected future earnings, it risks becoming bankrupt.

Negative net sales overseas reflect a current account deficit. While
developed nations like the United States frequently have deficits,
emerging economies frequently have current account surpluses. Poor
nations frequently have current account deficits.
Real Example of Current Account Deficits:
Current account fluctuations are mostly influenced by market dynamics.
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11 instance, the UK experienced a reduction in its cu rrent deficit following
the 2016 Brexit vote outcomes.
Because it is a nation that relies on high levels of debt to finance its
excessive imports, the United Kingdom has historically had a deficit.
Commodities make up a sizable amount of the nation's expor ts, and
falling commodity prices have reduced earnings for domestic businesses.
As a result of this decline, the UK's current account deficit grows because
less income is coming back into the country.
Market dynamics mostly impact current account volatilit y. Even in
countries that purposefully run deficits, the deficit varies. For instance,
the UK's current deficit decreased as a result of the 2016 Brexit vote
results.
The United Kingdom has historically had a deficit because it is a nation
that relies on h igh levels of debt to support its excessive imports. Large
portions of the country's exports are made up of commodities, and
declining commodity prices have decreased profits for domestic
enterprises. Because less money is going back into the UK as a resul t of
this drop, the current account deficit widens.
1.6 BALANCE OF TRADE
The difference in the monetary value of a country's imports and exports
over a specific time period is referred to as the balance of trade (BOT),
sometimes known as the trade balance . A surplus in trade is shown by a
positive trade balance, whilst a deficit in trade is indicated by a negative
trade balance. The BOT is crucial in figuring out a nation's current
account.
The following equation can be used to determine the trade balance:
BALANCE OF TRADE = V ALUE OF EXPORTS – VALUE OF
IMPORTS
Where:

Value of exports is the value of goods and services that are sold to
buyers in other countries.

Value of imports is the value of goods and services that are bought
from sellers in other count ries.
Contrary to popular belief, a strong or fragile economy is not necessarily
indicated by a positive or negative trade balance. Among other factors, the
nations involved, the trade policy decisions made, the length of the
positive or negative BOT, and the magnitude of the trade deficit determine
whether a BOT is advantageous for an economy. In conclusion, the BOT
figure by itself does not give a good indication of how well an economy is
doing. Most economists concur that neither trade deficits nor surpl uses are
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12  A positive balance occurs when exports > imports and is referred to
as a trade surplus.
 A negative trade balance occurs when exports < imports and is
referred to as a trade deficit.
IMPLICATIONS OF BA LANCE OF TRADE ON EXCHANGE
RATES:
Through its impact on foreign exchange supply and demand, the trade
balance affects currency exchange rates. There is comparatively higher
supply or demand for a country's currency when its trade balance does not
net to ze ro, that is, when exports do not equal imports. This affects that
currency's value on the global market. Exchange rates are expressed as
relative values, describing the cost of one currency in terms of another.
One American dollar, for instance, can be equ ivalent to 11 South African
rand. In other terms, a South African would purchase $1 for every 11 rand
sold by an American company or individual trading dollars for rand.
1.7 SUMMARY

1. International finance is the study of monetary interactions that
transpir e between two or more countries.

2. The balance of payments can be formally defined as the statistical
record of a country’s international transactions over a certain period of
time presented in the form of double -entry bookkeeping.
3. The current account inclu des all transactions that pertain to goods,
services, and primary and secondary incomes (or income and current
transfers).

4. The capital account shows credit and debit entries for non -produced
nonfinancial assets and capital transfers between residents and
nonresidents.

5. Exchange Rate is defined as the price of the domestic currency with
respect to another currency. The purpose of foreign exchange is to
compare one currency with another for showing their relative values.

6. The current account deficit is a me asurement of a country’s trade
where the value of the goods and services it imports exceeds the value
of the products it exports.

7. The balance of trade (BOT), also known as the trade balance, refers to
the difference between the monetary value of a country ’s imports and
exports over a given time period.



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13 1.8 QUESTIONS

1. Explain the various components of Balance of Payment?
2. Explain how Demand and Supply of Currency works?
3. Define Exchange Rate? What are the factors affecting Exchange Rate?
4. Discuss the probl em of Current Account Deficit in detail with some
real-world examples.
5. What is Balance of Trade? Explain its implications on Exchange Rate?
6. Short Notes:
i. Current Account
ii. Capital Account
7. Multiple Choice Questions:
a) _________ is the study of monetary interac tions that transpire
between two or more countries. (International Finance,
International HRM, International Economics)
b) The _______ can be formally defined as the statistical record of a
country’s international transactions over a certain period of time
presented in the form of double -entry bookkeeping. (Balance of
Trade, Balance of Payment, Balance of Accounting)
c) The ________ account includes all transactions that pertain to
goods, services, and primary and secondary incomes (or income
and current tran sfers). (Current, Capital, Financial)
d) The ______ account shows credit and debit entries for non -
produced nonfinancial assets and capital transfers between
residents and nonresidents. (Current, Capital, Financial)
e) ________ is defined as the price of the d omestic currency with
respect to another currency. The purpose of foreign exchange is to
compare one currency with another for showing their relative
values. (Financial Rate, Exchange Rate, Foreign Rate)
f) The ______ is a measurement of a country’s trade whe re the value
of the goods and services it imports exceeds the value of the
products it exports. (Capital Account Deficit, Current Account
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14 g) The _____, also known as the trade balance, refers to the
difference between the m onetary value of a country’s imports and
exports over a given time period. (Balance of Payment, Balance of
Trade, Balance of Account)
1.9 REFERENCES

 International Financial Management book (Seventh Edition) by
Cheol.S.Eun and Bruce.G.Resnick
 PrakashGApte, InternationalFinance:ABusinessPerspective
 Moosa, International Finance:AnAnalyticApproach
 JeffMadura,InternationalFinancialManagement
 Siddaiah, International FinancialManagement:AnAnalyticFramework
 https://www.investopedia.com
 https://corporatefinanceinsti tute.com



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15 2
INTERNATIONAL ECONOMICS
Unit Structure :
2.0 Objectives
2.1 Introduction
2.2 Globalization
2.3 Socialism
2.4 Communism
2.5 Protected Economies
2.6 International Grants
2.7 International Monetary Fund (IMF)
2.8 Summary
2.9 Questions
2.10 Refere nces
2.0 OBJECTIVES
 To understand the Globalization and its impact.
 To understand how Socialism and Communism works.
 To understand Protected Economies and its implications.
 To understand different International Grants.
 To understand the Structure and Role of IMF.
2.1 INTRODUCTION
The economic activity of numerous countries and their effects are the
subject of international economics. In other words, the study of
international economics focuses on the economic relationships between
nations and how these have an impact on global economic activity. It
examines political and economic concerns pertaining to commerce and
finance on a global scale.
International influences that affect domestic economic circumstances and
determine international trade relations are t he subject of the study of
international economics. In other words, it investigates the impact of
economic interdependence on national economies. International
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16 benefits, trade patterns , balance of payments, and foreign direct
investment. International economics also discusses production, commerce,
and investment between nations.
One of the most crucial ideas for nations today is international economics.
The study of international econom ics has significantly advanced
throughout time thanks to several theoretical, empirical, and descriptive
contributions. Economic activity between nations generally differs from
activity within states. Due to numerous constraints put in place by
governments , for instance, the factors of production are less mobile
between nations. The study of internal economics covers the effects of
various governmental limitations on production, commerce, consumption,
and income distribution. As a result, studying internati onal economics, a
branch of economics, is crucial.
2.2 GLOBALISATION
In recent decades, the term "globalisation" rose to prominence as a
catchphrase for characterising commercial operations, and it seems likely
that it will remain so throughout the current century. The integration of a
country's economy with the global economy is referred to as globalisation.
It has a variety of facets. It is the end result of a variety of tactics aimed at
changing the world in order to make it more interdependent and
integ rated. It entails the development of networks and initiatives that break
through social, economic, and geographic barriers. Globalization aims to
create connections between events such that those happening far away can
influence those happening in India. O r to put it another way,globalisation
is the method of interaction and union among people, corporations, and
governments universally.
Characteristics of Globalisation:
The idea has made it possible for businesses to achieve economies of scale
in both produ ction and distribution. Additionally, it has promoted
outsourcing and technology transfer between businesses and nations,
increasing their dependent on one another. Following is a list of the main
traits of globalisation:
1. Free Trade - With little interfere nce, globalisation has improved
international commerce volumes. The rationale is that governments do
not tinker with every last detail of commercial transactions. Countries
that have embraced globalisation have seen large increases in their
Gross Domestic Product (GDP), which has led to greater wealth.
Additionally, it has led to improved government cooperation, which
enhances commerce even more.
2. Liberalization - The improvement in the business environment for
firms is one of the fundamental aspects of glob alisation. It has aided
business owners in establishing operations and conducting transactions
both domestically and abroad. Due to globalisation, there are far less
restrictions on businesses, allowing for increased international trade.
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17 result of trade restrictions that are flexible. Globalization and
liberalisation are mutually reliant.
3. Increase in Employment - Both direct and indirect jobs are produced
by all industries. Additionally, whe n output rises, employment grows
as well. Companies can expand their manufacturing capacity and
establish businesses in many countries thanks to globalisation.
Additionally, it promotes employment prospects in the nations where
these businesses have establ ished operations.
4. Increased connectivity between nations - Countries trading
relationships with one another have improved thanks to globalisation.
It has boosted communication between customers and companies. A
country's economy and residents' level of liv ing are both boosted by
improved connection.
5. Interdependence - Countries are now more dependent on one another
as a result of globalisation. Businesses have the chance to make their
goods using cheaper raw materials that are imported. Additionally,
they ar e permitted to export to nations where there is a greater market
for their finished products. It has aided in lowering trade barriers and
fostering general economic development.
6. Cultural Exchange - People -to-people interactions have improved,
which has pro moted the blending of cultural practises and customs.
With other nations, it has made it possible for people to exchange
ideas, attitudes, and values. The effects of globalisation have reduced
community isolation. For instance, some American restaurants ha ve
spread to other regions of the globe. Similar to how foreign cuisine is
now easily accessible in the United States.
7. Urbanisation - The expansion of urban centres is one effect of
globalisation. A place becomes a hub of economic activity when
numerous fo reign and local businesses establish operations there. The
employees of those businesses require housing, transportation, retail
space, and other facilities close to their places of employment. Urban
centres are constructed within and around industrial are as as a result of
globalisation.
8. Standard of Living -The economy is growing, and there are more job
prospects, so individuals have more money in their pockets. Due to
better career chances, they also have a wider range of options. It is one
of the primary causes of globalization's ability to raise the standard of
living for an increasing number of people.
9. Production Cost -Companies are free to locate their operations in
places with cheap manufacturing costs in a globalised world. It has
become crucial to ha ve access to cheap land, labour, and raw
resources. Therefore, it makes sense for businesses to locate where
these resources are available in large quantities and at lower prices. It
gives them an advantage over their competitors by reducing expenses
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18 10. Outsourcing - The ability for businesses to hire outside contractors to
handle particular tasks is one of the hallmarks of globalisation. They
use this action to lower internal costs, boost service quality, or both.
For many nations with abundant human resources who want to create
jobs, outsourcing is a blessing. As a result of this strategy, nations like
India and the Philippines have benefited greatly.
Types of Globalization:
 Political Globalization - The degree of political globali sation in this
sort of globalisation is influenced by the number of participating
nations. The global economy is not fully politically globalised if
political interactions between nations are not convenient or
advantageous.
 Social Globalization - Social gl obalisation is a result of information
and idea exchange across nations. Regardless of physical distance or
geopolitical or geophysical differences, societies can form interactions
with one another.
 Economic Globalization - Economic globalisation rises whe n
economies are linked through trade and business. There are currently
relatively few countries with independent economies that don't rely on
external factors. Therefore, compared to other forms of globalisation,
economic globalisation is typically more pr evalent.
Effects of Globalization on India:
One of the nations that had tremendous success following the start and
execution of globalisation is India. The country is seeing a huge increase
in foreign investment in the corporate, retail, and scientific sec tors.
Additionally, it had a significant impact on social, financial, cultural, and
political spheres. Due to advancements in information technology and
transportation, there has been a surge in globalisation recently. Global
trade, doctrines, and culture are all growing as global synergies get better.
Globalisation in the Indian Economy:
Indian society is undergoing significant change as a result of urbanisation
and globalisation. The fundamental structure of the economy has been
directly shaped by economi c policy. Government -created and -managed
economic policies were crucial in determining the levels of societal
savings, employment, income, and investments. One of the most
significant effects of globalisation on Indian society is cross -country
culture. Cu ltural, social, political, and economic components of the nation
have all undergone major transformation as a result. The primary
component, however, that transforms a nation's economy into a global
economy is economic unification.

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19 Impact of Globalisatio n:
Globalization has had a significant impact on all aspects of life, including
individuals, groups, and institutions. Everyone, both locally and globally,
has experienced the effects of globalisation in both their personal lives and
in society. There are many ways that one can experience the effects of
globalisation in their daily lives.
Globalization has a constant impact on people, affecting their choices in
everything from their cars to the clothes they wear to the music they listen
to. Numerous global factors have such minor effects on people's everyday
lives that they are difficult to render. It influences what they want to buy
and consume, and it has an impact on their general standard of living.
Additionally, whether you're talking about intercity, i nterstate, or even
worldwide travel, it influences their decisions about where to travel and
how to travel. Everything in all of our lives is now significantly simpler
than it was even a few years ago thanks to globalisation.
Communities are a different ca tegory on which the effects of globalisation
are felt. Local, regional, and global communities are all significantly
impacted by globalisation. It also covers how organisations, companies,
and economies are affected by globalisation. Today's marketplace of fers
an enormous, at times astounding range of goods. Globalization is
essential for boosting the economy since it generates a huge marketplace
for both buyers and sellers. People who are a part of the community are
impacted by globalisation in every way, including where they live, who
they work for, and how they travel. It alters how regional cultures evolve
all over the world.
We must keep in mind that globalisation affects more than just the
movement of products and services that are available to custome rs and are
circulating in the economy. There is such a thing as intellectual
globalisation, where progressive principles that are sometimes labelled as
"Western" values are also exchanged. In fact, this goes both ways; as the
world develops, traditional, c onservative ideals are gradually supplanted
by more modern ones. On the other side, a number of Western
civilizations are also growing closer to those of the East, particularly in
regards to sustainability and traditional sustainable Eastern practices.
Importance of Globalization:
One of the enduring themes that is continually undergoing change and
evolution is globalisation. Like anything else, globalisation has both
advantages and disadvantages. These two forces are powerless to halt the
globalisation tha t is sweeping the globe.
It is altering how societies, corporations, and individuals communicate
with one another. People from different nations come together as a result
of globalisation to trade, exchange cultures, and rely on one another for
survival.
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20 Globalization and related topics have gained attention recently,
particularly since 1991 in India, as the globe is becoming more and more
dependent on international collaboration. The globe is currently
experiencing a number of approaching crises, ranging from political to
environmental to diplomatic, and resolving them will need a level of
international cooperation that can only be attained through global
interconnection, or globalisation.
We must consider globalisation in light of the fact that worldly
togetherness is increasingly the norm as well as the fact that our wants and
needs are spreading globally, particularly due to the fear of missing out.
Indians frequently go to other parts of the world in search of better jobs
and lives; this is one of the d raws of globalisation. It is crucial because it
gives us hope by illuminating the potential rather than forcing us to accept
the limitations of the present.
Advantages of Globalisation:
Globalization is a process with many benefits. It is a procedure that greatly
aids in the growth and development of a country. Here are a few
advantages of globalisation:
1. Employment - The number of employment available has expanded as
a result of the creation of special economic zones. The establishment
of export processing facilities around the world has contributed to the
employment of thousands of people. By outsourcing workers, the
multinational corporations in the west have given individuals
opportunities for employment.
2. Compensation - In comparison to domestic enterpris es, there has been
an increase in the level and amount of payment. The fundamental
cause of this is because domestic enterprises, often known as home
companies, are less skilled and knowledgeable than global
corporations. The management structure of the co mpanies is changing
as a result of increased compensation.
3. Standard of Living - The standard of living of people has changed as
a result of globalisation. People's levels of life have increased due to
differences in consumer behaviour. As a result, corpora te growth and
evolution have improved people's quality of life.
4. Increased Investment - Cross -border investments have increased as a
result of globalisation. Companies have invested and established
branches in numerous nations throughout the world as a resu lt. The
welfare of both countries has improved as a result of the growth in
cross -border investment.
5. Development of Infrastructure - The infrastructure of nations has
been improved by technological innovation. The nations are gaining
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21 6. Foreign Exchange Reserves - The worldwide financial flows have a
steady flow of capital thanks to globalisation. This capital inflow
assists nations in increasing their foreign exchange reserves.
Disadvantages of Globalisation:
It is un true that globalisation will continue to benefit us. It has many
different effects on us. Therefore, it also has some drawbacks. Which are:
1. Increasing Inequality - Due to increased specialisation and trade,
globalisation may result in greater inequality ar ound the world. Trade
and specialisation increase per capita income, but they can also lead to
relative poverty. We shall use an example to show this. The United
States is home to every dominating MNC in the globe. All of these
businesses procure labour at lower costs from emerging or
underdeveloped nations to assemble or manufacture their products.
Africa, China, and India are excellent examples of this. These nations
have higher employment rates, although they lag behind more
industrialised nations. Once more, businesses that travel to these
nations in search of cheap labour also deprive the residents of those
nations, i.e. Americans, of employment. Therefore, it would seem that
relative poverty is also developing in industrialised nations.

2. Increasing Une mployment Rate - Globalization may result in higher
unemployment. Globalization calls for more affordable, higher -skilled
jobs. However, nations with relatively weak institutions are unable to
produce highly competent employees. As a result, the nations'
unemployment rates are rising. When numerous international
businesses make significant investments in emerging nations, they hire
workers from those nations. Sometimes, their salaries are significantly
lower than those of other wealthy nations. Additionally , there is very
little demand for these workers in wealthy nations. Additionally, they
face the possibility of losing their jobs as a result of the global
economic crisis.

3. Trade Imbalance - The value ratio between a nation's exports and
imports of goods a nd services is known as the trade balance. Any
country can now trade with any other nation due to globalisation.
Because of this, emerging nations are occasionally more reliant on rich
nations for the import of commodities despite having lower export
capac ities than import. There has been a trade imbalance. The value
disparity between a country's imports and exports of goods and
services is what is meant by a trade imbalance. Trade imbalances are
another name for it. Competitors of wealthy countries may cau se trade
imbalances to worsen.

4. Environmental Degradation - As a result of globalisation,
industrialization is accelerating. Economic growth is accelerated by
industrialization, but the environment is also harmed. Globalization
destroys the environment and hurts us terribly. Let's use an example to
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22 Coca -Cola. This corporation uses a significant amount of water to
produce soft drinks. A Coca -Cola bottle factory in Uttar Pradesh, a
state i n northern India, was shut down by government order due to
excessive water use, according to local farmers. Although groundwater
is scarce in North India, extensive use of it for an MNC's purposes is
detrimental to local agriculture.

5. Loss of Culture - The previous culture and tradition of the people
have vanished because everything today is beautifully constructed and
technologically advanced. Most individuals prefer to live in the
modern world over living in the ways of the past.

6. Health Problems - There are numerous diseases that emerged
throughout the era of globalisation. The majority of health problems
are severe.

7. Economic Exploitation - Developed countries take advantage of less
developed nations as a result of globalisation. Developed nations may
make superior products by utilising current technology. Because of
this, developing nations cannot compete with developed nations. In
addition, developing nations are increasingly turning to developing
nations as their markets. Furthermore, in the guise of g lobalisation, the
wealthy nations are engaging in robbery and exploitation.
2.3 SOCIALISM
In a socialist society, each member of the community receives an equal
portion of the numerous resources that are produced, distributed, and
traded. A democratic type of government can offer this kind of ownership.
Another example of socialism is a cooperative society in which each
individual owns a portion of the resources shared by the group.

Socialism is an economic system in which the general public, as opposed
to the private sector, owns the resources. Socialism emphasises that
centralised planning and shared public ownership of resources result in a
more equitable distribution of commodities and services and a more just
society.

Socialism is based on the idea th at all production -related equipment, tools,
factories, and resources should be owned by the general population. In a
strictly socialist society, the central government makes all decisions on
investments and production.

Socialism envisions a shared ownersh ip and management among the entire
population, in contrast to the notion of capitalism, in which private
businesses/individuals own and control the production (assets &
operations) and pay salaries to the people who work for them.

Socialism is the idea th at all activities inside a nation should be under the
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23 is one in which the government controls all aspects of the economy, and
the financial structure that supports it is referred to as a socialist financial
system. The socialist economy is defined in a variety of ways by
academics. However, the idea of socialism refers to giving someone the
power to oversee and manage all economic activity in order to guarantee
national equality. Thi s concept was first presented by Karl Marx in his
"communist manifesto."
Features of Socialist Economy:
1. Ownership Should be Collective - The basic characteristic of
socialism explains why the government, and not any individual, is the
owner of all products of industry.
2. Equality - The goal of socialism is to bring about economic equality.
With the help of socialist ideals, class, caste, and skin colour will all be
eradicated.
3. Planning - Given its authority, the government sets objectives and
creates the requ ired plans to carry them out. It promotes economic
expansion.
4. Competition - Competition has no place in a socialist society
compared to one that is capitalist. It appears that a single business's
success might be shared by the entire nation.
5. Positive Power - The government should be used favourably because
it is essential to all operations including decision -making, financial
matters, policies, and production. There should be no abuse by the
government.
6. Work and Wages - To establish and uphold transparency in
socialism, the government should assign tasks based on each person's
aptitude and pay them in accordance with their requirements.
7. Social Welfare - To promote social wellbeing is socialism's central
goal. It alludes to how society has developed, especial ly for the poor.
There shouldn't be a distinction between classes.
8. Absence of Marketers - There would be no room for marketing or
advertising sales if the government played nothing but the same tune.
The occupancy will be higher if there are fewer options available.
9. Income Distribution - The gap between the rich and the poor will
disappear if all residents have fair income distribution. Hospitals,
schools, and other services are accessible to all citizens on an equal
basis.
Examples of Socialist Economy:
The nations that can comprehend a socialist economy and incorporate it
into their systems are held up as socialist economy role models. Many
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24 practise capitalism, socialist regimes are rigidly adhered to in nations like
Norway, Sweden, Denmark, Iceland, and Finland. These nations are
wholly socialist.
Examples of socialist economies can be found in these five Nordic
nations. According to their labour and contribution, they divide the mon ey
equally. They believe that in order to make the most use of savings, health
and education are more important topics. The best feature is that common
people participate in making decisions.
Types of Socialism:
There are various varieties of socialism. Ea ch type concentrates on
different facets of socialism.
 Democratic Socialism : In this system, an elected committee can
control the created items. They will organise the distribution of
government -provided consumer products.
 Revolutionary Socialism : Althou gh it need not be violent, the
revolution should be against capitalism.
 Libertarian Socialism : People should be free of race, ethnicity, and
religion, and they should also have equal access to economic, social,
and political opportunities.
 Fabian Socialis m : In the 19th century, the British government
employed this entirely nonviolent strategy. Through peace, they
acclimatise to socialism.
 Utopian Socialism : Equality is its central tenet. High scale
industrialization will be prioritised.
 Christian Sociali sm : Socialism promotes the same kind of
brotherhood that is implied in Christian teachings.
 Green Socialism : Another form of socialism is known as "green
socialism," which places a strong emphasis on enhancing natural
resources. so that there will never be a food shortage and that there
will always be peace in the nation.
 Market Socialism : In this kind of socialism, the workers take control
of production, allowing them to sell goods at fair rates and divide
profits equally with no room for feigning deman d.
Advantages of Socialism:
1. Economic Equality -
Socialism creates a society that is more economically equal. There are
lesser secret taxes applied than in a capitalist system. Additionally, the
public's income distribution is essentially equal, which lesse ns the
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25 2. Raised Public Wellbeing Standards -
The socialist countries typically feature a wide range of programmes to
enhance public welfare, including free healthcare, affordable private
Medicare, and less expensive transportation. The genera l population will
significantly benefit from this.
3. No exploitation of workers -
In a socialist society, the general populace owns the resources, which are
managed by a central government. Therefore, firms do not aim to
maximise profits. The general popu lace will all receive a just reward for
the effort they have completed.
4. Improved Labour Productivity -
Socialism was centred on getting the work from the workers by paying
them fairly, as well as by giving them good tools, access to healthcare, and
other advantages. This will boost employee motivation, which boosts
productivity.
5. A Free Market That Is Well -Regulated -
The socialist system incorporates a free market that is well -regulated by
the government. Instead of just focused on maximising profits, it enables
enterprises to operate in the general public's best interests. By doing this,
many possible unfavourable scenarios where enterprises might negatively
impact the general public in many ways will be avoided.
6. Lower Level of Poverty in the Socie ty -
In contrast to capitalism, the socialist system redistributes the entire social
budget. The welfare system is fully integrated within the communist
framework. Everyone will receive enough money to cover their
fundamental requirements. The certainty th at everyone will have access to
necessities lowers the incidence of poverty in society.
Disadvantages of Socialism:
1. Less drive for business operations -
Individuals are not given the chance to own property under socialism. As a
result, there won't be much drive behind business operations. Since there
won't be much of a difference in their earnings, there will be very little
incentive for everyone, from management to entry -level employees, to
carry out corporate operations successfully.
2. There are more union s in businesses -
Socialism encourages the formation of unions in the workplace. The
employees should feel some pressure and dedication to manage the
company successfully. The operations of the firm could be disrupted by
unions, resulting in a conflict bet ween management and the employees.
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26 3. A lack of creativity -
Since socialist enterprises are not profit -driven, they do not encourage
entrepreneurship. Thus, there is very little private investment in the
country. Innovation won't attract much funding or interest.
4. A decrease in the labour force -
A strong welfare state is a characteristic of socialist societies. The
drawback of this is that because of the welfare advantages they receive,
people won 't be inspired to give back to society. Due to people choosing
to remain at home rather than seek a job, the labour force may be
diminished as a result of this cause.
5. Increased Public Spending -
Socialism encourages the use of public funds to enhance socia l welfare.
More government spending as a result will have an impact on the
country's reserves. The government might not have enough reserves in the
event of a calamity or pandemic to adequately handle such a trying time.
Additionally, this will have an imp act on how local and international
commerce and spending are balanced.
6. Additional Regulated Sectors -
Regulations and government involvement are more prevalent in the
industries. This will be a drawback because judgements on how to balance
government laws with running a profitable firm may be contentious.
Greater government involvement could backfire on the sector as a whole.
2.4 COMMUNISM
Communism emphasises that the general populace, not specific people,
owns all money and assets. Communal business con trol and public
property ownership (such as transportation, power, energy, mines, mills,
and industrial facilities), including ownership of natural resources, are the
core tenets of this ideology, which seeks to replace profit -based
corporations and privat e property ownership.
Communism is an ideology that holds that the common people should
control the means of production in a society through state or government
administration. Its main concern is a society where everyone in the general
public enjoys econo mic equality. There will be divisions between the
working class and wealthy societies under communism. This idea
contends that public ownership of the production control, as opposed to
private ownership, is the best way to accomplish this. Karl Marx's view s
serve as the foundation for the concept of communism. The socialism -
related ideology is also present in communism.
Characteristics of Communism:
1. No Private Properties - In a communist society, private property does
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27 owns all the properties. Depending on what they require, each person
receives a portion.
2. Effective state and federal institutions - Since these organisations
should be in charge of all facets of economic output, communism
migh t be seen as having a powerful central government and state
administration. Additionally, the public should receive an equal
distribution of the output/services (food, transportation, energy,
housing, medical care, and education) to meet their basic needs.
3. Society Has No Classes - There are no distinctions between the rich
and the poor in communism. In contrast to capitalism, where there is
an owner class and a labour class, communism does not have multiple
classes.
4. The Bloody Revolution - In order to estab lish a communist state, the
working class rises up against society's upper class in a bloody
revolution.
5. Resources Under Common Public Ownership - According to the
communist ideology, the community as a whole share in the
advantages of all resources that a re publicly owned and managed by
the state.
6. Opposed to Democracy - Democracy is predicated on the notion that
for there to be a market based on commerce, private enterprises must
enter it. Contrarily, communist ideology rejects privatisation.
Types of Comm unism:
1. Marxism -Leninism -
The concept of Marxism -Leninism centres on how class society developed
and the causes of the conflicts between these classes. The conflict between
various economic classes is what defines society the most. Marxism -
Leninism holds t hat capitalism creates inequality and class segregation in
society, and that it will inevitably give way to socialism and finally
communism.
2. Anarcho -communism -
Anarcho -communism is a speculative philosophical viewpoint that
emphasises the complete aboliti on of the State, its institutions, and the
laws. This philosophy is predicated on the idea that the general populace
may live absolutely free of the constraints imposed by the State.
3. Austro -Marxism -
This ideology is a subset of communism that emphasises g roup
production. This worldview is opposed to undesirable power and hierarchy
rather than just the state or government. Between moderate democracy and
Marxism -Leninism, this ideology occupies a midway position.
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28 4. Marxism(Scientific Communism) -
Marxism, com monly referred to as Scientific Communism, emphasises the
conflicts that exist between the working class and capitalists. This is an
ideology or philosophy that Karl Marx and Friedrich Engels created.
Marxism is a way of looking at the world and an analyti cal ideology. It
examines how capitalism affects employment, production, and economic
growth as well as how the exploitation of workers by capitalists can lead
to conflict between these classes.
5. Council Communism -
Workers will ultimately battle against ca pitalism to overthrow it and
construct an administrative communist society, which will be the workers'
councils, according to the council communism model, which is founded
on working -class struggle. Directly democratic councils are established by
the worke rs as the fundamental components of the revolution in both
workplaces and communities. In accordance with this theory, the worker's
council is an association of the working class that governs itself as
opposed to being governed by a single body.
6. Eurocommun ism -
This theory, which gained traction in the early 19th century, placed more
emphasis on persuading people to embrace socialism than on committing
damaging or coercive revolutionary deeds. This concept gives the example
of running a communist society on a different piece of land. The high level
of living in this society will persuade others to join.
Examples of Communism:
Several nations previously practised communism. But at the moment,
North Korea, China, Vietnam, Cuba, Laos, and these are the nations that
adhere to the communist worldview. However, these nations do not adhere
to the communist theory in its entirety; however, some aspects of it are
still practised.
Advantages of Communism:
1. Monopolies in Business Are Prohibited -
In countries with a comm unist organisational system, the government runs
everything. The government chooses which enterprises should be
launched and how much money should be invested. This will outlaw
unfavourable market circumstances like monopolies. There won't be a
single or s mall number of enterprises who control the market and raise
prices as they choose, harming the general populace.
2. The country's economy is Centrally Coordinated -
Through a central government administration, the whole economy is
planned in communist countri es. This means that the development of
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29 planned by this administration to meet a long -term objective. The
government can consider all the factors and develop a long -term
sustainab le strategy for the whole economy of the country because
everything is planned centrally.
3. Less Disparities and Levels in Society -
The common public controls the means of production in a communist
framework through state or government administration. As a result, there
is no or less private ownership of the firms, and all members of the general
public are less different from one another. No such social employment
categories as "white collar" or "blue collar" exist.
4. All Participants Begin at the Same Levels -
Some people will start out rich and some people will start out poor in a
democratic or capitalist society. This makes those people's lives easier or
harder because it's a gift from their family. The disparities between the
lower wealthy groups' income, m oney, and property would make life for
them very difficult. However, communism is built on the idea that
everyone should have the same opportunity to live a happy life for
themselves and that there should be no such thing as differences.
5. Good Public Welfar e -
The governments of communist countries take a variety of measures to
enhance public welfare. For transportation, healthcare, and education, they
provide free or inexpensive services. Even the most impoverished
individuals canhave a life with quality we ll-being due to these.
Disadvantages of Communism:
1. People have less financial freedom -
Communist regimes do not permit private ownership of firms, in contrast
to capitalist or democratic societies. While the general populace will all
have roughly the s ame degree of wealth, there will be no financial
freedom for them. A skilled person cannot establish a new firm or
innovate in order to increase their income.
2. Ignore the Customer's Needs -
The real demands of the consumer might not be taken into conside ration in
a communist state. The notion of needing only the bare necessities for
survival might exist, which might prevent the items from truly meeting the
wants of the final customer.
3. Not Enough Innovation -
Communism does not support private enterpris e. Therefore, there is little
private investment in the country. Any invention or study in the world
needs to start with a certain amount of money, and the end product needs
to be profitable enough to cover the initial investment. But in communist
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30 4. Might Lead to Dictatorship -
In a communist society, the state or government controls all of the output.
In a dictatorship, the state or government might not act in the interests of
the general populace .
5. Government spending too much -
Communism encourages increased government spending on social
welfare. The government won't be able to adequately manage this
challenging moment if it increases spending without retaining reserves and
if a calamity or pan demic strikes.
6. Lower Motivation for Business Operations - Lower Efficiency -
Businesses cannot be privately owned under communism. There won't be
much drive for corporate operations. Since there won't be much of a
difference in the rewards they receive, there won't be as much incentive
for higher -level workers to conduct business operations successfully.
2.5 PROTECTED ECONOMIES
Government policies that limit international commerce in order to support
home sectors are referred to as protectionism or prote cted economies.
However, they can also be introduced due to safety or quality concerns.
Protectionist policies are typically implemented to increase economic
activity within a home economy. The act of adopting protective trade
policies is known as protecti onism. By enacting tariffs or other trade
restrictions, a protectionist trade policy enables a nation's government to
support domestic producers and so increase domestic production of
products and services. Through tariffs, quotas, subsidies, standards, et c.,
economies can be safeguarded.
2.6 INTERNATIONAL GRANTS
The World Bank, the IMF, the WHO, and other international organisations
offer a variety of international grants. Every foreign grant is unique in
terms of the contract, scope, recipient countries, etc.
2.7 INTERNATIONAL MONETARY FUND (IMF)
The 190 nations that make up the International Monetary Fund (IMF)
strive for sustainable growth and prosperity. In order to boost productivity,
job creation, and economic well -being, it accomplishes this by suppo rting
economic policies that encourage monetary cooperation and financial
stability. The member nations of the IMF are in charge of it and are
responsible to them. The IMF has three crucial responsibilities: advancing
global monetary cooperation, promoting trade and economic growth, and
discouraging unfavourable policies. IMF member nations collaborate with
one another and with other international organisations to carry out these
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31 A structured international monetary system was to be developed at th e
United Nations Monetary and Financial Conference, which was convened
in July 1944 in Bretton Woods, New Hampshire. This conference led to
the creation of the International Monetary Fund (IMF). According to its
charter, the IMF's main goals are to:
(1) encou rage international monetary cooperation among nations,
(2) encourage exchange rate stability,
(3) Encourage the free movement of capital funds between nations;
(4) encourage free commerce; and
(5) offer interim cash to member countries trying to remedy international
payment imbalances.
These goals make it obvious that the IMF wants to promote more business
globalisation.
A Board of Governors from each of the 185 member nations oversees the
IMF and is made up of financial officials (such as the president of the
central b ank). Additionally, it includes an executive board made up of 24
executive directors that represent the participating nations. This board,
which has its headquarters in Washington, D.C., meets at least three times
a week to go over current problems. The IM F's compensatory finance
facility (CFF), which aims to lessen the effects of export uncertainty on
national economies, is one of its main responsibilities. Despite being
accessible to all IMF members, this tool is primarily used by developing
nations. A na tion experiencing financial difficulties as a result of
decreased export revenues must prove that the decrease is temporary and
beyond its control.
It must also be eager to cooperate with the IMF in order to find a solution.
Each IMF member nation is given a quota based on a number of variables
that represent that nation's economic situation. Members must pay this
designated quota. Depending on its specific quota, each member has a
different maximum amount that can be borrowed from the IMF. Special
drawing rights (SDRs), which are used as a unit of account and distributed
to members of the IMF to bolster their foreign exchange reserves, are used
to measure the financing provided by the IMF. The value of the SDR
varies in line with that of the major currencie s.
The IMF actively participated in efforts to lessen the negative
consequences of the Asian crisis. It gave money to several Asian nations
in 1997 and 1998 in exchange for their commitments to take particular
measures aimed at boosting the economies of th ose nations.


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32 Funding Dilemma of the IMF :
Usually, in order to obtain IMF funding, a country must adhere to the
IMF's set of economic reforms. The IMF makes an effort to guarantee that
the nation makes proper use of the money in this way. However, some
nations seek money without implementing the IMF's suggested economic
reforms. As an illustration, the IMF might demand that a government cut
its budget deficit before providing assistance. Some governments have not
carried out the IMF -required reforms.
IMF Funding during the Credit Crisis:
The IMF spent $100 billion in 2008 to support developing nations that
were severely impacted by the economic crisis with short -term loans for
temporary liquidity. These resources made up half of the IMF's overall
assets. For Hungary and Ukraine, the IMF coordinated credit packages of
$25 billion and $16 billion, respectively. In addition, it gave money to
various other nations in Eastern Europe, as well as to South Korea,
Mexico, and Brazil. Eastern European governments h ad taken out loans
from European banks, and had they defaulted on those debts, greater
issues might have arisen for the lending banks.
2.8 SUMMARY
 International Economics: International economics refers to a study of
international forces that influence the domestic conditions of an
economy and shape the economic relationship between countries.

 Globalisation: The term globalisation refers to the integration of the
economy of the nation with the world economy.

 Socialism: Socialismrefers to the concept of gi ving ownership to the
government as a whole, regarding all activities of that particular
country.

 Communism: Communism is an ideology that believes the means of
production in a society should belong to the common public via
state/government administration .
2.9 QUESTIONS
1) Explain International Economics.
2) What is Globalisation? Explain its Features.
3) What is Globalisation? Explain its Advantages and Disadvantages.
4) Short Note on Types of Globalisation.
5) What is Socialism? Explain its Features and Examples.
6) What is Communalism? Explain various types of Communalism.
7) Write a short note on IMF. munotes.in

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33 8) Fill in the Blanks:
a) ________ refers to a study of international forces that influence the
domestic conditions of an economy and shape the economic
relationship between countr ies.
b) The term _________ refers to the integration of the economy of
the nation with the world economy.
c) ________ refers to the concept of giving ownership to the
government as a whole, regarding all activities of that particular
country.
d) ________ is an ide ology that believes the means of production in a
society should belong to the common public via state/government
administration.
2.10 REFERENCES
 International Financial Management book (Seventh Edition) by
Cheol.S.Eun and Bruce.G.Resnick
 PrakashGApte,Inter nationalFinance:ABusinessPerspective
 Moosa, International Finance:AnAnalyticApproach
 JeffMadura,InternationalFinancialManagement
 Siddaiah, International FinancialManagement:AnAnalyticFramework
 www.economicsdiscussion.net
 www.vedantu.com
 www.schoolofpolitic alscience.com
 www.corporatefinanceinstitute.com
 www.learnbusinessconcepts.com


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34 3
INTERNATIONAL MONETARY
SYSTEM INPUTS
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Barter System
3.3 Bimetallismand
3.4 Classical Gold Standard
3.5 Bretton Wood System
3.6 SDRs and Smiths onian agreements
3.7 Fixed and Float ing Rate System
3.8 European Monetary System
3.9 Summary
3.10 Questions
3.11 References
3.0 OBJECTIVES
 To understand the International Monetary System.
 To understand the Classical Gold Standard.
 To know about the Bretton Wood System.
 To understand the mechanism of SDRs.
 To understand the distinguish between Fixed and Floating Rate
System.
 To know about European Monetary System.
3.1 INTRODUCTION
The broad financial environment in which multinational firms and foreign
investors operate is defined by the i nternational monetary system. Since
the fixed exchange rate system was abandoned in 1973, the exchange rates
between important currencies, including the US dollar, British pound,
Swiss franc, and Japanese yen, have fluctuated. As a result, businesses munotes.in

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35 today operate in a market where fluctuations in exchange rates may
negatively impact their ability to compete. Due to this circumstance, many
businesses must carefully assess and manage their exposure to exchange
risk.
Similar issues with fluctuating exchange r ates affecting portfolio
performance are faced by foreign investors. However, as we shall cover
shortly, a lot of European nations have chosen a single currency known as
the euro, making intra -European commerce and investment significantly
less vulnerable to exchange risk. Due to the complexity of the
international monetary arrangements, managers must have a thorough
understanding of the structure and operation of the system in order to
make astute financial decisions.
The institutional setting for making i nternational payments,
accommodating capital transfers, and setting currency exchange rates is
known as the international monetary system. Regarding exchange rates,
foreign payments, and the movement of capital, a complex web of
agreements, laws, organizat ions, methods, and policies exists. The
fundamental business and political conditions that underlie the global
economy have changed over time, and they will continue to do so in the
future. As a result, the international monetary system has developed and
will continue to do so.
We shall examine the past of the global monetary system and consider its
possibilities for the future in this chapter. Additionally, we will contrast
fixed versus flexible exchange rate systems in order to better understand
alternate exchange rate systems. Understanding the dynamic nature of
global monetary ecosystems is crucial for savvy financial management.
The development of the global monetary system can be divided into
numerous main phases. The following is a summary of these ph ases:
1. Bimetallism: Before 1875.
2. Classical gold standard: 1875 –1914.
3. Interwar period: 1915 –1944.
4. Bretton Woods System: 1945 –1972
5. The Flexible Exchange Rate Regime: 1973 –Present
3.2 BARTER SYSTEM
Before the invention of the monetary system, the barter system, a form of
commerce, predominated in the world for centuries. In this arrangement,
exchanges of commodities and services take place. This indicates that the
parties directly exchange their goods on the basis of comparable
assessments of price and goods without the need of any financial
intermediaries.
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36 Examples of Barter System:
1. Mangoes are exchanged for Oranges.
2. Tea is exchanged for Salt.
3. Shoes are exchanged for clothes.
Features of Barter System:
 Mutual Benefit : In the past, before mon ey was created, when
civilization was less advanced. The barter system served as a
traditional means of obtaining what people need by providing them
with another good or service that meets their needs. The barter system
helps all parties involved in this w ay.
 Reciprocal : In a barter system, the exchange is reciprocal, meaning it
is negotiated so that the participant receives the good they need in lieu
of the good they are giving up in exchange.
 Lack of Money : In this kind of trading, there is no money exc hanged.
When there was no cash in the economy and no other form of payment
was available, the barter system was used.
 Informal Presence : At the moment, the barter system only functions
as an unofficial transaction method.
 Bilateral or Multilateral Trade : Trade may occur between two
parties or among several parties who are each competent to provide the
other with a good or service.
Limitations of Barter System:
Though barter exchange is simple and immediate, it has certain limitations
also, which are discu ssed hereunder:
1. Mutual Coincidence of Wants : This is among the most frequent
issues people in barter exchange encounter. Mutual coincidence,
sometimes known as double coincidence, refers to the idea that if one
party wants to trade a certain good with ano ther, the latter party need
not also be open to trading the good that the first party is seeking.
Therefore, two people's desires must be compatible. For instance: Let's
say Mr. Y wants a pair of shoes and is willing to pay for them with 5
kg of wheat. In that situation, he needs to find someone who needs 5
kg of wheat and is willing to exchange it for a pair of shoes.
2. Lack of a Common Measure of Value : Another significant problem
in barter trading is the absence of a Common Measure of Value.
People theref ore find it challenging to assess the genuine and accurate
value of the commodity in the absence of any universal unit of
measurement. The commodity is therefore only measured in terms of
the commodity.As an illustration, a fruit vendor and a carpenter wou ld
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37 the ratio of the two items that are to be exchanged should be, i.e. how
many dozens of fruits must be swapped for one chair. In essence, they
are individual transactions, and as the re is no standard unit of
measurement, the exchange can only be done arbitrarily.
3. Divisibility of Goods : Certain goods cannot be divided into minor
components without losing some of their actual value. The major time
this issue occurs is when livestock is the traded good. Different
commodities have different values. For instance, a person who wants
to trade his horse for 5 kg of rice. Assume that 100 kg of rice is
equivalent to 1 horse. He would be unable to separate the horse into
parts to obtain the rice in this situation. Additionally, he will lose if he
uses the horse against 5 kilograms of rice. As a result, it makes the
barter system awkward.
4. Difficult in Storing Value : Value is only capable of being kept in the
form of commodities, such as food grai ns, livestock, fruits, and
vegetables, which is impossible owing to perishability, quality
deterioration, lack of storage space, and costs associated with items.
For instance: Let's say someone helps out another individual in
exchange for 1 quintal of whea t and 4 goats. All of the wheat he had
been given was eaten by the goats. And eventually, a sickness caused
the goats to pass away. Storage in the form of goods is therefore
completely impossible.
5. Lack of Specialization : In the past, when the barter syste m was used
often throughout the nation, people tended to be self -sufficient, or we
could say they were a jack of all trades. Consequently, there wasn't
any specialisation. Consider this scenario: Suppose a person produces
everything he requires, such as wh eat, rice, pulses, cotton, etc., solely
for his own consumption. As a result, there is little interaction between
people, which inhibits economic progress.
6. Difficulty in Transportation : Transportation is difficult or
impossible when products and services are exchanged for one another.
For instance: Imagine that a farmer and a carpenter who are located
kilometres apart wish to trade furniture for food grains. If so, both of
them will need to carry their goods from one location to another.
3.3 BIMETALLISMAND : BEFORE 1875
Prior to the 1870s, many nations practised bimetallism, or a double
standard in which free coinage for both gold and silver was maintained.
Bimetallism, for instance, persisted in Great Britain until 1816 (after the
end of the Napoleonic Wars ), when Parliament passed a legislation that
kept free coinage of gold alone and did away with free coinage of silver.
Bimetallism was made lawful in the United States by the Coinage Act of
1792, and it persisted there until 1873, when Congress removed the silver
dollar from the list of coins that had to be struck. On the other hand, from
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38 continued its bimetallism. Other nations that met the silver level included
China, India, Germany, and Holland.
In the sense that both gold and silver were accepted as forms of payment
internationally and that the value of each currency was based on either its
gold or silver content, the pre -1870 global monetary system can be
described as "bimetallic." For instance, around 1870, the amount of gold
in the two currencies determined the exchange rate between the British
pound, which was fully on a gold standard, and the French franc, which
was formally on a bimetallic standard.
On the other hand, the silver con tent of the respective currencies
influenced the exchange rate between the franc and the German mark,
which were both pegged to the silver standard. The pound's and the mark's
exchange rate relative to the franc dictated their respective exchange rates.
It is also important to keep in mind that during the years 1848 –1879,
prominent nations like the United States, Russia, and Austria –Hungary
occasionally had irredeemable currencies due to numerous wars and
political upheavals. The international monetary syst em was not entirely
systematic until the 1870s, one may say.
Gresham's law, a well -knownphenomenon, was frequently observed in
nations that used the bimetallic standard. Only the plentiful metal was
used as money since the exchange rate between the two met als was set in
stone, excluding additional scarce metal from circulation. Gresham's law
states that "bad" (excessive) money drives out "good" (poverty -scarce)
money. For instance, when gold from recently discovered mines in
Australia and California flooded the market in the 1850s, the price fell and
gold was overvalued under the official French ratio, which made a gold
franc equal to a silver franc that was 1512 times as heavy. The franc
effectively became into a gold coin as a result.
Future payment challe nges: Since payments must be described in terms of
products and services, it might be challenging to enter into contracts
involving future payments in the absence of a reliable unit of
measurement. However, there is a chance that there will be disagreement s
on the good's quality, its specific type, or its changing worth. For instance,
two parties agreed that the latter would receive 10 kg of rice in exchange
for the services done by the former after a year. In the future, rice's worth
and quality could alte r. Deferred payment is therefore completely
impossible.
3.4 CLASSICAL GOLD STANDARD : 1875 -1914
Gold has long been a favourite of mankind as a means of trading and a
way of storing wealth; it was widely used by many different civilizations.
"Gold comprises treasure, and he who possesses it has all he needs in this
world," stated Christopher Columbus once. However, it wasn't until 1821
in Great Britain that the Bank of England's notes became completely
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39 As was indicated earlier, France officially embraced the gold standard in
1878 after operating on it informally since the 1850s.
In 1875, the newly established German empire, which would later receive
a hefty war indemnity from France, sw itched to the gold standard and
stopped issuing free silver coins. Russia and Japan embraced the gold
standard in 1897, followed by the United States in 1879. The worldwide
gold standard was a historical fact from 1875 and 1914, roughly speaking.
When Worl d War I started in 1914, the majority of the world's nations
sold their gold. Thus, the traditional gold standard functioned as an
international monetary system for almost 40 years. Because of Britain's
strong economy and dominant position in global trade, London during this
time became the epicentre of the global financial system.
When gold alone is guaranteed unrestricted coinage in the majority of
significant nations, when gold and national currencies are convertible in
both directions at a stable rate, and when all major countries are part of an
international gold standard, then this standard is said to exist.The
unfettered import and export of gold. Banknotes must be backed by a
minimum declared ratio of gold reserves in order to ensure unlimited
conver tibility into gold. Additionally, as gold enters and exits the nation,
the domestic money stock should change.
Between 1875 and 1914, the aforementioned requirements were largely
accomplished. Under the gold standard, the amount of gold in any two
currenci es will dictate how much they are worth to each other. Let's say,
for instance, that one ounce of gold costs 12 francs, and the pound is tied
to gold at six pounds per ounce. Therefore, the pound should be worth two
francs in relation to the franc. The exc hange rate between the two
currencies will stay steady to the extent that the pound and the franc are
tied to gold at the current values. The exchange rates between the
currencies of such important nations as Great Britain, France, Germany,
and the United States did not fluctuate significantly at all during that
time.For instance, the dollar -sterling exchange rate was restricted to the
$4.84 to $4.90 range per pound. Under the traditional gold standard,
extremely stable exchange rates created a setting that was favourable for
international trade and investment.
Cross -border gold flows will automatically rectify exchange rate
misalignment under the gold standard. International payment imbalances
will be automatically adjusted under the gold standard. Imagine a scenario
in which France imported more from Great Britain than the former
imported from the latter. Under the gold standard, this kind of trade
imbalance will not continue. A net movement of gold in the other
direction will accompany the net export from Great Britain to France. The
price of gold will decrease in France as a result of this international trade
from France to Great Britain, while increasing in Great Britain.
(Recall that under the gold standard, the domestic money stock is expected
to change depending on whether gold is entering or leaving the nation.)
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40 the relative price level, while exports from France would increase. As a
result, Great Britain's initial net export will gradually vanish. The price -
specie -flow mechanism, which is credited to Scottish philosopher David
Hume, is the name of this corrective mechanism.
The gold standard still retains enthusiastic proponents in academic,
commercial, and political circles who s ee it as the best protection against
price inflation despite having long since been abolished. Gold is naturally
scarce, and no one has the power to arbitrarily increase its supply. As a
result, if gold is the only base used to create domestic money, infla tion
cannot be brought on by an excessive money supply. Additionally, if gold
were the only form of international payment, the flow of gold would
automatically control the balance of payments between nations. No nation
is allowed to have a consistent trade surplus or deficit. The gold standard,
however, has some significant drawbacks.
First off, the availability of freshly produced gold is so constrained that a
deficiency in monetary reserves might substantially impede the expansion
of international trade a nd investment. There may be deflationary pressures
on the global economy. Second, the government may stop using the gold
standard if it deems it politically necessary to pursue goals at home that
conflict with doing so. In other words, there is no mechanis m inherent in
the global gold standard to compel each big nation to play by the rules.
Due to these factors, it is unlikely that the traditional gold standard will be
reinstated in the near future.
3.5 BRETTONWOOD SYSTEM : 1945 –1972
At Bretton Woods, New H ampshire, delegates from 44 countries met in
July 1944 to plan the postwar global monetary system. The Bretton Woods
system's basic document, the Articles of Agreement of the International
Monetary Fund (IMF), was finally drafted and signed by representati ves
after protracted negotiations and deliberations. The majority of nations
subsequently signed the accord, allowing the IMF to be established in
1945. The IMF was in charge of imposing a defined set of guidelines for
the conduct of international monetary policies. The International Bank for
Reconstruction and Development (IBRD), popularly known as the World
Bank, was also established by delegates. Its main function was to finance
certain development initiatives.
Representatives were concerned with how to overcome the lack of clear
rules of the game that plagued the interwar years as well as how to stop
the resurgence of economic nationalism with disastrous "beggar -thy-
neighbor" policies when developing the Bretton Woods system. John
Maynard Keynes and the British delegation advocated a global clearing
union that would produce the "bancor," a global reserve asset.
Countries would accept payments in bancor without restriction to settle
international transactions. Additionally, they would be permitted to
purch ase bancor utilizing the clearing union's overdraft options. The
American delegates, led by Harry Dexter White, on the other side, munotes.in

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41 advocated a currency pool to which members would contribute and from
which they may borrow to get through temporary balance -of-payments
deficits. Both delegates wanted stable currency rates without reinstituting
a global gold standard. The IMF's Articles of Agreement substantially
adopted the American idea.
The only currency that was fully convertible to gold during the Bretton
Woods system was the US dollar; other currencies were not immediately
convertible to gold. Both U.S. dollars and gold were retained by nations
for use as a global medium of exchange. The Bretton Woods system might
be characterized as a dollar -based gold ex change standard as a result of
these accords. The majority of a nation's reserves are held in the form of
money from another nation that truly adheres to the gold standard.
3.6 SPECIAL DRAWING RIGHTS (SDRs)
An artificial international reserve known as the SDR was established by
the IMF in 1970 to somewhat relieve the strain on the dollar as the
primary reserve currency. The SDR, a basket currency made up of
significant individual currencies, was allocated to IMF members so they
could conduct business with o ne another or with the IMF. Countries might
utilise the SDR in place of gold and foreign money to make international
payments. The SDR was initially intended to represent the weighted
average of 16 currencies from those nations with export shares greater
than 1%. Each currency's proportion holding in the SDR was roughly
corresponding to its share of global exports.
The SDR was significantly simplified in 1981, though, when it was
reduced to only five main currencies: the US dollar, German mark,
Japanese yen , British pound, and French franc. The relative weight of each
currency is revised on a regular basis to reflect the volume of reserves held
by IMF members in various currencies as well as the relative importance
of each nation in the global commerce in go ods and services. Currently,
the SDR is composed of four major currencies —the U.S. dollar (41.9
percent weight), euro (37.4 percent), British pound (11.3 percent), and
Japanese yen (9.4 percent).
In addition to serving as a reserve asset, the SDR also serv es as a unit of
account in cross -border transactions. The SDR's value tends to be more
stable than the value of any one of the currencies it consists of since it is a
"portfolio" of currencies. Under conditions of fluctuating exchange rates,
the SDR's port folio character makes it a desirable denomination currency
for international commercial and financial engagements.
SMITHSONIAN AGREEMENT:
The Group of Ten, a group of 10 major nations, convened in December
1971 at the Smithsonian Institution in Washington, D.C., in an effort to
maintain the Bretton Woods system. They came to an agreement known as
the Smithsonian Agreement, which saw the price of gold hiked to $38 per
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42 10% against th e dollar, and the range of movement that was permitted for
exchange rates was increased from 1% to 2.25 % in either direction.
Before it was attacked once more, the Smithsonian Agreement had only
been in place for a little over a year. It is obvious that t he dollar's
depreciation was insufficient to bring about stability. The dollar faced
intense selling pressure in February 1973, which once more prompted
central banks all around the world to purchase the currency. Gold's ounce
price was increased from $38 to $42 per ounce. By allowing European and
Japanese currencies to float in March 1973, the Bretton Woods system had
completely collapsed. Since then, the exchange rates between important
currencies including the dollar, mark (later replaced by the euro), p ound,
and yen have fluctuated.
A fixed exchange rate system, commonly referred to as a pegged exchange
rate, is one in which the government and central bank make an effort to
maintain the currency's set value in relation to the value of other
currencies. The flexibility of the currency rate (if any) is allowed under
this system, subject to IMF (International Monetary Fund) agreement, but
only to a limited level.
The Reserve Bank of India, India's highest bank, announces the offi cial
price of its currency in reserve currency when the exchange rate is set.
Following rate determination, the RBI commits to buying and selling
foreign currency while delaying individual purchases and transactions.
The exchange rate is modified by the ce ntral bank (if necessary).
A fixed rate, often known as a pegged rate, is the official exchange rate set
and maintained by the government (central bank). A predetermined price
will be compared to a significant world currency (usually the U.S. dollar,
but a lso other major currencies such as the euro, the yen, or a basket of
currencies). The central bank purchases and sells its own currency on the
foreign exchange market in exchange for the currency to which it is tied in
order to maintain the local exchange rate.
The central bank will need to make sure that it can supply the market with
dollars if, for instance, it is judged that the value of one unit of local
currency is equal to $3 in the United States. The central bank must retain a
significant number of f oreign reserves in order to keep the rate steady.
This is a set aside sum of foreign currency that the central bank has on
hand and can employ to inject (or absorb) extra money into the market.
This guarantees a suitable money supply, suitable market fluct uations
(inflation/deflation), and eventually a suitable exchange rate. The official
exchange rate may also be modified by the central bank if needed.

3.7 FIXED EXCHANGE RATE SYSTEM
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43 3.8 THE FLEXIBLE/FLOATING EXCHANGE RATE
REGIME : 1973 –PRESENT
A floating exchange rate, as contrast to a fixed rate, is decided by the
private market using supply and demand. Given that any disparities in
supply and demand will be immediately adjusted in the market, a floating
rate is frequently referred to as "self -correcting."
Flexible or floating exchang e rates refer to monetary systems where the
exchange rate is determined by supply and demand. The market demand
and supply for a country's currency are determined by its economic
situation.
In this system, the value of each currency in relation to other cu rrencies is
established by the market, therefore the larger the demand for a given
currency, the higher the exchange rate; conversely, the lower the demand,
the lower the value of the currency in relation to other currencies. As a
result, neither the gover nment nor the central bank have any influence
over the exchange rate.
Consider the following streamlined model: if a currency is in low demand,
its value will drop, increasing the cost of imports while increasing demand
for local products and services. Mor e jobs will be created as a result,
which will cause the market to automatically correct itself. A floating
exchange rate is one that fluctuates frequently. When it is important to
maintain stability and prevent inflation in a floating regime, the central
bank may also step in to help; however, this happens less frequently.
Without a known or predicted trend, a floating exchange rate is mostly
decided by the market. In particular, unless it is obvious that the exchange
rate's stability is not the consequenc e of official efforts, exchange rates
that meet the statistical criteria for a stable or crawl -like arrangement will
be labelled as such. Intervention in the foreign exchange market, whether
direct or indirect, can slow the rate of change and stop unwarran ted
volatility in the exchange rate, but policies that aim for a set exchange rate
level are incompatible with floating. Brazil, Korea, Turkey, and India are a
few examples.
COMPARISON BETWEEN FIXED EXCHANGE RATE AND
FLEXIBLE EXCHANGE RATE:
BASIS FOR
COMPA RISON FIXED EXCHANGE
RATE FLEXIBLE
EXCHANGE RATE
Meaning Fixed exchange rate
refers to a rate which the
government sets and
maintains at the same
level. Flexible exchange rate is
a rate that variate
according to the market
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44
Determined by Governm ent or central
bank Demand and Supply
forces
Changes in
currency price Devaluation and
Revaluation Depreciation and
Appreciation
Speculation Takes place when there is
rumour about change in
government policy. Very common
Self-adjusting
mechanism Operate s through variation
in supply of money,
domestic interest rate and
price. Operates to remove
external instability by
change in forex rate.

The Smithsonian Agreement, which was signed in December 1971,
changed the plus or minus 1 percent to plus or minus 2.25 percent range
for exchange rate changes. However, members of the European Economic
Community (EEC) chose a more constrained range for their currencies —
61.125 percent. The snake was the name given to the European version of
the (quasi -) fixed exchange rate system that emerged as the Bretton
Woods system began to falter. The EEC currencies moved closely
together within a larger band that was open to other currencies like the
dollar, hence the name "snake."The EEC governments c hose the snake
because they believed that encouraging intra -EEC trade and furthering
economic integration required stable exchange rates among EEC
members. The European Monetary System (EMS) took the place of the
snake arrangement in 1979. The EMS was init ially introduced in March
1979 after being first proposed by German Chancellor Helmut Schmidt.
Among its main goals are:
1. To build in Europe a "zone of monetary stability."
2. To coordinate exchange rate policies with respect to the currencies
outside the EMS.
3. To prepare for the eventual creation of the European Monetary Union.
On a political level, the EMS represented a Franco -German effort to
hasten the process of economic and political unity in Europe. With the
exception of the UK and Greece, all EEC members joined the EMS. The
European Currency Unit and the Exchange Rate Mechanism are the
EMS's two primary tools.
The European Currency Unit (ECU) is a "basket" currency created by
weighing the currencies of the European Union's member nations (EU).
The weights are determined by the relative GNP and intra -EU trade shares 3.9 EUROPEAN MONETARY SYSTEM:
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45 of each currency. The ECU functions as the EMS's accounting unit and is
crucial to how the exchange rate system operates.
The method by which EMS member nations collectively manage their
exchang e rates is known as the Exchange Rate Mechanism (ERM). The
"parity grid" system, which establishes par values between ERM
currencies, is the foundation of the ERM. By initially establishing the par
values of EMS currencies in terms of the ECU, the par valu es in the parity
grid are computed.
A currency could only depart from the parities with other currencies by a
maximum of 2.25 percent when the EMS was first introduced in 1979,
with the exception of the Italian Lira, which could stray by a maximum of
6 per cent. However, the range was expanded to a maximum of plus or
minus 15% in September 1993. The central banks of both nations must
interfere in the foreign exchange markets to keep the market exchange rate
within the band when a currency is at either its lo wer or upper bound. The
member nations contribute gold and foreign reserves to a credit fund, to
which the central banks can borrow, allowing them to interfere in the
exchange markets.
The EMS underwent a number of realignments as a result of the members'
waning commitment to coordinating their economic policies. For instance,
the value of the Italian lira was reduced by 6% in July 1985 and then by
3.7 % in January 1990. Italy and the U.K. left the ERM in September 1992
as a result of the large capital infl ows into Germany being caused by high
German interest rates. After the unification of Germany in October 1990,
the German government faced large budget deficits that were not covered
by monetary policy.
The U.K. and Italy were unwilling to raise their inte rest rates (which was
required to preserve their exchange rates) because of concern for rising
unemployment, and Germany refused to cut its interest rates out of
concern for inflation. But in an endeavor to join the European Monetary
Union, Italy returned to the ERM in December 1996. But the United
Kingdom is still not a member of the EMU.
Members of the European Union convened in Maastricht (Netherlands) in
December 1991 and signed the Maastricht Treaty despite the ongoing
turmoil in the EMS. The agreement stated that by January 1, 1999, the
EMS would permanently fix exchange rates between the member
currencies. After that, a unified European currency would be introduced to
replace separate national currencies. The issuance of common currency
and the formul ation of monetary policy in the euro zone would be the sole
purview of the European Central Bank, which would have its headquarters
in Frankfurt, Germany.
Then, the national central banks of many nations would operate very
similarly to the regional member banks of the American Federal Reserve
System. The member nations of the European Monetary System decided
to closely coordinate their fiscal, monetary, and exchange rate policies in
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46 European M onetary Union (EMU). Particularly, each member nation
should work to:
i) maintain total public indebtedness below 60% of GDP,
ii) maintain government budget deficits to GDP ratios around 3%,
iii) attain high levels of price stability, and
iv) keep its currency within th e ERM's permitted exchange rate bands. In
nations like the Czech Republic, Hungary, and Poland that may
eventually join the EMU, "convergence" is currently the in -thing.
3.10 SUMMARY
 International Monetary System: The international monetary system is
the i nstitutional framework that regulates international payments,
capital transfers, and the setting of exchange values between different
currencies. Regarding exchange rates, foreign payments, and the
movement of capital, a complex web of agreements, laws,
organisations, methods, and policies exists.
 The development of the global monetary system took place in five
stages:
a. Bimetallism
b. the traditional gold standard;
c. the interwar years,
d. The Bretton Woods system;
e. exchange rate regime with flexibility.

 The tradit ional gold standard was in use from 1875 to 1914. Under the
gold standard, the amount of gold in two currencies influences their
relative exchange rates. The price -specie -flow mechanism
automatically corrects balance -of-payments imbalance. Dedicated
propon ents of the gold standard still hold the view that it offers a
strong defence against price inflation. However, because there is a
finite supply of monetary gold, the global economy can experience
deflationary pressure under the gold standard.

 In 1944, re presentatives from 44 countries gathered in Bretton Woods,
New Hampshire, and adopted a new international monetary system to
prevent the recurrence of economic nationalism without defined "rules
of the game" as was seen during the interwar period. Each nat ion
established a par value in reference to the U.S. dollar, which was
completely convertible to gold, under the Bretton Woods arrangement.
Countries used gold and foreign exchange, particularly the US dollar,
as international payment methods. The Bretton Woods system was
created to conserve gold and preserve stable currency rates. The final
breakdown of the Bretton Woods system in 1973 was mostly caused
by internal inflation in the United States and the ongoing balance of
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47
 Flexible or flo ating exchange rate: A monetary system in which the
exchange rate is determined by supply and demand is referred to as
flexible or floating exchange rate.

 Fixed Exchange Rate: A fixed exchange rate system, sometimes
referred to as a pegged exchange rate, is one in which the government
and central bank make an effort to maintain the value of the national
currency fixed in relation to the value of foreign currencies.

 To create a "zone of monetary stability" in Europe, the EEC nations
established the Europea n Monetary System (EMS) in 1979. The
European Currency Unit (ECU) and the Exchange Rate Mechanism
are the EMS's two primary tools (ERM). The EMS's accounting unit is
the ECU, a basket currency made up of the currencies of its members.
The process by which EMS members jointly manage their exchange
rates is known as the ERM. The member nations are expected to
maintain the parity grid on which the ERM is based.
3.11 QUESTIONS
(i) Discuss the advantages and disadvantages of the gold standard.
(ii) What were the main obj ectives of the Bretton Woods system?
(iii) Comment on the proposition that the Bretton Woods system was
programmed to an eventual demise.
(iv) Explain how special drawing rights (SDRs) are constructed. Also,
discuss the circumstances under which the SDRs were create d.
(v) Explain the arrangements and workings of the European Monetary
System (EMS).
(vi) There are arguments for and against the alternative exchange rate
regimes.
a. List the advantages of the flexible exchange rate regime.
b. Criticize the flexible exchange r ate regime from the viewpoint of
the proponents of the fixed exchange rate regime.
(vii) Distinguish between Fixed and Floating Exchange Rate System.
(viii) Blanks:
 A monetary system, wherein the exchange rate is set according to the
demand and supply forces, is known as _______ exchange rate.
 An exchange rate regime, also known as the pegged exchange rate,
wherein the government and central bank attempts to keep the value of
the currency is fixed against the value of other currencies, is called
______ exchange rate. munotes.in

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48 3.12 REFERENCES
 International Financial Management book (Seventh Edition) by Cheol.
S. Eun and Bruce.G.Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 Jeff Madura, International Finan cial Management
 Siddaiah, International Financial Management : An Analytic Frame
work
 www.business jargons.com
 www.investopedia.com
 www.keydifferences.com





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49 4
FOREIGN EXCHANGE MARKETS
Unit Structure :
4.0 Objectives
4.1 Introduction
4.2 Exchange rate quotations
4.3 Direct and indirect rates
4.4 Cross currency rates
4.5 Vehicle currency
4.6 Spreads and calculation of cross rates
4.7 Settlements – cash, tom,s pot and forward
4.8 Arbitrage, Speculationand Trading
4.9 Interest rate parity and Purchasing power parity
4.10 Cover ed interest rate parity in arbitrage
4.11 Borrowing and investment decisions
4.12 Calculation offorward rates through use of forward schedul es
4.13 Annualized forward margin
4.14 Calculation of swap points
4.15 Summary
4.16 Questions
4.17 References
4.0 OBJECTIVES
 To understand about Foreign Exchange Markets works.
 To understand Exchange rate quotations.
 To know about Direct and Indirect ra tes.
 To understand cash, tom, spot and forward.
 To understand Arbitrage, Speculationand Trading
 To understand the Interest Rate Parity and Purchasing Power Parity.
 To understand how calculation of Swap points works.

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50 4.1 INTRODUCTION
The market where exchange rates are decided upon is the foreign
exchange, or forex (FX) market. A price, particularly the cost of one
currency relative to another, is called an exchange rate. It is the system
that links different world currencies together in the global economy. Th ere
are two popular ways to say it. One represents the exchange rate as the
cost of foreign currency in terms of domestic currency, or the quantity of
domestic currency required to buy one unit of a foreign currency, also
known as the price quotation syste m or direct quotation.
The alternative, also referred to as the volume quotation system or indirect
quotation, expresses the exchange rate as the cost of local currency in
terms of foreign currency, or as the quantity of foreign money needed to
buy one uni t of local currency. Keep in mind that an indirect quotation
simply reverses the meaning of a similar direct citation.
4.2 EXCHANGE RATE QUOTATIONS
There are two different ways to quote exchange rates: directly and
indirectly. When one unit of foreign money is stated in terms of domestic
currency, this is known as a direct quotation. Similar to an explicit quote,
an indirect quotation occurs when one unit of local currency is expressed
in terms of another.
4.3 DIRECT AND INDIRECT RATES
The price at which one cu rrency will be exchanged for another currency is
known as the exchange rate in the world of finance. Both direct and
indirect quotes of the exchange rate are acceptable. When the cost of one
unit of foreign currency is stated in terms of the local currency , the quote
is considered to be direct.
When the price of one unit of domestic currency is given in terms of
foreign currency, the quote is indirect. Since the US dollar (USD) is the
most widely used currency, it is typically against which exchange rates a re
presented. Now, a lower exchange rate in a direct quote suggests that the
value of the national currency is increasing. In contrast, a lower exchange
rate in an indirect quote suggests that the value of the home currency is
declining since less foreign currency is equivalent to the domestic
currency.
4.4 CROSS CURRENCY RATES AND ITS CALCULATION
A cross rate is an exchange rate used when two currencies are being
exchanged that are both being valued against a different currency. The
U.S. dollar is the curr ency that is typically used to determine the values of
the pair being exchanged in foreign exchange markets. The value of the
US dollar is always 1, since it is the base currency. A cross -currency pair
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51 one currency for its value in dollars. After that, the US dollars are
converted into another currency.
The U.S. dollar is utilised to determine the value of each of the two
currencies being traded in the aforementioned transaction. As a n
illustration, if you were figuring out the cross rate of the British pound and
the euro, you would first find out that on June 6, 2022, the British pound
was worth 1.25 to one U.S. dollar and the euro was worth 1.07 to one U.S.
dollar.
By definition, a c ross rate is any exchange between any two currencies
that aren't those of the nation where the quote was published. In actuality,
a cross rate is any currency exchange in which neither of the currencies is
the U.S. dollar. The euro and the Japanese yen are among the most popular
cross -currency combinations.
The phrase "cross rate" is used by foreign exchange (forex) traders to
describe price quotes between any two currencies in which neither is the
U.S. dollar. Major currency pairs see the majority of FX tr ansactions. In
other words, the American dollar is one of the currencies being
exchanged. For instance, if you see the currency pair USD/CAD quoted at
1.28 on a financial news website, it indicates the current exchange rate
between the two currencies. A cu rrency pair or transaction that excludes
the currency of the party initiating the transaction is also referred to as a
cross rate.
4.5 VEHICLE CURRENCY
In the past, a single currency that was used for international trade in goods
and assets dominated the g lobal economy. The American dollar has served
this purpose recently. The U.S. dollar serves as a "vehicle currency" in
that agents in non -dollar economies frequently use it as a medium of
exchange rather than conducting direct bilateral trade between their own
currencies.
When there are exchange fees associated with transactions, a vehicle
currency is preferred. The model of a vehicle currency's dynamic general
equilibrium is created. We examine the type of efficiency improvements
brought about by a vehicle currency and demonstrate how they rely on the
total number of currencies in use, the size of the economy of the vehicle
currency, and the monetary policy employed by the government of the
vehicle currency. In a system of numerous independent currencies, w e
discover that a vehicle currency may result in considerable welfare
advantages. However, these benefits are asymmetrically biased in favour
of citizens of the nation using the vehicle money. Natural boundaries are
imposed on a country's monetary policy b y the existence of a vehicle
currency.

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52 4.6 SPREADS AND ITS CALCULATION
A forex spread is simply how a broker earns money without taking a
commission on a transaction; it is the difference between the bid (sell)
price and the ask (buy) price of a currenc y pair. It's crucial for new traders
to comprehend how forex spreads operate, how to calculate them, and why
they even exist. Simply subtracting the ask and bid values of a currency
pair will give you the spread when calculating a forex spread. Here are
some instances using well -known currency pairs:
 If you are trading the EUR/USD at 1.1051/1.1053, the spread is: 1.1053 -
1.1051=0.0002 or 2 pips.
 If you are trading the EUR/GBP or bid price 1.1036/1.1039 ask price. The
spread is 1.1039 - 1.1036 = 3 pips.
Wheth er they be major, minor, or exotic currency pairs, this calculation is
applicable to all of them.
Keep in mind that you will be charged the entire spread when you open a
trade when trading forex, which is the reason why trades always open in
the negative b ecause the spread was charged immediately.
4.7 SETTLEMEN TS-CASH, TOM, SPOT AND FORWARD
CASH :
When an option or futures contract is exercised or expires, the value of the
stock or commodity that underlies it is paid in cash.
An underlying security or comm odity that can be bought or sold upon
exercise (defined by a price) or expiration serves as the basis for the
valuation of options and futures contracts (determined by a date).
Ownership of the stock or tangible good is rarely a problem for the parties
under these transactions. Because of this, the majority of holders opt to
settle in cash, satisfying the contract with the difference between the
underlying asset's current spot value and the amount stipulated in the
contract (could be a gain or a loss).
Cons ider a scenario where a contract expires and the market spot price of
the underlying stock X is $100. This will serve as an example of a cash
settlement for a put options contract. The contract's price is set at $75.
According to the contract's provisions, the holder is required to make the
purchase at a cost that is $25 more than the contract's stated price ($100
market - $75 contract = $25). The contract holder will suffer a $25 loss if
they settle their claim in cash.
Let's imagine a contract expires wit h the underlying asset's spot market
price for oranges at $100 to demonstrate a cash settlement utilising a put
futures contract. The contract specifies a fee of $150. The holder is
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53 The contract holder accepts a cash settlement of $50 ($150 contract - $100
market) rather than a specific number of oranges.
With the declared aim and intention of gaining from a positive spread in
the contract/market price upon execution or expiration of the contract,
investors typically acquire derivatives contracts for options and
commodities. The de facto fulfilment of a contract's requirements in this
regard is represented by the cash settlement of such contracts (whether a
gain or loss) rather than th e receipt or delivery of securities or goods.
TOM :
In a short -term foreign exchange (forex) transaction called tomorrow next
(tom next), a currency is simultaneously bought and sold over the course
of two different business days: tomorrow (on one business day) and the
day after that (two business days from today). The purpose of a tom next
transaction is to let investors and traders keep their positions open without
being compelled to accept physical delivery. Although this word is not
frequently used ther e, tom next trades are equally significant in the
markets for commodities derivatives.
In the currency markets, rolling over a position to postpone delivery is
referred to as "tomorrow next." To avoid taking delivery and holding onto
the currency at the s ame time, a trader might roll over their position to the
following and subsequent (i.e., two days later) business days. A broker's
STIR or currency desk can handle a tom next transaction.
Delivery occurs in the majority of currency exchanges two days (T+2)
following the transaction date. The majority of currency traders do not
intend to take delivery of the currency; thus, they need their positions to be
"rolled over" everyday, which leads to the emergence of tom -next trades.
This simultaneous transaction i s an FX swap, and the recipient will either
pay a fee or receive a premium depending on the currency they hold. Due
to the interest rate difference, traders and investors that possess high -
yielding currencies will be able to roll it over at a more advantag eous rate
(minimum). The cost of carry is the name given to this difference.
Dealers in the interbank market have an impact on the real tom -next
trades. The trader will either "buy and sell" or "sell and buy" the currency
they are rolling over, depending o n the direction of their transaction. The
forwards trading desk or the STIR (short -term interest rate) team typically
handle a tom -next transaction.
Instance of Tom Next: On the day of expiration, a trader is long on the
EUR/USD pair, which is priced at $1 .53 (1 euro equals 1.53 US dollars).
The trader issues a tom -next command to hold onto the pair indefinitely.
Assume that the pair's swap interest rates fall between 0.010 and 0.015.
The trader is presented with an interest rate of 0.010 at the conclusion of
the trading day, following the purchase and sale of shares. The following
day, the trader's position's new price is $1.52.
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54 SPOT:
The price paid for immediate delivery of a currency is referred to as the
spot, or current, exchange rate. Except in specif ic circumstances, such a
banknote exchange, "instant delivery" often refers to the settlement of a
foreign exchange contract within two working days. In order to buy and
sell foreign currencies, corporations, non -financial government entities,
and private individuals participate in the spot market, which is made up of
financial institutions (such as commercial and investment banks, pension
funds, hedge funds, money market funds, insurance companies, and
financial government entities).
In 2013, the daily vol ume of spot contracts was $1.759 trillion (38% of
total turnover), according to the BIS (2013) Triennial Survey. Only 19%
of daily spot transactions involved non -financial customers; the majority
of spot trading took place between financial organisations. This market is
renowned for its frenetic pace and the enormous sums of money that are
exchanged in reaction to minute changes in price quotations at breakneck
speeds. The price of a currency on the spot market is determined by supply
and demand for foreign exchange, just as in any other market.
FORWARD:
The rate set today for delivery of a currency at a future time is known as
the forward exchange rate. Although the rate is negotiated and agreed
upon at the time of contract formation, delivery and payment a re
postponed until maturity. For value periods of one month (30 days), two
months (60 days), three months (90 days), six months (180 days), nine
months (270 days), and twelve months, banks commonly provide forward
rates (360 days). Actual contracts, howeve r, can be negotiated for
durations up to 5 or 10 years.
A forward rate is an interest rate that will be used in a future financial
transaction. To establish the future interest rate that compares the total
return of a longer -term investment with a strategy of rolling over a shorter -
term investment, forward rates are computed from the spot rate and are
adjusted for the cost of carry. The rate set for a future financial obligation,
such as the interest rate on a loan payment, may also be referred to by this
word. The investor might sign a contract allowing them to reinvest money
six months from now at the current forward rate in order to reduce
reinvestment risks. Immediately advance by six months.The investor could
use the forward rate agreement to invest the money from the matured t -bill
at the more advantageous forward rate if the market spot rate for a fresh
six-month investment is lower. The investor could cancel the forward rate
agreement and make a new six -month investment at the current market
rate of i nterest if the spot rate is high enough.
Hedging, arbitrage, and speculation are the three primary types of activity
that the forward exchange market is useful for. Hedging is the process of
protecting oneself from the potential future swings in the spot e xchange
rate. By purchasing (selling) the requisite amount of foreign currency in
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55 a payment in foreign currency at a specific future date can protect
themselves against the exchange r ate risk. He is therefore aware of the
exact amount he will pay (get) in native currency because the conversion
rate is currently fixed.
The practise of profiting from interest -rate and price differences in the
forward and spot markets is known as arbitrag e and speculation. For
instance, a trader will purchase a currency in the forward market if he
thinks it will increase in value in the future. He'll sell the currency on the
open market to profit when the contract expires (if he got it right). As we
demons trate below, similar issues apply to arbitraging. In any event, there
are other methods of carrying out these tasks without using forward
contracts. Using the spot market is an additional option. Thus, the question
of which market is the better alternative automatically arises.
4.8 AR BITRAGE, SPECULATION AND TRADING
Investors are constantly doing their best to profit from the market. After
all, isn't that the core of trading? Investors, whether they are individuals or
institutions, utilise a financial plan t hat is specifically designed for them
and that is successful. The risks involved in arbitrage and speculation are
significantly different from one another.
Traders utilise financial tactics like speculation and arbitrage to boost their
earnings. However, t here are significant differences in how each tactic is
applied. A trader typically engages in speculation by taking on a foreign
exchange position in the anticipation of a positive shift in currency rates.
For instance, a trader might initiate a long posit ion on a currency
(purchase it now) with the hope of making money off of a potential
increase (i.e., sell the currency at a higher price in the future). The trader
may close the position with a profit if the value of the currency increases.
On the other ha nd, if the value of the currency drops, the trade can be
abandoned at a loss. A speculator is said to be bullish if they believe that a
currency will increase in value in the future. On the other side, if
speculators anticipate that the currency will decli ne, they may open a short
position (also known as selling short, or simply selling the currency now
in hopes of getting it again at a cheaper rate in the future). The position
will be lucrative if the currency falls. The trade might be closed at a loss if
the currency increases. A speculator is said to be bearish if they believe
that a currency will decline in value in the future. Therefore, speculation is
a form of financial strategy that carries a high level of risk.
Contrarily, arbitrage is a risk -free t rading approach that enables traders to
profit on price differences that are present simultaneously in various
marketplaces and across multiple currencies. Spatial arbitrage, which
exploits price differences between geographically distinct marketplaces, is
the most basic type of arbitrage in the FX market. The traders would
benefit from buying euros in London and simultaneously selling them in
New York if, for instance, the dollar -euro exchange rate quoted in New
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56 traders to make a risk -free profit of 1.6 cents on each euro bought and
sold. Due to this activity, the euro will strengthen in London and weaken
in New York, creating an arbitrage -free equilibrium where the two rates
are equal.
To sum up, arbitrage is a pretty frequent strategy used by hedge funds and
institutional investors, and it has a relatively low risk. This kind of
approach entails holding a sizeable position in a security that is traded at a
variety of prices in two different m arkets. In order to profit from the price
differential, the investor will purchase it for a cheap price on one market
and sell it for a slightly higher price on another. Due to the nature of this
method, tiny, individual investors don't typically employ it .
On the other hand, speculation might be. This technique may not be
dependent on market dynamics and does not require a substantial
investment foundation. Any sort of security, including real estate, can be
used, and it is predicated on assumptions. While arbitrage has a relatively
low risk, speculation has a higher potential for profit or loss.
4.9 INTEREST RATE PARITY AND PURCHASING
POWERPARITY
INTEREST RATE PARITY:
The purchasing -power parity criteria only addresses arbitrage in markets
for commodities and services; it makes no mention of arbitrage in global
financial markets. An important parallel condition that emphasises the
significance of interest rates occurs for these markets. It relates to
arbitrage in global financial markets and is known as the interest parity
conditions. This condition essentially states that interest yields on
comparable financial instruments should be the same worldwide when
assessed in a common currency. If this were not the case, money would
tend to move from one nation to another until there was no preference for
investing domestically or internationally.
According to the interest rate parity (IRP) theory, the difference in interest
rates between two nations is equal to the difference between the forward
and spot exchange r ates. The basic formula governing the correlation
between interest rates and exchange rates is known as interest rate parity.
Interest rate parity's fundamental tenet is that hedged returns from
investments in various currencies should be the same regardle ss of the
interest rates associated with those investments. Forex traders look for
arbitrage possibilities using parity.
By linking interest rates, spot exchange rates, and foreign exchange rates,
interest rate parity (IRP) plays a crucial role in the fore ign exchange
markets. IRP is the key formula that controls how interest rates and
currency exchange rates interact. IRP's fundamental tenet is that hedged
returns from investments in various currencies should be the same
regardless of the interest rates as sociated with those investments. The idea
of no -arbitrage in the foreign exchange markets is known as IRP (the munotes.in

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57 simultaneous purchase and sale of an asset to profit from a difference in
the price). Investors cannot buy a currency at a lower cost than the cu rrent
exchange rate and then buy another currency from a nation with a higher
interest rate.
The formula for IRP is:
F0=S0×(1+ic/1+ib)
where:
F0 = Forward Rate
S0 = Spot Rate
Ic = Interest rate in country c
Ib = Interest rate in country b
THE PUR CHASING POWER PARITY PRINCIPLE :
The purchasing -power parity (PPP) condition, which applies to markets
for both commodities and services, is concerned with the long -term link
between exchange rates and price levels. PPP's philosophical roots can be
traced b ack to David Ricardo, while it is commonly believed that Gustav
Casellis wrote about it in the 1920s. The fundamental idea is that once the
price of the commodity is measured in the same currency, arbitrage forces
will cause the price of the good to equali se worldwide. As a result, the
theory shows how the law of one price can be used. This law merely states
that identical goods supplied in different markets will have the same price
when expressed in terms in the existence of competitive global
marketplaces and in the absence of transportation costs and other trade
barriers.
Macroeconomic experts frequently use the purchasing power parity (PPP)
statistic to compare the currencies of various nations using a "basket of
goods" method. When a basket of items is priced the same in both nations
while accounting for exchange rates, two currencies are said to be in
equilibrium, or to be at par. Economists can compare economic production
and living standards across nations thanks to purchasing power parity
(PPP). In o rder to account for PPP, some nations modify their GDP
estimates.
The relative version of PPP is calculated with the following formula:
S=P2/P1
where:
S= Exchange rate of currency 1 to currency 2
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58 The World Bank publishes a report every few years that compares the
productivity and growth of various nations in PPP and US doll ars.
Weights based on PPP measurements are used by the International
Monetary Fund (IMF) and Organization for Economic Cooperation and
Development (OECD) to forecast the future and suggest economic
policies. Financial markets may experience an immediate sh ort-term
impact as a result of the suggested economic reforms.
PPP is also used by certain forex traders to identify either overvalued or
undervalued currencies. The survey's PPP numbers can be used by
investors who own foreign company stock or bonds to fo recast how
exchange rate movements would affect a nation's GDP and, in turn, their
investment.
4.10 COVERED INTEREST RATE PAR ITY IN
ARBITRAGE
A theoretical situation when the connection between interest rates and the
spot and future values of two countries is in equilibrium is known as
covered interest rate parity. Due to the covered interest rate parity
condition, forward contracts cannot be used for the common practise of
interest rate arbitrage between nations. According to the covered interest
rate parit y condition, there is an equilibrium between two countries'
interest rates and their spot and forward currency values. No possibility of
arbitrage via future contracts is assumed. When forward and anticipated
spot rates are equal, covered and uncovered int erest rate parity is also
equal.
The Formula for Covered Interest Rate Parity is:
(1 + id) = F/S * (1 + if)
Id=The interest rate in the domestic currency or the base currency
If=The interest rate in the foreign currency or the quoted currencyS =The
current spot exchange rate
F=The forward foreign exchange rate
A no -arbitrage requirement that might be applied in the foreign exchange
markets to establish the future foreign exchange rate is covered interest
rate parity. Additionally, it stipulates that investo rs may cover their
exposure to unanticipated foreign exchange risk or exchange rate swings
(with forward contracts). As a result, it is argued that the foreign exchange
risk is mitigated. Parity in interest rates may exist for a while, but that does
not gu arantee that it will continue. Currency and interest rates fluctuate
over time.

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59 4.11 BORROWING AND INVESTMENT DECISIONS
Many factors, like interest rates, markets, etc., influence borrowing and
investing decisions, but they also vary from company to compa ny and
investor to investor.
Already covered in Forward Exchange Rate in this Chapter itself. Kindly
refer to that section of this Chapter.
4.13 ANNUALIZED FORWARD MARGIN
The difference betw een the spot pricing and the forward rate for a specific
commodity or currency is reflected in the forward margin, also known as
the forward spread. Depending on whether the forward rate is higher or
lower than the spot rate, the difference between the two rates can either
represent a premium or a discount. The difference between the forward
rate and the spot rate, or, in the case of a discount rate, the spot rate and
the forward rate, is known as the forward margin.
The expenditures involved in securing a price for a future date are
represented by the forward margin, which can be high, small, negative, or
positive. Depending on how far away the delivery date is, the forward
margin will change; for example, a one -year future will be priced
differently than a 30-day forward. The forward margin, also known as the
forward points, is frequently expressed in basis points. The forward rate is
the result of adding or subtracting the forward points from the spot rate.
4.14 CALCULATION OF SWAP POINTS
A simultaneous exc hange of identical amounts of one currency for another
with two separate value dates is known as a currency swap, or FX swap
(normally spot to forward).
The term "swap points" refers to the difference in pips between the
forward rate and the spot rate for a certain currency pair. The calculation
of these points makes use of the economic idea of interest rate parity.
According to this hypothesis, regardless of how much money is invested
in different currencies' interest rates, the hedged returns should be
equivalent.By taking into account the net cost or advantage associated
with lending one currency and borrowing another against it throughout the
time frame covered by the spot value date and the forward delivery date,
forward traders can use this theory to c alculate the forex swap points for
any particular delivery date.
The value of 0.05 GBP would be accumulated to a trader's account if they
open a 1 lot transaction on the EURUSD and hold a Sell transaction
overnight. On the other side, the trader's account would be charged 3.79
GBP if they hold a Buy transaction overnight. The accruals and costs vary 4.12 CALCULATION OF FORWARD RATES
THROUGH USE OF FORWARD SCHEDULES
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60 according to the financial instrument the trader is interested in, and many
traders use methods centred on keeping positions open overnight to get the
largest a ccruals. Such techniques frequently leverage the USDTRY,
USDMXN, and EURAUD markets.
The majority of indices also don't add any accruals or charges to the open
positions of the traders. The calculation below can be used to accomplish
this:
Swap point rate x Pip value
4.15 SUMMARY
 Direct Quote : When the price of one unit of foreign currency is
stated in terms of the local currency, the quote is considered direct.
 Indirect Quote : When the price of one unit of domestic currency is
stated in terms of foreign currency, the quote is considered indirect.
 Cross Rate : A cross rate is an exchange rate used to compare the
value of two currencies against one another.
 Cash Settlement : Upon exercise or expiration of an option or futures
contract, a cash settlement is a payment made in cash for the value of
the stock or commodity that underlies the contract.
 TOM : Tomorrow next (tom next) is a short -term foreign exchange
(forex) transaction in which a currency is simultaneously purchased
and sold over two different wor king days, namely tomorrow (in one
working day) and the day after that (two business days from today).
 Spot : The price paid for immediate delivery of a currency is known as
the spot rate, sometimes known as the current exchange rate.
 Forward : The rate se t today for delivery of a currency at a future
time is known as the forward exchange rate. Although the rate is
negotiated and agreed upon at the time of contract formation, delivery
and payment are postponed until maturity.
4.16 QUESTIONS

1. Distinguish between Direct and Indirect Exchange Rate Quote.
2. What are Cross Currency Rates? Explain with example.
3. Short Notes on:
4. Cash
5. TOM
6. Spot
7. Forward
8. Speculation
9. Arbitrage
10. Explain the Interest Rate Parity.
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61 4.17 REFE RENCES

 International Financial Management book (Seventh Edition) by
Cheol. S.Eun and Bruce.G.Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 Jeff Madura, International Financial Management
 Siddaiah , International Financial Management : An Analytic
Framework
 www.toppr.com
 www.investopedia.com
 www.thetradingbible.com
 www.investinganswers.com
 www.xtb.com

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62 5
EUROCURRENCY MARKETS
Unit Structure :
5.0 Objectives
5.1 Introduction
5.2 Origin and reasons for growth of Eurocurrency markets, their
characteristics and components
5.3 Eurocurrency deposits, loans, bonds and notes
5.4 Off shorebanking, tax havens
5.5 Summary
5.6 Questions
5.7 References
5.0 OBJECTIVES
 To study the Origin and Reasons for Growth of Euro Currency
markets.
 To study Characteristics and Components of Euro Currency markets.
 To understand Euro Currency Deposits.
 To study Off Shore banki ng.
 To understand how tax havens works.
5.1 INTRODUCTION
The introduction of the euro in January 1999 is unquestionably a historic
event, especially in light of the fact that no European currency has been in
use since the fall of the Roman Empire. Gaius Di ocletianus, the Roman
emperor from A.D. 286 to 301, reorganized coinage and instituted a
common currency for the entire realm. The introduction of the euro also
signifies the first occasion when independent sovereign nations have
consciously given up their monetary sovereignty to promote economic
unification. Therefore, the euro is a historically unique experiment whose
results will have broad ramifications. For instance, both the euro and the
dollar will rule the world of international banking if the exper iment is
successful. Additionally, the political unionization of Europe may receive
a strong boost from the success of the euro.
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63 The market for Euro money is the foreign exchange market for currencies
that are accepted as legal tender. The euro currency m arket is used by
banks, multinational corporations, mutual funds, and hedge funds. They
seek to stay away from the common regulatory requirements, tax laws,
and interest rate ceilings seen in domestic banking. The term "Euro
currency" is a generalisation o f the Eurodollar and is not to be confused
with the euro, the official currency of the EU. Not just in Europe, but also
in many other financial hubs throughout the world, there is a demand for
Euro money.
The Marshall Plan's massive outflow of dollars to r ebuild Europe after
World War II gave rise to the eurocurrency market. Because banks
required a dollar -deposit market outside of the USA, the market first
emerged in London. Even if they are stored outside of Europe, dollars held
outside of the United Stat es are referred to as Eurodollars. In markets like
Singapore or the Cayman Islands, they are able to hold them. When other
currencies trade outside of their native markets, like the British pound and
the Japanese yen, they are included in the eurocurrency market. The
largest market is still for Eurodollars.
ORIGIN OF EURO CURRENCY MARKETS:
The European Union's history of ever -deepening integration, which started
in earnest with the establishment of the European Economic Community
in 1958, should be seen as the source of the euro. In order to maintain a
European zone of monetary stability, the European Monetary System
(EMS) was established in 1979; members were obl igated to limit changes
in their currency exchange rates. A draught Treaty on the European Union
was adopted by the Maastricht European Council in 1991, and it stipulated
that a unified European currency would be implemented by 1999.
The European Monetary Union (EMU) was established on January 1,
1999, with the introduction of the euro. The European Currency Unit
(ECU), which served as the forerunner to the euro, is a logical extension
of the EMS. In fact, a one -to-one conversion of ECU contracts to euro
contracts was mandated by EU legislation. Each national currency of the
euro-11 countries was permanently linked to the euro at a conversion rate
as of January 1, 1999 as soon as the currency was introduced. Euro
banknotes and coins entered circulation on Ja nuary 1, 2002, replacing the
gradually withdrawn national bills and coins.
National currencies lost their legal tender status on July 1, 2002, becoming
the euro the only legal tender in the nations that make up the euro zone.
The European Central Bank (ECB ), with its headquarters in Frankfurt,
Germany, now oversees monetary policy for the nations that make up the
euro zone. The ECB's principal goal is to preserve price stability. In order
to prevent the ECB from being overly influenced by political pressure 5.2 ORIGIN AND REASONS FOR GROWTH OF
EUROCURRENCY MARKETS, THEIR
CHARACTERISTICS AND COMPONENTS
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64 from any member countries or institutions, its independence is legally
maintained.
The German Bundesbank, which was very successful in ensuring price
stability in Germany, is largely the model that the ECB is based on. "Price
stability" was described by W illem (Wim) Duisenberg, the first president
of the ECB and former head of the Dutch National Bank, as an annual
inflation rate of "less than but near to 2 percent."
REASONS FOR GROWTH OF EURO CURRENCY MARKETS:
1. Regulation "Q" of the Federal Reserve Act, whi ch placed a cap on the
interest rates that US banks could provide on deposits, was one of the
factors that helped this industry expand. Consequently, European
banks could by providing higher interest rates, you can entice deposits
in US dollars.
2. Federal Re serve Act Regulation "M," which required reserves to be
kept against deposits taken by US banks. Due to the widening of the
disparity between deposit and lending rates, this raised the cost of
deposits for banks in the USA. European banks took advantage of this
feature because they were exempt from reserve requirements for
deposits made in euros.
3. The mandate that all US banks must insure any deposits they receive
from the general public. Because the Euro -Currency market is
unregulated, Eurobanks were not re quired to guarantee Euro -Currency
deposits. This diminished a fee for deposits.
4. The US monetary authority's introduction of the Interest Equalization
Tax in 1963 increased the effective cost of borrowing in the US for
non-resident firms. Due to the fact th at Euro -banks were exempt from
the "Interest Equalization Tax," they turned to the offshore market for
their funding requirements.
5. In 1965, the US implemented the Voluntary Restraint Program, under
which US borrowing for supporting foreign enterprises was
constrained. Loans to foreign borrowers were discouraged from being
made by US institutions. In 1968, statutory limits on overseas direct
investments took the place of the guidelines.Effectively, US
multinationals were now forced to borrow money from overs eas
sources as wellmarket for their global endeavours.
6. People who are not US citizens have unequal cash flows in USD. They
obtain USD through exports to the US and require it to cover the cost
of US imports. Both times, there is a conversion into or out of native
currency. The deposited such entitieswhen necessary, they withdrew
their export revenues from Euro -banks to pay for imports. Such
entities could now preserve their foreign currency holdings without
paying conversion fees or exchange rate risk, earn ing the higher
deposit rates offered by the euro -currency market, and having the ease
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65 CHARACTERISTICS OF EUROCURRENCY MARKETS:

Source: https://image.slidesharecdn.com/eurocurrencymarket -
110224231901 -phpapp022 -12033111 4722 -phpapp 02/95/ eurocurrency
market -110224231901phpapp02 -2-3-728.jpg?cb=1333196432
COMPONENTS OF CEUROCURRENCY MARKETS:
 The most significant route for raising and allocating capital globally
has emerged as the eurocurrency market. By definition, no nation' s
monetary policy has direct influence over the Eurodollar market. It is
appropriately stated that because they are in London and are
denominated in dollars, the dollar deposits there are neither under
American or British authority. The market's expansion is greatly owed
to the fact that no governmental body has any control over it.
 Interest is paid on all of the deposits in this market, which range in
maturity from one day to several months. Eurodollar deposits are
primarily a short -term instrument, despit e the fact that some of them
have a maturity of over a year. Most analyses of the Eurodollar market
treat it primarily as a credit market —a market for dollar bank loans —
and as a crucial complement to the Eurobond market.
 Eurobonds are used for loans with terms of three months or longer.
Out of the Eurodollar market, Eurobonds were created to offer longer -
term loans than were typically available with Eurodollars. These bonds
are typically issued by a group of banks and issuing organizations.

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66 A foreign currency deposit into a bank that participates in the European
financial system is known as a euro deposit. These banks use the euro, a
single European currency, to conduct business. An external investor
effectively puts euros when th ey deposit foreign currency into one of these
institutions. The account holder may anticipate earning income at the
floating interest rate set by the European Central Bank by depositing
money into a bank account in Europe (ECB).
Money placed in a European account is known as a euro deposit. These
deposits enable individuals from other countries to invest in euros and
earn interest at a rate established by the European Central Bank (ECB).
Since 2014, the ECB has offered negative rates for reserves. To pass a long
the costs, large banks have begun charging clients for euro deposits. A
foreign national or business may use a euro deposit as a means of
protecting their funds in the event that the value of their home currency
falls significantly. Minimums can be se t by banks for these overseas
deposits. Customers have historically received large interest payments
from European banks for "parking" their money in these accounts. This
technique encourages big businesses and rich clients to keep a larger sum
of money in these European Accounts.
The European Central Bank (ECB), on the other hand, for the first time
cut interest rates to levels below zero in 2014. Since then, the rate has
continuously decreased till it is now at a minus 0.5% as of November 27,
2020, which is the lowest rate ever. Negative interest rates on deposits had
to be imposed due to the lower interest rate. Many foreign banks provide
money to the ECB. These foreign banks essentially started paying to lodge
money at the ECB after negative interest rat es were introduced by the
ECB. Negative interest rates cost the banks money, therefore many of
them decided to pass those expenses on to their clients.
EUROCURRENCY LOANS :
A loan with a currency other than the lending bank's home currency is
referred to a s a eurocredit. The idea is closely related to that of
"eurocurrency," which is any currency that is kept or exchanged outside of
its nation of issuance. A loan provided by a U.S. bank that is not
denominated in USD is an example of a Eurodollar, which is a dollar
deposit held or traded outside of the United States.
A eurocurrency can currently be held or a eurocredit loan made wherever
in the globe that local banking regulations permit. The "euro -" prefix in
the phrase arose because historically such curre ncies were held, and loans
made, in Europe.
Due to its simplicity of conversion and lack of domestic trading
constraints, the eurocurrency market is a significant source of funding for
international trade. Similar banks participate in both the eurocurrency and
eurocredit markets, but the loans offered on the eurocredit market are
often bigger and have longer terms. The eurocredit market has been able 5.3 EUROCURRENCY DEPOSITS
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67 to grow dramatically as the global financial system has become more
linked and deregulated over the past few decades, with many nations first
removing capital controls before allowing foreign banks to participate in
domestic banking sectors.
Due to its simplicity of conversion and lack of domestic trading
constraints, the eurocurrency market is a significant sou rce of funding for
international trade. Similar banks participate in both the eurocurrency and
eurocredit markets, but the loans offered on the eurocredit market are
often bigger and have longer terms. The eurocredit market has been able
to grow dramatical ly as the global financial system has become more
linked and deregulated over the past few decades, with many nations first
removing capital controls before allowing foreign banks to participate in
domestic banking sectors.
Eurocredit supports both domesti c and international investment finance as
well as the movement of capital across nations. Matching surplus units
(who deposit money at the bank) with deficit units is a key responsibility
of banks (who borrow from the bank). The ability to do this
internat ionally, across national boundaries and between different
currencies, increases the liquidity and efficiency of the finance markets. In
the eurocredit market, banks may also participate in syndicated loans, in
which a loan is made by a collection (syndicat e) of banks. Syndicated
loans are frequently used when the loan amount is too large for one bank
to handle on its own and lower the risk of borrower default for each
individual bank lending money.The fact that the banks in a syndicate
frequently have diffe rent nationalities while lending in the same currency
is an illustration of how the eurocredit market might help to increase the
flow of money across borders.
EUROCURRENCY BONDS :
A financial instrument known as a "Eurobond" is one that is issued on a
mark et or in a nation where the native currency is not used. The currency
in which eurobonds are denominated, such as euro -dollar or euro -yen
bonds, is frequently used to categorise them. Eurobonds are frequently
referred to as foreign bonds because they are i ssued in a different
currency. Eurobonds are significant because they enable businesses to
raise cash while providing the option to issue them in different currencies.
Eurobonds are typically issued on behalf of the borrower by a global
syndicate of financ ial institutions, one of which may underwrite the bond
and therefore guarantee the sale of the entire issuance.
A financial instrument known as a "Eurobond" is one that is issued on a
market or in a nation where the native currency is not used. Eurobonds a re
significant because they enable businesses to raise cash while providing
the option to issue them in different currencies. The term "Eurobond"
simply means that the bond was issued outside of the country that issued
the currency; it does not imply that the bond was issued in Europe.
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68 Due to its great degree of flexibility, which allows issuers to select the
country of issuance based on the regulatory environment, interest rates,
and market depth, Eurobonds are quite popular as a financing vehicle.
They a re particularly appealing to investors since they typically have low
face values or par values, making them inexpensive to buy in.
Additionally, because of their high liquidity, Eurobonds are simple to buy
and sell.
The name "Eurobond" merely refers to the fact that the bond was issued
outside of the nation that established the currency; it does not imply that
the bond was issued in Europe or that it was priced in the euro. A business
could, for instance, issue a US dollar -denominated Eurobond in Japan.
The organization that oversaw Italy's national railroads, Autostrade, issued
the initial Eurobond in 1963. A $15 million Eurobond was created by
bankers in London, issued at Schiphol Airport in Amsterdam, and paid for
in Luxembourg to lower taxes. It offered secure investments in dollars to
investors across Europe. The spectrum of issuers includes multinational
businesses, independent states, and supranational organizations.
Even while the majority of bonds have a duration of less than 10 years, a
single bond offering can have a size of well over a billion dollars and have
maturities ranging from five to thirty years. Eurobonds provide investors
with diversification while being particularly appealing to issuers
headquartered in nations without significant capit al markets.
EUROCURRENCY NOTES :
The banknotes come in two series. Seven different denominations make
up the first series: 5, 10, 20, 50, 100, 200, and 500 euros. The €100 and
€200 were released on May 28, 2019, bringing the second series, often
known as t he Europa series, to a close. The 500 euro banknote was not a
part of the Europa series and has been discontinued as of April 27, 2019.
The Europa series of notes is gradually replacing the first series, which
was first released in 2002. In the whole euro zone, all notes are accepted
as legal money.
When a business or person deposits money in a bank that is not in their
country of residency, this is referred to as offshore banking. Many
offshore banks are actually found in onshore regio ns, such as Panama,
Luxembourg, and Switzerland, despite the fact that the word indicates that
these banks are situated on islands. The benefit of offshore banking is that
monies are frequently excluded from taxes where the institutions are
situated. While offshore banks usually provide more secrecy than
"onshore" banks do, they also provide the same services as domestic
banks.
Banks that were founded on the British Channel Islands, off the coast of
northwest France, are where the phrase "offshore bank" fir st appeared. In
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69 havens. Many countries where offshore banks are based currently do not
tax deposits. Private banking is another name for offshore banking.
The same services that an o nshore bank offers are also offered by an
offshore bank. It is a place where savings can be deposited, and it also
offers its customers investing services. To open an account, a depositor
does not need to physically visit. Offshore banks commonly open acco unts
based on certified verification of the person's identity and assets because
they are situated in locations that would require extensive travel periods.
Accounts can be opened for sizable deposits through onshore
intermediaries in the depositor's count ry of residence.
Off shore banks are frequently found in places where gains and deposits
are subject to little or no taxation. They also provide a certain level of
secrecy, protecting assets from being examined or seized by tax officials
in the depositor's country of origin. Offshore banks are subject to less
regulation because they either function as standalone financial institutions
or as a component of larger firms with onshore operations in other nations.
Offshore banks also provide a benefit by giving depositors who reside in
nations with unstable political conditions a safe and secure location to
store their assets.
In a politically and economically secure climate, a tax haven is a nation
that gives foreign firms and individuals little to n o tax liability for their
bank accounts. They provide tax benefits for businesses and the very rich,
and it is clear that they might be abused in nefarious tax avoidance
schemes. Tax havens can be used legally by businesses and rich people to
store money g enerated abroad while avoiding paying higher taxes in the
US and other countries.
Tax havens may also be utilized unlawfully to conceal money from
domestic tax authorities. This can be accomplished by the tax haven
cooperating poorly with foreign tax offi cials. Recent years have seen an
increase in the political pressure on tax havens to assist with investigations
into international tax evasion.
By giving firms and the wealthy tax breaks, tax havens attract
international depositors. Many countries have con fidentiality rules that
prevent foreign tax officials from learning about their deposits. As long as
the depositor pays the taxes that the depositor's own country requires,
depositing money in a tax haven is acceptable.
In general, tax havens are places wh ere people and foreign companies that
want to deposit money in their financial institutions can do so with no
residency requirements and very low taxes. Corporations and individuals
can hide some of their revenue from tax authorities in foreign countries
thanks to a combination of loose regulations and secrecy rules.
The Tax Justice Network keeps track of the nations that it deems to be
"most involved" in aiding multinational businesses in tax evasion through TAX HAVENS :
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70 the Corporate Tax Haven Index. Bermuda, the Caym an Islands, and the
British Virgin Islands had the worst records as of 2021. Tax havens might
be found abroad or simply in a different jurisdiction.
5.5 SUMMARY
 Eurocurrency : This is money that is kept on deposit by organizations
or governments that do bu siness abroad. For instance, a deposit of US
dollars (USD) maintained in a British bank or a deposit of British
pounds (GBP) placed in the US would both be regarded as examples
of eurocurrency.
 Euro deposits : Money put in a European account is known as a euro
deposit. These deposits enable individuals from other countries to
invest in euros and earn interest at a rate established by the European
Central Bank (ECB).
 Eurocurrency Bonds : A Eurobond is a debt instrument that is issued
in a country or market b ut is not issued in the home currency of that
country or market.
 Offshore banking : Offshore banking is the practice of a business or
individual depositing money in a bank that is situated outside of their
country of residence.
 Tax Haven : In a politically and economically stable climate, a tax
haven is a nation that gives international corporations and individuals
little to no tax responsibility for their bank deposits.
5.6 QUESTIONS
1. Explain the Origin of Eurocurrency Markets.
2. Describe the Characteristics of Eurocurrency Markets.
3. Explain the Eurocurrency loans.
4. Explain the Eurocurrency Deposits.
5. Discuss in detail Tax Haven?
6. Explain the term Eurocurrency.
7. Explain the term Offshore Banking.
8. Explain the term Tax Haven with example.
9. Explain the term Euro depos its.
10. Explain the term Euro Bonds.

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71 11. Fill in the Blanks:
1. _______banking refers to the deposit of funds by a company or
individual in a bank that is located outside their national
residence.
2. A ______ is a country that offers foreign businesses and individu als
minimal or no tax liability for their bank deposits in a politically
and economically stable environment.
3. _______ is currency held on deposit by governments or
corporations operating outside of their home market. For example,
a deposit of U.S. dollars (USD) held in a British bank would be
considered eurocurrency, as would a deposit of British Pounds
(GBP) made in the United States.
4. _________ are funds deposited in a European account. These
deposits allow foreign citizens to invest in euros, collecting o n the
interest rate set by the European Central Bank (ECB).
5. A ________ is a debt instrument that's denominated in a currency
other than the home currency of the country or market in which it
is issued.
5.7 REFERENCES
 International Financial Management book (Seventh Edition) by Cheol.
S. Eun and Bruce. G. Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 JeffMadura, International Financial Management
 Siddaiah, International Financial Management : An Analytic
Framework
 www.ecb.europa.eu
 www.pocketsense.com
 www.bms.co.in
 www.benchpartner.com
 www.investopedia.com
 www.cleartax.in

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72 6
INTERNATIONAL EQUITY MARKETS
Unit Structure :
6.0 Objectives
6.1 Global Depository Receipts and American Depository Receipts
6.2 Foreign currency convertible bonds
6.3 Foreign Direct Investments and Foreign Portfolio Investments
6.4 Participat orynotes
6.5 Summary
6.6 Questions
6.7 References
6.0 OBJECTIVES
 To study Global Depository Receipts (GDR) and American Depository
Receipts (ADR).
 To understand the Foreign Currency Convertible Bonds.
 To study Foreign Direct Investment (FDI) and Foreign Por tfolio
Investment (FPI).
 To study Participatory Notes.
6.1 GLOBAL DEPOSITORY RECEIPTS (GDRs) AND
AMERICAN DEPOSITORY RECEIPTS (ADRs)
GLOBAL DEPOSITORY RECEIPTS (GDRs):
A depositary bank will issue a financial instrument known as a global
depositary receipt (GDR). It is traded on the national stock exchanges of
investors' home countries and represents shares of a foreign corporation.
With the aid of GDRs, a business (the issuer) can connect with investors
on international capital markets. Issuers frequently use GDRs when raising
money from foreign investors through private placements or initial public
offerings of stock. The difference between an American depositary receipt
(ADR) and a worldwide depositary receipt is that an ADR exclusively lists
shares of fo reign companies on U.S. marketplaces.
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73 A tradable financial security is a global depositary receipt. It is a share -
representation certificate that trades on two or more international stock
markets. GDRs generally trade on American stock exchanges in additi on
to those in the Eurozone or Asia. The local currency of the markets where
the GDRs are traded is used to determine the price of GDRs and their
dividends. GDRs offer American and worldwide investors a simple way to
buy foreign stocks.
An worldwide compan y's equity is represented by a sort of bank certificate
known as a global depositary receipt. The shares that support the GDR are
still held in escrow by a depositary bank or custodial organization. Global
investors residing overseas can invest in the shar es of an international firm
using GDRs, even though those shares trade as domestic shares in the
nation where the company is headquartered. Companies can raise money
from investors in several nations using GDRs.
The GDRs will be issued in those investors' home nation currencies.
Because GDRs are tradable certificates that may be negotiated, they can
offer investors chances for arbitrage. When European investors want to
trade shares of non -European businesses locally, they typically refer to
GDRs as European Depositary Receipts, or EDRs. GDR transactions
typically cost less than alternative methods by which investors can trade
foreign securities.
EXAMPLE OF GDR :
A GDR can be used by a U.S. -based corporation to list its stock on the
London and Hong Kong Stock Exchanges. With each of the foreign
depositary banks, the American business engages into a depositary receipt
arrangement. To their respective stock exchanges, these banks then
package and issue shares. Both countries' regulatory compliance standards
are adhered to in these activities.
ADVANTAGES OF GDRs:
 GDRs can potentially boost share liquidity while assisting foreign
enterprises in reaching a wider and more varied audience of potential
investors.
 Businesses are able to carry out a private offering effe ctively and
affordably.
 An otherwise unknown foreign company's status or legitimacy may
grow if its shares are listed on significant international markets.
 GDRs give investors the chance to diversify their investments abroad.
 Investors don't have to pay cr oss-border custody or safekeeping fees,
and GDRs trade, clear, and settle in accordance with the investor's
domestic processes and procedures.
 GDRs are more convenient and less expensive than setting up
international brokerage accounts and buying stocks o n foreign
marketplaces.
 Any dividends and capital gains are realized by GDR holders in U.S.
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74 DISADVANTAGES OF GDRs:
 Dividend payments are made after deducting currency translation costs
and foreign taxes, which are automatically withheld by the dep ositary
bank.
 GDRs may have considerable administrative fees.
 In order to prevent paying taxes twice on capital gains achieved, U.S.
investors may need to request a credit from the Internal Revenue
Service (IRS) or a refund from the foreign government's t axing body.
 The value of GDRs could change in response to actual events in the
foreign country, such as a recession, financial collapse, or political
upheaval.
 GDRs have the potential to have poor liquidity, making them difficult
to sell. They can also hav e currency risk and political risk.
AMERICAN DEPOSITORY RECEIPTS (ADRs):
Although foreign equities can be traded directly on a national stock
exchange, they are typically traded as depository receipts. For instance,
Yankee stock issuance frequently trade a s American Depository Receipts
on U.S. exchanges (ADRs). An ADR is a receipt that represents a number
of foreign shares that are kept on deposit with the custodian of the U.S.
depository in the home market of the issuer. For the ADRs, which are
traded on A merican listed exchanges or in the OTC market, the bank acts
as the transfer agent.
The first ADRs went on the market in 1927 as a way to reduce some of the
dangers, hold -ups, difficulties, and costs associated with dealing the actual
shares. 396 ADRs wer e traded on U.S. listed exchanges as of the end of
2012.
On the American OTC market, many hundred more ADRs are traded. The
Singapore Stock Exchange is also where Singapore Depository Receipts
are traded. Using Global Depository Receipts (GDRs), a foreign company
can cross -list at the same time on various national exchanges. The London
and Luxembourg stock markets both provide GDR trading. The DR
market has expanded dramatically over time; as of year -end 2012, there
were 3,678 DR programs trading on interna tional exchanges, representing
issuers from 82 different nations.
Compared to transacting directly in the underlying stock on the foreign
exchange, ADRs provide significant benefits for U.S. investors. ADRs are
also available to non -U.S. investors, who typ ically choose to do so
because to the investing benefits over purchasing the underlying stock.
ADVANTAGES OF ADRs:
 ADRs are available for purchase through the investor's usual broker
and are traded on a U.S. stock exchange with a dollar equivalent.
Contrar ily, in order to trade the underlying shares, the investor would
most likely need to: open an account with a broker from the nation
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75 make arrangements for the delivery of the stock certificat es or the
creation of a custodial account.

 In contrast to investments in the underlying shares, which require the
investor to collect foreign dividends and do currency conversions,
dividends received on the underlying shares are collected and
converted to dollars by the custodian and paid to the ADR investor.
Additionally, tax agreements between the United States and some
nations reduce the rate of dividend tax that nonresident investors must
pay. Due to this, American shareholders of the underlying shares must
submit a form to request a refund of the tax difference withheld.
However, ADR holders only receive the appropriate taxes and not the
whole dollar equivalent dividend.

 Similar to U.S. stocks, ADR trades settle in three business days, but
settlement procedures for the underlying stock differ elsewhere.

 ADR price quotes are given in USD.

 While the majority of underlying equities are bearer securities, ADRs
(apart from Rule 144A issues) are registered securities that offer
ownership rights protection.

 The depository receipt for an ADR investment can be traded to another
investor on the U.S. stock market, or the underlying shares can be sold
on a regional stock exchange. In this instance, the ADR is delivered to
the bank depository for cancellation, an d the buyer receives the
underlying shares as a result.

 In order for the ADR to trade in a price range that is typical for
American investors, ADRs usually represent a multiple of the
underlying shares rather than a one -to-one correspondence. Depending
on the value of the underlying shares, a single ADR may represent
more or less than one underlying share.

 ADR holders instruct the depository bank on how to exercise voting
privileges connected to the underlying shares. Absent specific
instructions from the ADR holders, the depository bank does not
exercise its voting rights.
TYPES OF ADRs:
ADRs come in two varieties: Sponsored and Unsponsored.

1. At the request of the foreign firm that issued the underlying
instrument, a bank will generate sponsored ADRs. The sponsoring
bank frequently provides ADR investors with a range of services,
including investment advice and English translations of some annual
report sections. The only ADRs that can be listed on American stock
exchanges are sponsored ADRs. New ADR initi atives require
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76 2. Unsponsored ADRs were typically issued at the request of a U.S.
investment banking business without the direct involvement of the
foreign issuing corporation; some of these documents date back to
before 1980 still exist. As a re sult, the foreign firm may not quickly or
regularly furnish financial reports or investment information to the
depository. The foreign company covers the depository fees for
sponsored ADRs. On unsponsored ADRs, depository costs are paid by
ADR holders. Uns ponsored ADRs may have multiple issuing banks,
with each bank's offering terms being unique. Typically, the only
ADRs that trade on NASDAQ or the major stock exchanges are
sponsored ADRs.




A convertible bond that i s issued in a currency other than the issuer's home
currency is known as a foreign currency convertible bond (FCCB). In
other words, the issuing corporation is raising money through the sale of
foreign currency. A product that combines debt and equity is k nown as a
convertible bond. Regular principal and coupon payments are made, and
while it functions like a bond, these bonds also allow the bondholder the
opportunity to convert the bond into stock.

A type of bond that is issued in a currency other than th e issuer's native
currency is known as a foreign currency convertible bond (FCCB). With
the ability to be converted into stock, convertible bonds operate as a
middle ground between debt and equity financial products. Large,
international corporations with locations all over the world frequently list
these bonds when they need to raise cash in different currencies.

A bond is a type of debt security that offers investors income in the form
of periodic interest payments known as coupons. The bond's full -face
value is returned to the investors on the bond's maturity date. Convertible 6.2 FOREIGN CURRENCY CONVERTIBLE BONDS
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77 bonds are a form of bond that some corporate organizations issue.A
convertible bond's option to be converted into a predetermined number of
shares of the issuing business is availa ble to bondholders.

Bonds that are convertible into equity have a conversion rate that must be
met. The bond won't be converted, though, if the stock price remains
below the conversion price. As a result, convertible bonds enable
bondholders to join in th e growth of the underlying shares of the issuer.
The foreign currency convertible bond is one of many different varieties
of convertible bonds.

An FCCB is a convertible bond that was issued in a foreign currency,
meaning that the principal repayment and p eriodic coupon payments will
also be payable in a foreign currency. As an illustration, an American
listed firm has effectively issued an FCCB when it issues a bond in India
in rupees. Multinational corporations that operate internationally and are
looking to raise cash in foreign currencies frequently issue foreign
currency convertible bonds. Investors in FCCBs are frequently foreigners
and hedge fund arbitrators. These bonds may also include put options or
call options, the latter of which gives the bond issuer the right to redeem
the bonds (whereby the right of redemption lies with bondholder).

A business may choose to raise capital outside of its own nation in order to
access new markets for brand -new or expansionary projects. Companies
typically issue FCCBs in the currencies of those nations where interest
rates are typically lower than in the country of residence or where the
foreign economy is more stable than the domestic economy. The coupon
payments on the bond are lower for the issuer than a straig ht coupon -
bearing plain vanilla bond, which lowers its debt -financing costs because
the equity side of the bond provides value. Furthermore, a positive shift in
exchange rates can lower the issuer's cost of debt, which is the interest
paid on bonds.

Due t o the fact that the principle must be returned at maturity, an
unfavourable shift in exchange rates that weakens the local currency could
result in payback cash outflows that are greater than any interest rate
savings, resulting in losses for the issuer. F urthermore, when issuing
bonds in a foreign currency, the issuer is subject to all political, economic,
and legal risks that exist in that nation. Additionally, FCCB investors
won't convert their bonds into equity if the issuer's stock price falls below
the conversion price, forcing the issuer to repay the principal at maturity.

These bonds are available for purchase at stock exchanges by FCCB
investors, who can choose to convert the bonds into equity or a depositary
receipt at a later date. By converting the bond to equity, investors can
benefit from any increase in the value of the issuer's shares. Bonds that are
tied to warrants that are activated when the stock price reaches a specific
level allow bondholders to profit from this appreciation.

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78 6.3 FOREI GN DIRECT INVESTMENTS AND FOREIGN
PORTFOLIO INVESTMENTS

FOREIGN DIRECT INVESTMENT (FDI):

An ownership stake in a foreign company or project is known as a foreign
direct investment (FDI) and is made by a foreign investor, business, or
government. Typicall y, the phrase refers to a corporate decision to buy a
sizable portion of a foreign company or to buy it altogether in order to
expand operations to a new area. The phrase is typically not used to refer
to a stock purchase in a single overseas firm. FDI is a crucial component
of global economic integration since it forges strong, long -lasting ties
between nations' economy.

Foreign direct investments (FDIs) are sizeable, long -term investments
made into a foreign enterprise by a company or a government. Inves tors in
foreign direct investment (FDI) frequently hold controlling positions in
domestic businesses or joint ventures and actively participate in their
management. The investment could entail purchasing a material supply,
growing a business's reach, or es tablishing a global presence. Over the
past few years, China and the United States have been the major recipients
of FDI. The top contributors to FDI outside of their own boundaries have
historically been the United States and other OECD nations.

Target b usinesses or projects in open economies that have a trained
workforce and above -average development potential for the investor are
typically taken into consideration by businesses or governments seeking a
foreign direct investment (FDI). The value of minim al government
regulation is also common. FDI typically involves more than just capital
expenditures. It might also entail the provision of management,
technology, and tools. The fact that foreign direct investment develops
effective control over the foreig n company, or at the very least significant
influence over its decision -making, is one of its key characteristics.

With more than $1.8 trillion in foreign direct investments expected to be
made in 2021, the net quantities of money involved with FDI are
enormous. In that year, China, Canada, Brazil, and India were the other
leading FDI destinations after the United States. The United States was
also in first place for FDI outflows, followed by Germany, Japan, China,
and the United Kingdom.

A nation's appea l as a long -term investment destination can be determined
by looking at FDI inflows as a share of its gross domestic product
(GDP).In nominal terms, the Chinese economy is now smaller than the
American one, however as of 2020, China's FDI as a proportion o f GDP
was higher than that of the US at 1.7%. FDI as a proportion of GDP is
frequently substantially higher for smaller, more active economies:
examples include 110% for the Cayman Islands, 109% for Hungary, and
34% for Hong Kong (also for 2020).
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79 Opening a subsidiary or associate firm abroad, buying a controlling stake
in an existing overseas business, merging with another foreign business, or
forming a joint venture are all examples of ways to make foreign direct
investments. According to rules establishe d by the Organisation for
Economic Co -operation and Development (OECD), a minimum 10%
ownership position in a firm with a foreign basis is required for an FDI to
establish a controlling interest. That description is open -ended. In some
circumstances, obtai ning less than 10% of the voting shares of a
corporation can result in the establishment of an effective controlling stake
in it.
TYPES OF FDI :
Horizontal, vertical, and conglomerate categories are frequently used to
describe foreign direct investments.
 A corporation establishes the same kind of business activity in a
foreign country as it does in its own with a horizontal FDI.

 In a vertical FDI, a company purchases a complementary firm in
another nation, like in the case of a U.S. -based cell phone carri er
purchasing a chain of phone stores in China. For instance, a US
business may buy stock in a foreign firm that provides it with the raw
resources it requires.

 A company invests in a foreign business that is unrelated to its primary
business in a conglom erate FDI. This frequently takes the form of a
joint venture because the investing business has no prior experience in
the field of expertise of the foreign company.
EXAMPLES OF FDI :
Mergers, acquisitions, or joint ventures in the retail, service, logisti cs, or
manufacturing sectors may be part of foreign direct investments. They
point to a global business expansion plan. They may also encounter
regulatory issues. For instance, the U.S. business Nvidia announced in
2020 that it would buy the British chip d esigner ARM. The U.K.'s
competition authority stated in August 2021 that it will look into whether
the $40 billion transaction would lessen competition in sectors that depend
on semiconductor processors. The agreement was terminated in February
2022.
ADVAN TAGES OF FDI:
1. Economic boost : The creation of jobs is one of the most important
factors in a country (especially a developing country) attracting
foreign direct investment. FDI boosts the manufacturing and service
sectors, which boosts employment and lowe rs unemployment rates in
the respective nation. Increased employment boosts salaries and gives
the populace more purchasing power, boosting the economy as a
whole.
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80 2. The expansion of human capital : Human capital refers to the
knowledge and survival of any worker. The education system and
human capital of a nation can be improved by the diverse talents that
employees acquire through diverse training and practices. It assists in
educating individual resources in different fields, trades, and
businesses over t ime.

3. A rise in exports : Many FDI -produced goods have international
markets and are not just based on home demand. The creation of
divisions that are entirely focused on exports assists FDI investors in
promoting exports from other foreign nations.

4. Advan ced Capital Flow : The capital inflow is particularly
advantageous for nations with limited domestic resources and little
opportunities to issue equities on the international capital market.

5. Competitive Market : FDI encourages the development of a
competi tive environment and destroys domestic trust by encouraging
the entry of foreign companies into domestic markets.
DISADVANTAGES OF FDI :
1. Domestic investment impediment : FDI can occasionally obstruct
domestic investment. Local firms in countries start to b ecome less
interested in financing their family assets as a result of FDI.

2. Negative exchange valuations : It is uncommon for foreign direct
investments to have an adverse impact on exchange rates, favoring one
nation while harming another.

3. Higher costs : When investors finance enterprises in other nations,
they could observe higher costs compared to domestic exports. Often,
more money is spent on intellectual and mechanical resources than on
local workers' wages.

4. Financial non -viability : Although foreig n direct investments may be
capital -intensive from the perspective of investors, they can
occasionally be extremely risky or unreliable from an economic one.

5. Modern commercial colonialism : Third -world nations with a
colonial past are frequently concerned that foreign direct investment
would lead to modern economic colonialism, exposing host nations
and leaving them defenseless against persecution by multinational
corporations.
FOREIGN PORTFOLIO INVESTMENT (FPI):
Securities and other financial assets he ld by investors in another country
make up foreign portfolio investment (FPI). Depending on the turbulence
of the market, it is relatively liquid but does not provide the investor direct
ownership of a company's assets. FPI is one of the popular ways to in vest
in a foreign economy, along with foreign direct investment (FDI). For the
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81
Holding financial assets from a nation other than the investor's own is
referred to as a foreign por tfolio investment (FPI). Stocks, ADRs, GDRs,
bonds, mutual funds, and exchange -traded funds are all examples of
possible FPI holdings. FPI, along with foreign direct investment (FDI), is
one of the popular ways for investors, particularly individual invest ors, to
engage in a foreign economy. FPI, in contrast to FDI, comprises of passive
ownership; investors don't have any direct influence over businesses,
ownership of real estate, or ownership interests in companies.

Making and keeping a hands -off, or pass ive, investment in a portfolio of
assets is done with the hope of getting a return. Stocks, American
depositary receipts (ADRs), or global depositary receipts of companies
with headquarters outside of the investor's country are examples of
securities that can be included in a foreign portfolio investment. Holding
also includes mutual funds or exchange traded funds (ETFs) that invest in
foreign or international assets, as well as bonds or other debt issued by
these businesses or foreign governments.

The lik elihood of an individual investor using an FPI to invest in
possibilities located outside of their home nation is high. On a larger scale,
a country's foreign portfolio investment is reflected on its balance of
payments as part of its capital account (BOP) . The BOP calculates the
amount of money that moves from one nation to another throughout a
single fiscal year.
EXAMPLE OF FPI :
In terms of FPI, 2018 was an excellent year for India. The number of
investment funds registered with the Securities and Exchan ge Board of
India (SEBI) increased by more than 600, reaching 9,246 in total. The
interest of international investors was sparked, in part, by a more
favourable regulatory environment and the recent great performance of
Indian shares.
ADVANTAGES OF FPI:
1) The emergence of such investors has resulted in a significant growth in
the depth and breadth of the secondary market.

2) The Capital Market takes on an institutional quality due to the
deliberate channeling of global money into local markets through
research and analytical studies. Against predetermined risk parameters,
these monies were transferred into different assets.

3) By increasing demand for the target companies' shares, these
investments raise their PE Ratios. This enables these businesses to
raise fin ancing more affordably.

4) A channel for investment diversification, wealth protection, and at a
macro level, a chance for cross -country hedging in terms of currencies,
industries, and geographical locations are made available to
international investors.
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82 5) Better investor protection laws in developing nations, liberalised
access to these markets, and improved macroeconomic fundamentals
in emerging economies can all be credited with the rise in FPI in
recent years.

6) They act as a safety net for financing the Ba lance of Payments deficits,
assisting in the maintenance of the host entry's foreign exchange
reserves.
DISADVANTAGES OF FPI :
1) Political risk is the potential for a change in the political climate,
which might alter investment standards and repatriation la ws.

2) Low retail involvement leads to insufficient liquidity, which causes
price volatility in emerging markets, which benefit from the majority
of FPI.

3) As a result of their unpredictability, these funds have a propensity to
switch markets frequently. Vola tility brought on by FPI inflows and
outflows has a negative impact on the economy of the host nation.

4) Emerging economics tend to have depreciation prone currencies. This
exposes theforeign investor to exchange rate risk on both principal and
returns.
COM PARISON CHART: FDI VS FPI:
BASIS FOR
COMPARISON FDI FPI
Meaning FDI refers to the
investment made
by the foreign
investors to obtain
a substantial
interest in the
enterprise located
in a different
country. When an international
investor, invests in the
passive holdings of an
enterprise of another
country, i.e.
investment in the
financial asset, it is
known as FPI.
Role of investors Active Passive
Degree of control High Very less
Term Long term Short term
Management of
Projects Efficient Comparatively l ess
efficient.
Investment in Physical assets Financial assets
Entry and exit Difficult Relatively easy.
Results in Transfer of funds,
technology and
other resources. Capital inflows
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83 Investors or hedge funds must use participato ry notes, often known as P -
notes or PNs, in order to purchase Indian shares without first registering
with the Securities and Exchange Board of India (SEBI). P -notes are one
of the investments that are categorised as offshore derivative investments
(ODIs). The investors receive any dividends or capital gains generated by
the securities. Because they worry that hedge funds using participation
notes may produce economic instability in India's exchanges, Indian
regulators generally oppose participatory notes.
The Securities and Exchange Board of India (SEBI) requires brokers and
foreign institutional investors (FIIs) to register. Non -registered investors
are able to invest in the Indian market thanks to participatory notes.
Participatory notes, often known as P -notes or PNs, are derivative
financial products with Indian assets as their base. Investing in
participatory notes is popular since it keeps the investor's identity secret.
Participatory notes are foreign derivative products that have Indian shares
as the ir underlying assets. Regulators have fewer rules for foreign
institutional investors because investment is short -term in nature. These
investors exchange participation notes in order to invest in the Indian
stock markets and sidestep the onerous regulator y approval procedure.
Investors from foreign nations who desire to purchase Indian assets are
issued the financial instruments by (FIIs). The participatory notes are
issued by brokers and foreign institutional investors that have registered
with the Securi ties and Exchange Board of India (SEBI) and invest on
behalf of foreign investors. Brokers are required by the regulating body to
disclose their participatory note issuance status once a month.
High -net-worth individuals, hedge funds, and other investors c an
purchase Indian shares through this technique without having to register
with the Indian regulatory agency. They give people access to rapid cash
on the Indian stock market. Investors benefit from direct registration's
time, cost, and reduced scrutiny. Due to the fact that they permit foreign
investment into India, these investments are also advantageous to that
nation.
Participatory note trading is not under the purview of SEBI. The
participation notes trade among foreign institutional investors is not
documented, despite the fact that foreign institutional investors are
required to register with the Indian regulatory board. Officials worry that
this technique could result in the P -notes being used for unlawful
purposes like money laundering.
The Special Investigation Team (SIT) wants stronger compliance
standards for the selling of participatory notes because of this inability to
track money. In Indian law enforcement, the SIT is a specialist squad of
officers made up of people who have received training in conducting
investigations into significant offences. 6.4 PARTICIPATORY NOTES
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84 However, the Indian market became incredibly turbulent in the past when
the government put trade limits on the notes. For instance, the
government declared it was considering limiting participation n ote
trading in October 2007. The announcement resulted in a loss of 1,744
points, or more than 8%, on the Sensex index during the day's trading.
Investor and government concerns that the P -note ban would have a
negative impact on the Indian economy led to this market disturbance.
This is due to the fact that greater regulation would make it harder for
foreign capital to enter the market. Foreign institutional investors fuel the
expansion of the Indian economy, industries, and capital markets. In the
end, th e government decided against regulating participatory notes.
Through a series of processes, investors can buy any Indian security they
like using P -notes. An investor deposits money with a registered foreign
institutional investor (FII), such HSBC or Deuts che Bank, in the U.S. or
Europe. Next, the investors let the bank know which Indian security or
securities they want to buy. The investor transfers money to the FII
account, and the FII then issues the client participatory notes and
purchases the underlyin g stock or equities in the appropriate amounts
from the Indian market.
Any dividends, capital gains, or other payments payable to stockholders
who own shares of the Indian firm may be received by the investor. Each
month, the FII discloses all of its issua nces to the Indian regulators;
however, by law, it is not required to reveal who the real investor is.
The Securities and Exchange Board of India (SEBI) introduced
participant notes in India in 2000 to give foreign investors —financial
institutions and high -net-worth individuals —access to the country's
financial markets without the need to first register as foreign institutional
investors (FII). Overseas institutional investors (FIIs), who are local
Indian investors, issue P -notes to foreign investors lookin g to access
Indian markets. The P -notes are not traded on an exchange; instead, they
are sold directly to investors.
When opening an account with a registered foreign institutional investor,
foreign investors do have to go through a due diligence procedure (FII).
Participatory notes are legitimate in India, but the Securities and
Exchange Board of India (SEBI) has no direct authority over them.
Nevertheless, SEBI has made an effort to regulate the market by
imposing various restrictions on the sale of parti cipatory notes by foreign
institutional investors (FII) in India.
6.5 SUMMARY
 GDRs : A tradable financial security known as a global depositary
receipt. It is a share -representation certificate that trades on two or
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85  ADRs : An ADR is a receipt that is deposited with the custodian of
the U.S. depository in the issuer's home market and represents a
number of foreign shares.
 Foreign direct investment (FDI) : An investor, business, or
government from another nation makes an owne rship position in a
foreign enterprise or project .
 Foreign portfolio investment (FPI) : Securities and other financial
assets held by investors in another nation make up foreign portfolio
investment (FPI).
 Participatory notes : Investors or hedge funds mus t use participatory
notes, often known as P -notes or PNs, in order to participate in Indian
shares without first registering with the Securities and Exchange
Board of India (SEBI).
6.6 QUESTIONS

 Explain the American Depository Receipts in detail.
 Explain the Global Depository Receipts in detail.
 Explain FDI with its advantages and disadvantages.
 Explain FPI with its advantages and disadvantages.
 What are Participatory Notes?
 ________ is a tradable financial security. It is a certificate that
represents sh ares in a foreign company and trades on two or more
global stock exchanges.
 ________ is a receipt representing a number of foreign shares that
remain on deposit with the U.S. depository’s custodian in the issuer’s
home market.

 _______ is an ownership stak e in a foreign company or project made
by an investor, company, or government from another country.
 ________ consists of securities and other financial assets held by
investors in another country.
 _______ also referred to as P -notes, or PNs, are financial instruments
required by investors or hedge funds to invest in Indian securities
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86 6.7 REFERENCES

 International Financial Management book (Seventh Edition) by Cheol.
S. Eun an d Bruce. G. Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 JeffMadura, International Financial Management
 Siddaiah, International Financial Management : An Analytic
Framework
 www.i nvestopedia.com
 www.keydifference.com
 www.aplustopper.com
 www.bms.co.in

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87 7
INTERNATIONAL DEBT MARKETS
Unit Structure :
7.0 Objectives
7.1 Introduction
7.2 International Bond Markets
7.3 Features of Foreign Bonds
7.4 Features ofEuroBonds
7.5 Risksin International Bonds
7.6 Summary
7.7 Questions
7.8 References
7.0 OBJECT IVES
 To understand the International Bond Markets.
 To study the Features of Foreign Bonds.
 To study the Features of Euro Bonds.
 To understand the Risks involved in International Bonds.
7.1 INTRODUCTION
With an emphasis on the global bond market, this chapt er continues the
topic of global capital markets and institutions. The chapter is intended to
be helpful for both foreign investors interested in international fixed -
income instruments and the financial officer of an MNC looking to source
fresh debt capita l on the global bond market. The meanings of the terms
used to define the international bond market are provided in the next
section. The factors that set these market segments apart as well as the
various kinds of bond instruments traded in them are furth er discussed in
the ensuing discussion.
The foreign bond market increased rapidly starting in the 1980s. It
currently makes up a sizable portion of the overall amount of bonds
outstanding on the global bond market. Bonds that a re exchanged across
international borders are traded on the international bond market. They 7.2 INTERNATIONAL BOND MARKETS munotes.in

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88 bring together investors from various nations. International bonds are the
bonds that are traded on global bond markets. These bonds are typically,
but not always, issued in the issuer's own currency. In actuality, that
depends on where the intended subscription is.In this case, the issuer may
issue bonds with US dollars or euros as the unit of currency. Additionally,
just like most other bond kinds, foreign bonds pa y interest at regular
intervals and return the principal to the holder when the bond matures.
Foreign bonds and Eurobonds are the two primary market groups that
make up the global bond market. A foreign bond issue is a bond that is
sold to investors in a n ational capital market by a foreign borrower and is
priced in that country's currency. An illustration would be a German MNC
selling bonds to American investors denominated in dollars. A bond issue
with a euro denominator is one that is traded on a nationa l capital market
outside of the nation that issued the currency.
An illustration would be a Dutch borrower issuing bonds denominated in
dollars to investors in the Netherlands, the United Kingdom, and
Switzerland. The domestic national bond markets coexist with the markets
for foreign bonds and Eurobonds, and all three market groupings engage
in rivalry with one another. The sale of bonds by non -Japanese Asian
issuers through Asian syndication, often with bonds valued in U.S. dollars,
is known as the "Drago n bond" market. You might think of this market as
a subsection of the Eurobond market.
Governments, traders, institutional investors, and individuals all
participate in the global bond market. The foreign bond market has less
liquidity, though, for bonds. And as a result, a significant portion of them
are held by institutional investors like pension funds, mutual funds, etc.
The ICMA estimates that the global bond market will be worth roughly
$130 trillion in US dollars. Only 32% of the market is made up of
corporate bonds. By using SSA bonds, the rest of the market is covered
(government and government agencies).
Credit rating organisations rate foreign bonds but not Euro bonds when it
comes to international bonds. As a result, in order to draw in investors , the
company issuing the Eurobond must have a high level of confidence. Like
domestic bonds of the issuing nation, foreign bonds are subject to the laws
and regulations of that nation. However, there are no specific national
restrictions that apply to Eur obonds.
7.3 FOREIGN BONDS
When a foreign entity issues a bond in the domestic market's currency to
raise capital, the bond is referred to as a foreign bond. The practise of
issuing foreign bonds, such as bulldog bonds, Matilda bonds, and samurai
bonds, is widespread among international companies that conduct
substantial business on the local market.
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89 A multinational business will issue a foreign bond in a nation other than
their own, denominating it in the currency of that nation. Owning foreign
bonds allo ws domestic investors to diversify their holdings abroad, and
because they are traded on regional exchanges, they are simpler to get.
Nevertheless, there are some implicit and explicit risks related to foreign
bonds, such as the effects of two interest rat es, currency exchange rates,
and geopolitical uncertainty.
Investors find these bonds appealing because they can diversify and add
international content to their portfolios without the increased currency rate
exposure, as foreign bond investors are typical ly domestic investors.
However, there are still some particular dangers associated with holding
foreign bonds. Foreign bonds often have higher yields than domestic
bonds because investing in them entails many risks. There is interest rate
risk with foreign bonds.
The market value or resale value of a bond decreases when interest rates
increase. Let's take the scenario where an investor owns a 4% -paying 10 -
year bond and interest rates rise to 5%. Few investors are interested in
buying the bond without a pric e reduction to make up for the income gap.
Inflation risk also exists for foreign bonds. When purchasing a bond at a
fixed interest rate, the real value of the bond is derived by deducting the
yield for inflation. An investor's true return is the net diffe rence of 3% if
they buy a bond with a 5% interest rate at a period when inflation is 2%.
For foreign bonds, currency risk continues to be an implicit concern.
Exchange rate fluctuations, for instance, might cause the yield on a bond
with a 7% return in a E uropean currency to drop to 2% when converted to
dollars.
Note that this risk is implicit because the price of these bonds would
always be expressed in US dollars. Before making an investment,
investors should think about political risk by evaluating the s tability of the
government issuing the bond, the rules governing its issuance, the
functioning of the legal system, and other considerations. Foreign bonds
have a risk of payback. It's possible that the nation issuing the bond lacks
the resources to pay of f the loan. A portion or the entirety of an investor's
principal and interest may be lost.
Examples of Foreign Bonds:
Only a few of the numerous examples of foreign bonds are included here.
For instance, a foreign bank or company may issue a bulldog bond i n the
United Kingdom in British pounds sterling. These bonds are generally
issued by foreign firms seeking funding in the UK when interest rates
there are lower than those in their own country.
A bond issued in the Australian market by a non -Australian cor poration is
known as a Matilda bond. For instance, Apple Inc. sold $1.4 billion in
notes with maturity dates of June 2020, January 2024, and June 2026 in
June 2016. Apple joined other businesses, including Qantas Airways Ltd.,
Coca -Cola Co., and Asciano Lt d., in selling securities beyond the seven -munotes.in

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90 year threshold that had previously been the upper limit for many
nonfinancial corporate borrowers.
A corporate bond issued in Japan by a non -Japanese corporation is known
as a samurai bond. Samurai bonds, which ha ve a maturity of seven years,
were sold for $1.1 billion in May 2016 by the French bank
SocieteGenerale SA. The transaction came after Bank of America
Corporation's $1.08 billion euro -yen offering earlier in the same month.
Features of Foreign Bonds :

Source: https://image3.slideserve.com/6675888/foreign -bonds -characteristics -l.jpg
7.4 EUROBONDS
The organisation that oversaw Italy's national railroads, Autostrade, issued
the initial Eurobond in 1963. It was a $15 million Eurodollar bond that
was created by bankers in London, issued at Schiphol Airport in
Amsterdam, and paid for with taxes saved in Luxembourg. It offered
secure investments in dollars to investors across Europe. The spectrum of
issuers includes multinational businesses, independent states, and
supranational organisations. Even while the majority of bonds have a
duration of less than 10 years, a single bond offering can have a size of
well over a billion dollars and have maturities ranging from five to thirty
years.Eurobonds provide investors wi th diversification while being
particularly appealing to issuers headquartered in nations without
significant capital markets.
A financial instrument known as a "Eurobond" is one that is issued on a
market or in a nation where the native currency is not us ed. Eurodollar or
Euro -yen bonds are two examples of how Eurobonds are typically
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91 are frequently referred to as foreign bonds because they are issued in a
different currency.
Eurobonds are significant because they enable businesses to raise cash
while providing the option to issue them in different currencies.
Eurobonds are typically issued on behalf of the borrower by a global
syndicate of financial institutions, one of which may under write the bond
and therefore guarantee the sale of the entire issuance.
A financial instrument known as a "Eurobond" is one that is issued on a
market or in a nation where the native currency is not used. Eurobonds are
significant because they enable busin esses to raise cash while providing
the option to issue them in different currencies. The term "Eurobond"
simply means that the bond was issued outside of the country that issued
the currency; it does not imply that the bond was issued in Europe.
Due to it s great degree of flexibility, which allows issuers to select the
country of issuance based on the regulatory environment, interest rates,
and market depth, Eurobonds are quite popular as a financing vehicle.
They are particularly appealing to investors si nce they typically have low
face values or par values, making them inexpensive to buy in.
Additionally, because of their high liquidity, Eurobonds are simple to buy
and sell.
The name "Eurobond" merely refers to the fact that the bond was issued
outside o f the nation that established the currency; it does not imply that
the bond was issued in Europe or that it was priced in the euro. A business
could, for instance, issue a US dollar -denominated Eurobond in Japan.
Features of Eurobonds:

Source: https://im age3.slideserve.com/6675888/the -main -features -of-a-
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92 Investors must be concerned about any risk that could result in the price of
the bonds dropping by the time they desire to sell the bonds because it is
usual practise to sell international bonds on secondary markets. Four types
of risk are associated with international bonds from the standpoint of
investors:
1. RISK OF DEFAULT CREDIT
2. RISK OF INTEREST RATES;
3. LIQUIDITY RISK
4. EXCHANGE RATE RISK.

1. CREDIT RISK : The p ossibility of default, in which case interest or
principal payments to investors are halted temporarily or permanently,
is represented by the credit risk of foreign bonds. This danger may be
particularly important in nations with severely restricted credit or rights
since it may be difficult for creditors to compel debtor companies to
take the necessary steps to enable debt repayment.Even if the company
that issued the bonds is still making its regular coupon payments,
unfavourable economic or company -specif ic circumstances can make
the issuing company consider bankruptcy as being more likely. The
needed return on these bonds increases as the issuing company's credit
risk rises because potential investors want to be compensated for the
rise in credit risk. In order to account for the credit risk to potential
buyers of the bonds, any investors who wish to sell their bond holdings
under these circumstances must do so at a lower price.

2. INTEREST RATE RISK : The risk of falling bond value as a result
of rising lon g-term interest rates is represented by the interest rate risk
of foreign bonds. The needed rate of return for investors increases as
long-term interest rates rise. Investors increasingly employ a higher
discount rate to calculate the current value of bond s expected future
cash flows.As a result, bond valuations decrease. When interest rates
rise, even bonds with minimal credit risk exposure frequently lose
value. Because fixed -rate bonds' coupon rates are fixed even when
interest rates rise, they are more susceptible to interest rate risk than
floating -rate bonds. In order to make up for investors accepting a
coupon rate that is lower than their desired return, the market price of
these bonds must be decreased.

3. EXCHANGE RATE RISK : Exchange rate risk is th e chance that
bonds' value will decrease (from the investor's perspective) if the
bond's currency depreciates against the investor's home currency. As a
result, the bond's estimated future coupon or principal payments may
be converted into less of the inve stor's home currency.

4. LIQUIDITY RISK : Due to the lack of a regularly active market for
the bonds, there is a risk that their value will decrease when they are
put up for sale. As a result, investors who want to sell the bonds might 7.5 RISKS IN INTERNATIONAL BONDS:
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93 have to reduce their a sking price. Liquidity risk is decreased when the
bond market is continually active because there is a steady stream of
buyers and sellers. To persuade other investors to buy the bonds in the
secondary market, investors must lower the price at which they i ntend
to sell foreign bonds when they are not regularly traded.

7.6 SUMMARY

 Foreign Bonds : A foreign bond is a bond issued in a domestic
market by a foreign entity in the domestic market's currency as a
means of raising capital.

 Eurobond : A Eurobond i s a debt instrument that's denominated in a
currency other than the home currency of the country or market in
which it is issued.

 Credit Risk : The credit risk of international bonds represents the
potential for default, whereby interest or principal pay ments to
investors are suspended temporarily or permanently.

 Interest Rate Risk : The interest rate risk of international bonds
represents the potential for the value of bonds to decline in response to
rising long -term interest rates.

 Exchange Rate Risk : Exchange rate risk represents the potential for
the value of bonds to decline (from the investor’s perspective) because
the currency denominating the bond depreciates against the home
currency of the investor.

 Liquidity Risk : Liquidity risk represents the potential for the value of
bonds to decline at the time they are for sale because there is not a
consistently active market for the bonds.

7.7 QUESTIONS

1) What are Foreign Bonds? Explain its characteristics.
2) What are Euro Bonds? Explain its features.
3) What are the risks involved in Foreign Bonds. Explain each type of
risk involved in it.
4) ______ is a bond issued in a domestic market by a foreign entity in
the domestic market's currency as a means of raising capital.
5) _____ is a debt instrument that's deno minated in a currency other than
the home currency of the country or market in which it is issued. munotes.in

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94 6) _______of international bonds represents the potential for default,
whereby interest or principal payments to investors are suspended
temporarily or permanen tly.
7) _______ risk of international bonds represents the potential for the
value of bonds to decline in response to rising long -term interest rates.

8) _______ represents the potential for the value of bonds to decline
(from the investor’s perspective) becaus e the currency denominating
the bond depreciates against the home currency of the investor.
9) ________ represents the potential for the value of bonds to decline at
the time they are for sale because there is not a consistently active
market for the bonds.
7.8 REFERENCES

 International Financial Management book (Seventh Edition) by Cheol.
S. Eun and Bruce. G. Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 JeffMadura, International Financial Management
 Siddaiah, International Financial Management : An Analytic
Framework
 www.efinancemanagement.com
 www.investopedia.com



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95 8
CURRENCY FORWARD AND FUTURES
Unit Structure :
8.0 Objectives
8.1 Forward and Future contracts
8.2 Non-deliverable Forwards
8.3 Currency Future sterminologies
8.4 Pricing Currency Futures
8.5 Hedging, Speculation and Arbitrage with forwards and futu res
8.6 Summary
8.7 Questions
8.8 References
8.0 OBJECTIVES
 To understand Forward and Future Contracts.
 To study terminologies related to Currency Futures.
 To Study Hedging, Speculation and Arbitrage.
8.1 FORWARD AND FUTURE CONTRACTS
FORWARD CONTRACT:
The rate set today for delivery of a currency at a future time is known as
the forward exchange rate. Although the rate is negotiated and agreed
upon at the time of contract formation, delivery and payment are
postponed until maturity. For value periods of one month (30 days), two
months (60 days), three months (90 days), six months (180 days), nine
months (270 days), and twelve months, banks commonly provide forward
rates (360 days). Actual contracts, however, can be negotiated for
durations up to 5 or 10 y ears.
Hedging, arbitrage, and speculation are the three primary types of activity
that the forward exchange market is useful for. Hedging is the process of
protecting oneself from the potential future swings in the spot exchange
rate. By purchasing (sellin g) the requisite amount of foreign currency in
the forward market, an importer (exporter) who must make (is to receive)
a payment in foreign currency at a specific future date can protect
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96 exact amount he will pay (get) in native currency because the conversion
rate is currently fixed.
In any event, there are other methods of carrying out these tasks without
using forward contracts. Using the spot market is an additional option.
Thus, th e question of which market is the better alternative automatically
arises. We'll examine this issue by examining the situation of an economic
agent who needs foreign money to speculate, make a payment in the
future, or invest in foreign bonds. For the sake of simplicity, let's
concentrate on a market for one -period forwards and refer to the
appropriate forward rate as Ft; t+1, where t and t+1 are the dates on which
the forward contract is negotiated and executed, respectively.Additionally,
let A, St, it, an d i*t represent the sum of foreign currency that will
eventually be due, the date t spot exchange rate, and the domestic and
international interest rates for one period, respectively.
FUTURE CONTRACT:
A futures contract to exchange one currency for another at a specific
future date at a price (exchange rate) that is set on the purchase date is
known as a currency future, or FX future. A futures contract is a binding
commitment to buy or sell a certain commodity asset, securities, or both at
a defined price at a predetermined future date.
For the purpose of facilitating trading on a futures exchange, futures
contracts are standardised for both quality and quantity. When purchasing
a futures contract, the buyer assumes the responsibility for purchasing and
receiving the underlying asset at the contract's expiration. The underlying
asset must be available and delivered by the futures contract seller by the
expiration date.
Futures contracts are a type of financial derivative that obligates either the
buyer or t he seller to buy or sell an underlying asset at a present price and
date in the future. By employing leverage and a futures contract, an
investor can speculatively predict the future direction of an asset,
commodity, or financial instrument. Futures are fr equently used to protect
against losses from unfavourable price movements by hedging the
movement of the underlying asset's price. Almost every commodity
imaginable, including grains, cattle, energy, currencies, and even stocks,
has tradable futures contra cts. The Commodity Futures Trading
Commission oversees futures transactions in the US (CFTC).
Futures are a type of derivative financial contract that binds the parties to
exchange an item at a fixed price and future date. Regardless of the market
price on the day of expiration, the buyer or seller must acquire or sell the
underlying asset at the predetermined price. Physical commodities or other
financial instruments are examples of underlying assets. Futures contracts
are standardised to make trading on a futures market easier and specify the
quantity of the underlying asset. Futures can be utilised for trading
speculation or hedging.The terms "futures contract" and "futures" are
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97 For instance, you may hear someone mention that they purcha sed oil
futures, which is the same as an oil futures contract. When someone uses
the term "futures contract," they usually mean a particular kind of future,
such as futures on S&P 500 index, gold, bonds, or oil. One of the most
straightforward ways to inve st in oil is through futures contracts. The more
generic term "futures" is sometimes used to refer to the entire market, as in
the sentence "They're a futures trader." In contrast to forward contracts,
futures contracts are standardised.
COMPARISON BETWEEN FUTURE AND FORWARD
CONTRACT :

Source:https://investinganswers.com/sites/www/files/forward -and-
future -contracts -table.jpg
8.2 NON -DELIVERABLE FORWARDS
A cash -settled, typically short -term forward contract is known as a Non -
Deliverable Forward (NDF). Non -deliverable transactions are those in
which the notional amount is never exchanged. For a predetermined sum
of money —or, in the case of a currency NDF, at a predetermined rate —
two parties consent to take opposing sides in a transaction. This means
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98 price is settled between counterparties. The difference between the agreed -
upon rate and the spot rate at the time of settlement is used to determine
the profit or loss on the notional amoun t of the agreement.
A two -party currency derivatives contract known as a non -deliverable
forward (NDF) is used to swap cash flows between the NDF and current
market rates. The discrepancy resulting from the comparison between this
exchange.
Cash flow = (N DF rate - Spot rate) * Notional amount
NDFs are frequently quoted for time periods ranging from one month to
one year and are traded over -the-counter (OTC). They have gained
popularity among firms looking to hedging exposure to illiquid currencies
during t he 1990s and are most usually quoted and settled in U.S. dollars. A
non-deliverable forward (NDF) is typically carried out offshore, i.e., away
from the illiquid or untraded currency's domestic market. For instance, it
won't be feasible to settle the trans action in a currency with a party outside
the restricted country if that money is prohibited from moving offshore.
The NDF can, however, be resolved between the two parties by changing
each party's earnings and losses from the contract into a freely tradab le
currency. The earnings or losses can then be divided among them in that
freely traded currency. Having said that, illiquid markets or currencies are
not the only ones that use non -deliverable forwards. They can be utilised
by parties that are not intere sted in providing or receiving the underlying
product but are trying to hedge or expose themselves to a certain asset.
All NDF contracts specify the currency pair, notional amount, fixing date,
settlement date, and NDF rate. They also specify that the tran saction will
be settled at the spot rate in effect on the fixing date. The calculation of the
difference between the current spot market rate and the agreed -upon rate
takes place on the fixing date. The settlement date is the deadline by which
the party re ceiving payment must pay the difference. An NDF settles more
like a forward rate agreement (FRA) than like a conventional forward
contract.
There could be a non -deliverable forward between the two parties if one
agrees to buy U.S. dollars (sell yuan) and t he other agrees to buy Chinese
yuan (sell dollars). They settle on a 6.41 percent interest rate on a million
dollars. In one month, the fixing date will be set, and settlement will
follow soon after. The value of the yuan in relation to the dollar has
increased if the rate is 6.3 after one month. Money is owing to the entity
that purchased the yuan.The party who purchased U.S. dollars is owed
money if the rate rose to 6.5 since the value of the yuan has declined (the
value of the dollar has climbed).
The Ch inese yuan, Indian rupee, South Korean won, New Taiwan dollar,
Brazilian real, and Russian ruble are the largest markets for NDF. NDF
trading is primarily conducted in London, while there are other significant
markets in New York, Singapore, and Hong Kong. The U.S. dollar serves
as the primary medium of exchange for NDF trading. The euro, the munotes.in

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99 Japanese yen, and, to a lesser extent, the British pound and the Swiss
franc, are also used in active markets.
8.3 CURRENCY FUTURES
Exchange -traded futures contracts k nown as currency futures define the
price in one currency at which another currency may be purchased or sold
at a later time. Currency futures contracts are enforceable in court, and
counterparties who are still in possession of them on the contract's
expiration date are obligated to produce the specified currency amount at
the agreed -upon price on the agreed -upon delivery date. Currency futures
can be used to speculate on currency price movements as well as to hedge
other trades or currency concerns. In co ntrast to non -standardized currency
forwards, which are traded over -the-counter, currency futures (OTC).
Futures contracts for currencies called "currency futures" describe the cost
of exchanging one currency for another at a later time. The spot rates of
the currency pair are used to calculate the rate for currency futures
contracts. To protect against the danger of receiving payments in a foreign
currency, one can use currency futures. The Chicago Mercantile Exchange
(CME), which hosts the world's biggest currency futures market today,
established the first currency futures contract in 1972. Contracts for future
foreign exchange are daily marked -to-market. This means that traders are
in charge of making sure they have enough money in their account to pay
margins and any losses that may arise after taking a position.
Prior to the delivery date specified in the contract, futures traders can
cancel their commitment to buy or sell the currency. By closing out the
position, this is accomplished. Currency futures contracts are physically
delivered four times a year on the third Wednesdays of March, June,
September, and December, with the exception of those involving the
Mexican Peso and South African Rand.
For instance, purchasing a Euro FX future at 1.20 on the U .S. exchange
obligates the buyer to purchase Euros at $1.20 USD. They are accountable
for purchasing 125,000 euros at $1.20 USD if they let the contract expire.
The buyer would need to purchase this much since each Euro FX future on
the Chicago Mercantile Exchange is worth 125,000 euros. On the other
hand, the contract's seller would be required to deliver the euros and get
US dollars. Speculators who liquidate their positions before to the futures
expiration date make up the majority of participants in the futures markets.
They fail to give the actual money in the end. Instead, they gain or lose
money depending on how much the price of the futures contract changes.
Currency Future Example :
Consider a fictitious corporation XYZ, a company with its headquart ers
in the United States, wants to protect against its anticipated receipt of 125
million euros in September since it is highly exposed to foreign exchange
risk. The business might offer futures contracts on the euros they will be
getting before September. The contract unit for euro FX futures is
125,000 euros. Because they are a U.S. corporation and don't require the munotes.in

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100 euros, they sell euro futures. As a result, they may sell them now and lock
in a price at which the euros can be converted into dollars becau se they
are certain they will receive euros.
1000 Euro futures contracts are sold by Company XYZ to cover its
anticipated receipt. Consequently, the company's anticipated receipt is
safeguarded if the euro declines in value relative to the dollar. As a res ult
of their rate lock, they are able to sell their euros at that rate. However,
the corporation forfeits any gains that might result from an increase in the
value of the euro. The gain (compared to the price in August) they would
have made if they had not sold the contracts must be forfeited because
they are still required to sell their euros at the price of the futures
contract.

Source:https://th.bing.com/th/id/OIP.oKx2750vCLJ -myO dqBCJow
HaFj? w=199&h=180&c=7&r=0&o=5&dpr=1.3&pid =1.7
8.5 HEDGING, SPECULATION AND ARBITRAGE
WITH FORWARDS AND FUTURES
HEDGING:
Hedging in the stock market is a technique to preserve your portfolio,
which is frequently just as vital as portfolio growth. Hedging is frequently
described in broader terms th an are its explanations. It is not, nonetheless,
an obscure term. Even if you are just starting out as an investor,
understanding what hedging is and how it functions can be helpful. By
establishing a contrary position in a comparable asset, investors can use
the risk management technique of hedging to offset losses on their
investments. Potential gains are often reduced as a result of the risk 8.4 PRICING CURRENCY FUTURES
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101 reduction offered by hedging. Hedging is paying a premium in exchange
for the security it offers. Derivatives like options and futures contracts are
frequently used in hedging strategies.
Hedging is best understood by considering it to be a type of insurance.
When someone chooses to hedge, they are protecting their finances from
the effects of a bad incident. This doe s not guarantee that all bad things
won't happen. However, the impact of a terrible incident is lessened if
you have adequate insurance coverage. Hedging happens practically
everywhere in reality. You can protect yourself against fires, break -ins,
and othe r unforeseeable tragedies by purchasing homeowner's insurance,
for instance.
Hedging strategies are used by portfolio managers, individual investors,
and businesses to lessen their exposure to certain risks. Hedging,
however, is more complex in the financi al markets than simply paying an
insurance provider a premium each year for coverage. Using financial
instruments or market techniques systematically to balance the risk of any
unfavourable price swings is known as hedging against investment risk.
To put i t another way, investors use a trade in another investment to
protect one investment. To technically hedge, you must execute opposing
trades in securities that have low correlations. Of course, you will still
need to pay for this insurance in some way.
Example of Hedging :
For instance, if you hold shares of the XYZ Corporation, you can
purchase a put option to hedge against sharp declines in the value of your
stock. However, you must pay the option's premium in order to purchase
it. Therefore, lowering ris k always lowers the likelihood of reward.
Therefore, hedging is primarily a strategy designed to minimise
prospective losses (and not maximise a potential gain). In the event that
the investment you are hedging against is profitable, you have typically
also decreased your prospective profit. If your hedge was effective and
the investment loses money, you will have lessened your loss.
Using derivative financial instruments is a common component of
hedging strategies. Option contracts and futures are two of t he most
popular derivatives. You can create trading strategies using derivatives
where a loss in one investment is balanced out by a gain in another.
Let's say you are a shareholder in Cory's Tequila Corporation (ticker:
CTC). Despite your long -term confid ence in the company, you are
concerned about some potential short -term losses in the tequila market.
You can purchase a put option on the firm, which provides you the right
to sell CTC at a specified price, to hedge against a decline in CTC (also
called th e strike price). This tactic is referred to as a married put. Losses
incurred if your stock price drops below the strike price will be partially
offset by put option gains.
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102 Another traditional illustration of hedging concerns a business that relies
on a s pecific commodity. Let's say Cory's Tequila Corporation is
concerned about agave prices fluctuating (the plant used to make tequila).
If agave prices skyrocketed, the business would be in serious difficulties
because this would negatively affect their prof itability.
CTC has the option to enter into a futures contract to protect itself from
the volatility of agave prices (or its less -regulated cousin, the forward
contract). A futures contract is a kind of hedging tool that enables the
business to purchase th e agave at a particular price at a predetermined
point in the future.CTC may now plan its budget without being concerned
about agave's changing price.
This hedging approach will be successful if the price of agave skyrockets
over the price stipulated by th e futures contract since CTC will save
money by paying the lower price. However, CTC is still bound to pay the
agreed -upon price even if it decreases. They would have been better off
not hedging against this risk, thus they should have done so. An investor
can hedge against almost anything because there are so many different
forms of options and futures contracts, including stocks, commodities,
interest rates, and currencies.
Each hedging technique has a price attached to it. Therefore, you should
consider whether the possible advantages outweigh the cost before
deciding to employ hedging. Keep in mind that the purpose of hedging is
to safeguard against losses, not to make money. It is impossible to avoid
paying for a hedge, whether it is the price of an opt ion or losing earnings
from being on the wrong side of a futures contract. Although it's tempting
to contrast insurance and hedging, insurance is much more exact. When
you have insurance, your loss is fully covered (usually minus a
deductible). A portfolio 's hedging is not an exact science. Things can go
wrong very easily. Although risk managers constantly strive for the ideal
hedge, it is incredibly challenging to implement.
SPECULATION :
Speculation, often known as speculative trading, is the act of engag ing in
a financial transaction that carries a considerable risk of losing value but
also carries the hope of a sizable gain or other significant value. With
speculation, the chance of a sizable gain or other form of compensation
more than offsets the risk of loss.
The act of engaging in a financial transaction that carries a high risk of
value loss but also carries the expectation of a sizable gain is referred to
as speculation. There wouldn't be much incentive to speculate without the
promise of huge gains . Think about whether speculation is influenced by
the type of asset, the anticipated length of the holding term, and/or the
level of leverage used.
A speculative investment buyer is probably preoccupied with price
changes. Despite the high level of risk i nvolved in the investment, the
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103 the investment's market value than on long -term investing. Currency
speculation is the practise of investing speculatively when buying foreign
currency i s involved. In this case, an investor purchases a currency with
the intention of selling it at a higher price in the future as opposed to an
investor who purchases a currency to fund an import or a foreign
investment.
There wouldn't be much incentive to sp eculate without the promise of
huge gains. Sometimes it can be challenging to distinguish between
speculation and straightforward investment, forcing the market
participant to think about whether speculation or investment depends on
factors that gauge the asset's nature, the anticipated length of the holding
period, and/or the amount of leverage used on the exposure.
When purchasing a house with the goal to rent it out, for instance, the
boundary between investment and speculation in real estate can become
hazy. Even if this would count as investment, purchasing several condos
with little down payment in order to sell them off soon and for a profit
would surely be viewed as speculating.
Speculators can increase market liquidity and reduce the bid -ask spread,
which helps producers effectively manage price risk. Through betting
against favourable results, speculative short -selling may also rein in rabid
bullishness and stop asset price bubbles from forming. Mutual funds and
hedge funds frequently speculate in t he bond, stock, and foreign exchange
markets.
With an estimated $6.6 trillion changing hands between buyers and
sellers each day on the forex markets, they operate at the largest volume
and monetary value in the whole world. Using lightning -fast electronic
trading platforms, positions can be taken and reversed in this market 24
hours a day, anywhere in the globe.
Spot deals to purchase and sell currency pairings, like EUR/USD (Euro -
US Dollar), for delivery through options or straightforward exchange are
a common component of transactions. Asset managers and hedge funds
with multibillion dollar portfolios rule this market. It can be challenging
to distinguish between normal hedging procedures —where a business or
financial institution buys or sells a currency to protect against market
fluctuations —and speculation in the forex markets.
Example of Speculation :
For instance, the sale of foreign currency in connection with the purchase
of bonds may be regarded as either a common speculative move or a
hedge of the bond's value. If the currency position is repeatedly bought
and sold while the fund owns the underlying bond, it may become
difficult to clearly describe these relationships.

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104 ARBITRAGE :
Arbitrage is the simultaneous purchase and sale of a single asset o r a
group of related assets in various markets with the goal of making a profit
from minute variations in the asset's quoted price. It takes advantage of
brief fluctuations in the cost of identical or comparable financial products
on various markets or in various forms. Market inefficiencies give rise to
arbitrage, which both takes advantage of and corrects them.
Arbitrage is the simultaneous acquisition and disposal of an asset in many
marketplaces in an effort to take advantage of minute price variations.
Arbitrage transactions are made in equities, commodities, and currencies.
Arbitrage makes use of the inescapable market inefficiencies. But
arbitrage gets markets closer to efficiency by taking advantage of
inefficiencies. Any time a stock, commodity, or piece of currency can be
bought at one price on one market and simultaneously sold at a greater
price on another, arbitrage can be used. The circumstance offers the trader
the chance to benefit without taking any risks.
Arbitrage offers a way to make sure that prices don't diverge significantly
from fair value over an extended period of time. Technology
improvements have made it very challenging to profit from pricing
mistakes in the market. A lot of traders have automated trading
programmes configured to t rack changes in similar financial instruments.
Any ineffective price structures are typically addressed immediately,
frequently within a few seconds, and the opportunity is lost.
COMPARISON BETWEEN HEDGING AND SPECULATION :

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105 8.6 SUMMARY
 Future Contract : A futures contract is a legal agreement to buy or
sell a particular commodity asset, or security at a predetermined price
at a specified time in the future.

 Forward Contract : A forward contract is a customizable derivative
contract between two parties to buy or sell an asset at a specified
price on a future date .

 Hedging : A hedge fund is a limited partnership of private invest ors
whose money is managed by professional fund managers who use a
wide range of strategies, including leveraging or trading of non -
traditional assets, to earn above -average investment returns.

 Speculation : In the world of finance, speculation, or specul ative
trading, refers to the act of conducting a financial transaction that
has substantial risk of losing value but also holds the expectation
of a significant gain or other major value.
 Arbitrage : Arbitrage is the simultaneous purchase and sale of the
same or similar asset in different markets in order to profit from tiny
differences in the asset’s listed price.
8.7 QUESTIONS
1. Distinguish between Future and Forward Contract.
2. Explain the Hedging in detail.
3. Explain the Arbitrage in detail.
4. Explain Specula tion in detail.
5. Explain how Forward Contract works.
6. Explain how Future Contract works.
7. A _______ contract is a legal agreement to buy or sell a particular
commodity asset, or security at a predetermined price at a specified
time in the future.
8. ________ con tract is a customizable derivative contract between
two parties to buy or sell an asset at a specified price on a future
date.
9. A ______ fund is a limited partnership of private investors whose
money is managed by professional fund managers who use a wide
range of strategies, including leveraging or trading of non -traditional
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106 10. _______refers to the act of conducting a financial transaction that
has substantial risk of losing value but also holds the expectation
of a significant gain or other major value.
11. _______is the simultaneous purchase and sale of the same or similar
asset in different markets in order to profit from tiny differences in the
asset’s listed price.
8.8 REFERENCES
 International Financial Manag ement book (Seventh Edition) by Cheol.
S. Eun and Bruce.G.Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 Jeff Madura, International Financial Management
 Siddaiah, International Financial Management : An Analytic
Framework
 www.investopedia.com



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107 9
CURRENCY OPTIONS
Unit Structure :
9.0 Objectives
9.1 Introduction
9.2 Option terminologies, Options pay -offs
9.3 Hedging with Currency Options
9.4 Range forward
9.5 Zero Cost collar
9.6 Participating forward
9.7 Barrier options
9.8 Asianoptions
9.9 Innovation in options
9.10 Summary
9.11 Questions
9.12 References
9.0 OBJECTIVES
 To study Currency Options.
 To understand Option terminologies.
 To study Hedging with Currency Options
 To understand Participating forward, range forward, zero cost colla r,
Barrier options.
 To study Asian Options and Innovations in options.
9.1 INTRODUCTION
The right to buy or sell currencies at set prices is provided by currency
options. The Australian dollar, British pound, Brazilian real, Canadian
dollar, euro, Japanese yen, Mexican peso, New Zealand dollar, Russian
ruble, South African rand, and Swiss franc are just a few of the various
currencies in which they are offered. A contract that grants the buyer the
right, but not the responsibility, to purchase or sell a spe cific currency at a munotes.in

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108 particular exchange rate on or before a set date is known as a currency
option (also known as a forex option). The vendor receives a premium in
exchange for this right. One of the most popular strategies used by
businesses, people, and financial institutions to protect themselves from
unfavourable changes in exchange rates is through the use of currency
options.
Contracts for currency options can be put or called. The right to purchase a
specific currency at a specific price (referred to as the strike price or
exercise price) within a specific time frame is offered by a currency call
option. It is applied as a payables hedge. The right to sell a specific
currency at a specific price within a specific time frame is offered by a
currency pu t option. It is applied to future receivables hedging. On an
exchange, call and put options on currencies can be acquired. Since there
is no obligation, they provide more freedom than forward or futures
contracts. The company has the option to decide not t o exercise the option.
The use of currency options as a hedge has grown in popularity. About 30
to 40 percent of the Coca -Cola Company's forward contracts have been
replaced with currency options. Even though forward contracts are used
by the majority of M NCs, many of them also use currency options.
9.2 OPTION TERMINOLOGIES
1. Spot Rate : The spot rate is the current exchange rate.
2. Strike Price : The strike price is the exchange rate at which the
contract can be exercised.
3. Call and Put Options : A call option pro vides the buyer with the right
to buy a currency at the strike price. A put option provides the buyer
with the right to sell a currency at the strike price. Buying a call on
USD is the same as buying a put on the CAD because in both cases,
the buyer is sel ling CAD for USD.
4. Expiration Date : An expiration date provides the time frame in which
the option contract is valid.
5. Contract Size : The contract size is an essential element that
determines how much currency is being settled.
6. American vs European Options : American options can be exercised
by the buyer at any point prior to and on the expiration date. European
options are limited only to be exercised on the expiration date.
7. In the Money and Out of the Money : In-the-money occurs when the
option can be exercis ed, allowing the buyer to buy at the strike price
that is better than the spot rate. Out -of-the-money occurs when the
option will not be exercised because it is more expensive than buying
at the spot rate.
8. Premium : The premium is the amount paid by the buy er to the seller
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109 and demand, as well as if the strike price is in -the-money or out -of-
the-money.
OPTIONS PAY -OFFS:
A derivative, or contract, is an option that grants the buyer the right but
not the responsibility to purchase or sell the underlying asset by a
particular date (expiration date) at a particular price (strike price). Options
come in two varieties: calls and puts. Options of the American variety may
be exercised at any moment b efore they expire. Only the expiration date
can be used to exercise European -style options. The buyer must pay an
option premium in order to enter into an option contract. The two most
popular options are called calls and put options:
Call Option :
Calls gr ant the buyer the option —but not the obligation —to purchase the
underlying asset at the option contract's designated strike price. Investors
purchase calls when they anticipate a gain in the price of the underlying
asset and sell calls when they anticipate a decrease.
Put Option :
The buyer of a put has the option, but not the responsibility, to sell the
underlying asset at the contract's designated strike price. If the put buyer
exercises their option, the writer (seller) of the put option is compelled to
purchase the asset. Investors purchase puts when they anticipate a decline
in the underlying asset's price and sell puts when they anticipate a gain.
PAYOFFS FOR OPTIONS: CALLS AND PUTS :
The option premium for a call option is fully paid by the buyer at the time
the contract is signed. After then, if the market shifts in his favour, the
buyer can potentially profit. There is no chance that the option will cause a
loss in excess of what was paid for it. One of the most alluring aspects of
purchasing alternati ves is this. The buyer secures a limitless profit
potential with a known and severely constrained loss possibility for a little
investment.
The investor loses the money they paid for the option if the spot price of
the underlying asset does not increase ov er the option's strike price before
it expires. However, the call buyer gets money if the value of the
underlying asset does rise over the strike price. The profit is calculated as
the difference between the market price and the option's strike price,
multiplied by the underlying asset's incremental value, and deducted from
the option's purchase price.
For instance, 100 shares of the underlying stock are covered by a stock
option. Let's say a trader purchases a single call option contract with a $25
strike price on the ABC stock. He buys the option for $150. The price of
shares of ABC stock on the option's expiration date is $35. The
buyer/owner of the option makes use of his right to buy 100 shares of munotes.in

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110 ABC at the strike price of $25 per share. At the $35 per share going rate
on the market, he sells the shares right away.
He purchased 100 shares for $2,500 ($25 x 100), and he later sold them
for $3,500 ($35 x 100). He will make $1,000 ($3,500 - $2,500) in profit
from the option after deducting the $150 option premium. As a result, his
net profit after transaction charges is $150, or $850. For just a $150
investment, that's a pretty nice return on investment (ROI).
Selling Call Options :
The downside for the call option seller is virtually limitless. The writer o f
the option suffers a loss since the spot price of the underlying asset is
higher than the strike price (equal to the option buyer profit). The option
expires worthless if the market value of the underlying asset does not rise
above the strike price. In p roportion to the price they paid for the option,
the option seller makes a profit.
The possible payoff for a call option on RBC stock with a $10 option
premium and a $100 strike price is illustrated in the example below. If the
share price of RBC does not rise over $100 in the example, the buyer
suffers a $10 loss. In contrast, the call's author is profitable as long as the
share price stays below $110 per unit.

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111 PUTS:
The right to sell the underlying asset at the option strike price is granted to
the buyer of a put option. The amount that the spot price deviates from the
strike price determines how much the option buyer will profit. The put
buyer is "in -the-money" if the spot price is lower than the strike price. The
option will not be exercised if the current price stays higher than the strike
price. Once more, the option buyer's loss is strictly capped at the option
premium.
If the spot price of the underlying asset is less than the contract's strike
price, the put writer is "out -of-the-money." Their loss is equal to the gain
of the put option buyer. The option expires without being exercised and
the writer keeps the option premium if the spot price stays above the
contr act's strike price.
The payoff for a hypothetical 3 -month RBC put option with a $100 strike
price and a $10 option premium is depicted in the figure below. The
possible loss for the buyer (blue line) is capped at the $10 price of the put
option contract. I f the stock price stays over $90, the put option seller, or
writer, is in -the-money.

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112 9.3 HEDGING WITH CURRENCY OPTIONS
The ability to buy or sell a foreign currency con tract at a certain price on a
specific date is provided by foreign currency options. The owner of the
option is not compelled to exercise the option under this hedging strategy,
unlike forward contracts. If currency movements have rendered exercising
the o ption lucrative for him/her, the contract buyer may do so at the agreed
price (referred to as the strike price) when the precise date (known as the
expiration date) of the contract approaches. If changes have rendered the
choice worthless, it expires witho ut being used by the business or person.
9.4 RANGE FORWARD
A range forward contract is a zero -cost forward contract that uses two
derivative market positions to generate a range of exercise prices. A range
forward contract is designed to offer defense agai nst unfavourable changes
in exchange rates while maintaining some upside potential to profit from
advantageous currency moves.
In order to protect against currency market volatility, range forward
contracts are most frequently utilized. In order to provide settlement for
funds within a range of prices, range forward contracts are built. They
need to hold two positions in the derivative market, which establishes a
range for settlement at a later date.
A trader must use two derivative contracts to take long a nd short positions
in a range forward contract. Usually, the net cost of the two jobs together
is zero. To manage currency risks from overseas clientele, large firms
frequently use range forward contracts.
9.5 ZERO COST COLLAR
A zero -cost collar is a type of options collar strategy that involves buying
call and put options that cancel each other out in order to limit a trader's
losses. The disadvantage of this method is that returns are limited if the
value of the underlying asset rises. To protect against price volatility in an
underlying asset, adopt a zero -cost collar method. The purchase of call and
put options that set a ceiling and floor on gains and losses for the
derivative is a zero -cost collar approach. Because premiums or prices for
various altern atives may not always match, it could not always be
profitable.
In a zero -cost collar approach, one half of the strategy spends money to
offset the expense experienced by the other half. After taking a long
position in a stock that has seen significant gai ns, this protective options
technique is used. The investor sells a covered call and purchases a
defensive put. This tactic is also known as hedge wrappers, zero cost
options, and equity risk reversals. The investor purchases an out -of-the-
money put option and simultaneously sells or writes an out -of-the-money
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9.6 PARTICIPATING FORWARD
A foreign exchange instrument that enables importers and exporters to
control their currency risk and take advantage of positive market trends. A
protection rate for a given currency amount for a future settlement date
will be agreed upon.
An instr ument that combines forward and option trading is a participation
forward. You divide the amount you wish to hedge or protect into two
halves. One component function like a typical forward contract. To put it
another way, you bind yourself legally to excha nging a specific sum of
foreign currency at a specific rate on a specific date. The second
component functions similarly to a typical financial option product. In
other words, you have the option —but not the requirement —to exchange
a given quantity of fore ign currency at a particular rate on a particular
date. You decide how to divide. You might choose a ratio of 50:50 (50
percent forward and 50 percent choice), 60:40, or perhaps another one that
makes more sense to you.
Nevertheless, there will be a single exchange rate that applies to the entire
contract. This rate is referred to as the worst -case rate. Participating munotes.in

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114 forwards don't force you to pay a premium to lock in your worst -case rate
like regular options do. Additionally, you are only required by law to
complete the forward portion of the transaction. Therefore, you can still
profit from the market exchange rate if it is higher than the "worst -case
rate."
On the other hand, because forward contracts constitute a legal obligation,
there is a limit to h ow much you can profit from a favourable exchange
rate as you will always have to exchange some of the money at the worst -
case rate. Additionally, the worst -case rate is less favourable than the rate
you would receive from a typical forward contract. You c ompensate for
not paying a premium for the option with the worse rate.
9.7 BARRIER OPTIONS
The payment of a barrier option, a particular kind of derivative option
contract, is based on the value of the underlying asset. Alternatively put,
the payoff only o ccurs if the asset underlying the barrier options reaches or
exceeds a predefined price specified in the option contract. If the price of
the underlying asset rises over a specific level, a barrier option may expire
worthless (a knock -out option), reducing the option holder's profit and the
option writer's losses (seller). The barrier option may be a knock -in option,
meaning that it is worthless until the underlying asset reaches a specific
price.
Due to the fact that barrier choices have more features than standard
American and European options, they are regarded as exotic options.
Since barrier options' values fluctuate together with the value of the
underlying assets, they are also known as path -dependent options.When
the value of the underlying asset sur passes a specific price threshold, the
option may be exercised.
Classification of Barrier Options:
Barrier options are classified into the following:
1. Knock -in barrier option :
A knock -in barrier option is a type of barrier option where the associated
rights begin to exist once the price of the underlying asset is reached. The
holder can only exercise the option at and after the price reaches a specific
level in the open market, according to this clause. The barrier option
becomes a vanilla option and is pric ed accordingly if the knock -in price
level is reached at any point during the barrier option's contract term. The
knock -in barrier option expires worthless if the knock -in price level is
never achieved.
Options for knock -in barriers are further divided int o options that are up -
and-in or down -and-in.
 An up -and-in barrier option's option contract doesn't begin until the
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115  On the other hand, if it is a down -and-in barrier option, it becomes
valid as soon as the value of the underlying asset falls under the first
established barrier price.
2. Knock -out barrier options:
When the underlying asset encounters a barrier during the contract's time
horizon, knock -out barrier options lose their validity. Possibil ities for
knocking down barriers can also be divided into up -and-out and down -
and-out options.
a. When the price of the underlying security rises above the barrier that
was established above the starting price of the underlying security, an
up-and-out option ceases to exist.

b. A down -and-out option terminates when the underlying security drops
below the barrier that was established below the underlying security's
initial price. The option is cancelled or knocked out if an asset that
supports the barrier option crosses the barrier at any time during the
option's term.
As opposed to normal options (American and European), which base their
reward on the price of the underlying asset at a certain moment in time,
Asian options base their payoff on th e average price of the underlying
asset over a specified period of time (maturity). With these options, the
buyer can buy (or sell) the underlying asset at the average price rather than
the current market rate.
Average options are another name for Asian op tions. The word "average"
might be interpreted in a number of different ways, and the options
contract needs to make that clear. The price of the underlying asset at
specific intervals, which are also mentioned in the options contract, is
often averaged ge ometrically or arithmetically to determine the average
price. The averaging mechanism accounts for the relatively low volatility
of Asian options. They are employed by traders who have long -term
exposure to the underlying asset, including buyers and seller s of
commodities, etc.
Asian options fall under the category of "exotic options," which are
utilised to address specific business issues that conventional options
cannot. They are created by making slight adjustments to common
settings. Asian options typic ally cost less than their conventional
counterparts, though this is not always the case because the average price
is less volatile than the spot price.
When a company is worried about the average exchange rate over time,
for example.
9.8 ASIAN OPTIONS
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116 1. When a specific pr ice at a particular moment might be manipulated.
2. When the underlying asset's market is very volatile.
3. When pricing is inefficient as a result of light market activity (low
liquidity markets).
9.9 INNOVATION IN OPTIONS
Innovation Options evaluate effo rts based on the flexibility they offer the
company in the present, not on irrational forecasts about the future. When
dealing with uncertain or untested markets, this kind of risk management
is more accurate, practical, and sound.
9.10 SUMMARY

a. Options ar e a type of derivative that grant the buyer the right, but not
the duty, to purchase or sell the underlying asset by a particular date
(the expiration date) at a specific price (strike price).

b. Currency Options provide you the opportunity to buy or sell cu rrencies
at predetermined rates.

c. A range forward contract is a zero -cost forward contract that uses two
derivative market positions to create a range of exercise prices.

d. A barrier option is a specific kind of derivative option contract, and its
payout is based on the value of the underlying asset.

e. When the price of the underlying security rises above the barrier
established above the starting price of the underlying security, an up -
and-out option ceases to exist.

f. When the price of the underlying securit y drops below the barrier that
was established below the underlying security's opening price, the
down -and-out option ceases to exist. The option is cancelled or
knocked out if an asset that supports the barrier option crosses the
barrier at any time durin g the option's term.

g. Asian Options give the buyer the option of buying (or selling) the
underlying asset at the average price rather than the current market
rate.

9.11 QUESTIONS

1. Explain how Option Payoffs works.

2. how Hedging with Currency Option works.
3. Explain Range Forward in detail. munotes.in

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117
4. Short Note on Zero cost collar.
5. Short Note on Participating forward.
6. Short Note on Barrier options.
7. Short Note on Asianoptions.
8. Short Note on Types of Barrier Options.
9. An ________ is a derivative, a contract that gives the buyer the right,
but not the obligation, to buy or sell the underlying asset by a certain
date (expiration date) at a specified price (strike price).
10. ____________ provide the right to purchase or sell currencies at
specified prices.
11. ________ contract is a zero -cost forward contract that creates a
range of exercise prices through two derivative market positions.
12. __________ is a type of derivative option contract, the payoff of
which depends on the value of the underlying asset.
13. ___________ stops existin g when the underlying security moves
above the barrier that was set above the initial price of the underlying
security.
14. ____________ stops existing when the underlying security moves
below the barrier that was set below the initial price of the underlying
security. If an asset underlying the barrier option strikes the barrier
anytime during the option’s life, the option is terminated or knocked
out.
15. _____ options allow the buyer to purchase (or sell) the underlying
asset at the average price instead of the spot price. The option contract
starts only when the price of the underlying asset exceeds the
predetermined price barrier.
16. ________, it turns valid as the underlying asset value drops below the
initially set barrier price.
9.12 REFERENCES

 International Financial Management book (Seventh Edition) by Cheol.
S. Eun and Bruce.G.Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 Jeff Madura, International Financial Management
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118  Siddaiah, I nternational Financial Management : An Analytic
Framework
 www.corporatefinanceinstitute.com
 www.investopedia.com
 www.wikihow.com
 www.assurehedge.com
 www.dbinetti.com



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10
SWAPS
Unit Structure :
10.0 Objectives
10.1 Introduction
10.2 Meaning
10.3 Interest Rate Swaps
10.4 CurrencySwap
10.5 Summary
10.6 Questions
10.7 References
10.0 OBJECTIVES
 To understand the concept of Swaps.
 To study Interest Rate Swaps.
 To stu dy Currency Swaps.
10.1 INTRODUCTION
There are two main families of derivatives contracts: Contingent claims,
first (e.g., options) 2. Forward claims, such as swaps, forward contracts,
and exchange -traded futures. An agreement to swap cash flow sequences
for a predetermined amount of time is known as a swap. At least one of
this series of cash flows is typically decided by a random or unknown
variable at the time the contract is initiated, such as an interest rate,
foreign exchange rate, equities price, or commodity price.Conceptually, a
swap could be compared to a collection of forward contracts or to holding
long positions in one bond and short positions in another bond. The two
most popular and fundamental types of swaps —interest rate and currency
swaps —are covered in this chapter.
10.2 MEANING
Through a derivative contract known as a swap, two parties can exchange
the liabilities or cash flows from two various financial instruments.
Although the instrument can be almost anything, most swaps involve cash
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120 principal typically doesn't change hands. One leg of the swap is made up
of every cash flow. One cash flow is often constant, whereas the other is
variable and dependent on an index pri ce, a benchmark interest rate, or a
fluctuating currency exchange rate.
An interest rate swap is the most typical type of exchange. In general,
swaps are not traded on exchanges or used by regular investors. Instead,
swaps are specialized over -the-counter (OTC) contracts that are made to
meet the interests of both parties and are typically made between
businesses or financial organizations.
10.3 INTEREST RATE SWAPS
A forward contract known as an interest rate swap exchanges one stream
of future interest payme nts for another based on a predetermined principal
sum. In order to decrease or increase exposure to interest rate swings or to
achieve a somewhat lower interest rate than would have been achievable
without the swap, interest rate swaps often include the e xchange of a fixed
interest rate for a floating rate, or vice versa. A basis swap, which involves
trading one kind of floating -rate for another, is another example of a swap.
With interest rate swaps, one set of cash flows is exchanged for another.
The con tracts are between two or more parties according to their desired
parameters and can be tailored in many different ways because they trade
over-the-counter (OTC). If a business can readily borrow money at one
type of interest rate but wants another, swaps are frequently used.
TYPES OF INTEREST RATE SWAPS :
There are three different types of interest rate swaps:
1. Fixed -to-floating,
2. floating -to-fixed, and
3. float-to-float.
1. Fixed -to-Floating :
Consider the case of TSI, a business that may offer its investors b onds
with very appealing fixed interest rates. The management of the
organisation believes that a variable rate will result in a greater cash flow.
In this situation, TSI may agree to a swap with a bank acting as the
counterparty, whereby the firm obtains a fixed rate and pays a fluctuating
rate.
The two fixed -rate payment streams are netted, and the exchange is
constructed to match the fixed -rate bond's maturity and cash flow. The
preferred floating -rate index is selected by TSI and the bank; it is typical ly
LIBOR for a one -, three -, or six -month duration. Then, TSI receives
LIBOR plus or minus a spread that takes into account both market interest
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121 2. Floating -to-Fixed :
If a corporation can't get a fixed -rate loan, it ca n borrow money at a
floating rate and use a swap to get a fixed rate. The loan's floating -rate
tenor, reset, and payment dates are mirrored and netted on the swap. The
swap's fixed -rate component becomes the business's borrowing rate.
3. Float to Float :
Basis swaps are contracts that businesses occasionally enter into to alter
the kind or duration of the variable rate index that they pay. For instance,
if the six -month LIBOR rate is more desirable or aligns with other
payment flows, a corporation may switch f rom the three -month LIBOR to
it. A business may alternatively choose another index, such as the federal
funds rate, the price of commercial paper, or the rate on Treasury bills.
10.4 CURRENCY SWAP
The exchange of interest —and occasionally principal —in one currency for
the equivalent amount in another is known as a currency swap, often
known as a cross -currency swap. Throughout the term of the contract,
interest payments are exchanged at predetermined intervals. It is regarded
as a foreign exchange transacti on, and a company's balance sheet is not
obliged by law to include it.
To get past exchange controls, which are governmental restrictions on the
buying and/or sale of currencies, currency swaps were initially conducted.
Foreign exchange restrictions are ty pically used by countries with weak or
developing economies to prevent currency speculation, but most
industrialised economies now no longer impose them. Therefore, swaps
are currently most frequently performed to protect long -term investments
and alter th e parties' exposure to interest rates. Businesses that operate
internationally frequently utilise currency swaps to obtain loans at more
favourable rates in the local currency than they might if they obtained a
loan from a bank in that nation.
In a currenc y swap, the parties predetermine whether or not they would
first exchange the major amounts of the two currencies. The inferred
exchange rate is determined by the two primary sums. A swap including
the exchange of €10 million for €12.5 million, for instanc e, results in an
assumed EUR/USD exchange rate of 1.25. Exchange rate risk arises from
the requirement to exchange the same two principle amounts at maturity
since the market might have moved away from 1.25 in the interim.
Based on interest rate curves at the time of commencement and the credit
risk of the two parties, pricing is typically expressed as London Interbank
Offered Rate (LIBOR), plus or minus a specific number of points. One can
exchange currencies in a number of ways. Many swaps only use notion al
principal amounts, which implies that the principal amounts are not really
traded but are instead used to calculate the interest due and payable each
period. If the entire principal is exchanged when the transaction is signed,
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122 relatively flexible kind of foreign exchange because their maturities can be
negotiated for at least 10 years. Both fixed and fluctuating interest rates
are possible.
RISKS OF INTEREST RATE SWAPS AND CURRENC Y SWAPS :
 Interest rate risk is the possibility that interest rates will decline
before the swap bank can release a counterparty on the other side of an
interest rate swap agreement.

 Exchange -rate risk is the risk that the swap bank encounters as a
result of changing exchange rates while the bank is laying off a swap it
has with one counterparty with an opposite counterparty.

 Credit risk : The main risk a swap broker faces is credit risk. It speaks
of the possibility of a counterparty defaulting. The swap bank that is in
the middle of the two counterparties has obligations exclusively to the
counterparty that is not in default. Each counterparty and the swap
bank are parties to a separate agreement.

 Basis risk refers to a situation in which the floating r ates of the two
counterparties are not pegged to the same index. Any difference in the
indexes is known as the basis. For example, one counterparty could
have its FRNs pegged to LIBOR, while the other counterparty has its
FRNs pegged to the U.S. Treasury b ill rate. In this event, the indexes
are not perfectly positively correlated and the swap may periodically
be unprofitable for the swap bank. In our example, this would occur if
the Treasury bill rate was substantially larger than LIBOR and the
swap bank r eceives LIBOR from one counterparty and pays the
Treasury bill rate to the other.

 Mismatch Risk : The difficulty of finding an exact opposite match for
a swap the bank has agreed to take is referred to as mismatch risk. The
mismatch could be with regard t o the size of the principle sums the
counterparties want, the individual debt issues' maturities, or the dates
for debt service.

 Sovereign Risk: The likelihood that a nation may impose exchange
limitations on a currency engaged in a swap is referred to as sovereign
risk. Due to this, it could be extremely difficult or even impossible for
a counterparty to fulfil their duty to the dealer. Provisions allow for the
termination of the swap in this situation, costing the swap bank money.

The International Swaps and Derivatives Association (ISDA) has
standardised two swap agreements to make it easier for the swap market to
function. The "Interest Rate and Currency Swap Agreement" governs
currency swaps, and the "Interest Rate Swap Agreement" specifies the
general parameters for interest rate swaps denominated in U.S. dollars.
The time needed to set up swaps has been shortened thanks to the
standardised agreements, which also include provisions for early
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123 10.5 SUMMARY
 Swap: A swap is a derivative contract through which two
parties exchange the cash flows or liabilities from two different
financial instruments.

 Interest Rate Swap: An interest rate swap is a forward contract in
which one stream of future interest payments is exc hanged for another
based on a specified principal amount.

 Currency Swap: A currency swap, sometimes referred to as a cross -
currency swap , involves the exchange of interest —and sometimes of
principal —in one currency for the same in another currency.
10.6 Q UESTIONS
1. Explain the term Swaps.
2. Explain various types of Swaps.
3. Explain Currency Swaps.
4. Explain Interest Rate Swaps.
5. Explain different types of Interest Rate Swaps.
6. A _____ is a derivative contract through which two parties exchange
the cash flows or liab ilities from two different financial instruments.
7. An ______ is a forward contract in which one stream of future
interest payments is exchanged for another based on a specified
principal amount.
8. __________ sometimes referred to as a cross -currency swap , involves
the exchange of interest —and sometimes of principal —in one
currency for the same in another currency.
10.7 REFERENCES
 International Financial Management book (Seventh Edition) by Cheol.
S. Eun and Bruce.G.Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 JeffMadura, International Financial Management
 Siddaiah, International Financial Management : An Analytic
Framework
 www.investopedia.com
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124 11
CAPITAL BUDGETING FOR
INTERNATIONAL PROJECT
INVESTMENT DECISIONS
Unit Structure :
11.0 Objectives
11.1 Introduction
11.2 Calculation of DCF
11.3 Project IRR, NPV and Pay-back period
11.4 Impact of Transfer pricing
11.5 Summary
11.6 Questions
11.7 References
11.0 OBJECTIVES
 To understand Capital Budgeting.
 To understand capital budgeting appraisal techniques in international
project investments.
11.1 INTRODUCTION
The procedure a company uses to assess potential big projects or
investments is calle d capital budgeting. Before a project is accepted or
denied, capital budgeting is necessary. Examples of such projects include
the construction of a new plant or a significant investment in a third -party
enterprise. A business may examine the lifetime cash inflows and outflows
of a planned project as part of capital budgeting to ascertain whether the
projected returns will satisfy an adequate target benchmark. The practise
of capital budgeting is sometimes referred to as investment assessment.
In an ideal w orld, firms would take advantage of any and all chances and
projects that increase profit and value for shareholders. To choose the
projects that will generate the best return throughout the course of the
relevant time, management uses capital budgeting pr ocedures since the
amount of capital or money that each organisation has available for new
projects is restricted.

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125 11.2 DISCOUNTED CASH FLOW (DCF )
The term "discounted cash flow" (DCF) refers to a method of valuation
that calculates an investment's valu e based on its anticipated future cash
flows. Using estimates of how much money an investment will make in
the future, DCF analysis seeks to evaluate the value of an investment
today. It can aid those who are trying to decide whether to purchase
securities or a firm. Business owners and managers can use discounted
cash flow analysis to help them make decisions about operational and
capital budgets.
The value of an investment is ascertained using discounted cash flow
analysis using the investment's projected cash flows. The projected
discount rate is used to calculate the present value of anticipated future
cash flows. If the DCF is more than the investment's current cost, the
opportunity may yield profits and be worthwhile. Because it takes into
consideratio n the rate of return anticipated by shareholders, businesses
frequently utilise the weighted average cost of capital (WACC) as the
discount rate. The fact that DCF relies on potentially erroneous future cash
flow projections is a drawback.
The goal of a DC F analysis is to calculate an estimate of the return on
investment, taking time value into account. A dollar you have today is
worth more than a dollar you receive tomorrow because it can be invested,
according to the time value of money theory. As a resul t, a DCF analysis
is helpful in any circumstance where someone is paying money now with
the hope of obtaining more in the future.
EXAMPLE:
For instance, $1 in a savings account will be worth $1.05 after a year if the
interest rate is 5%. Similar to this, i f you cannot move a $1 payment to
your savings account to collect interest, its current worth is just 95 cents.
Using a discount rate, discounted cash flow analysis determines the
present value of anticipated future cash flows. The idea of the present
value of money can be used by investors to assess whether the future cash
flows of a project or investment will be more valuable than the initial
investment.
Consider the opportunity if the computed DCF value is more than the
investment's current cost. It may not be a good opportunity or additional
research and analysis may be required before moving forward with it if the
calculated value is less than the cost.
An investor must estimate future cash flows and the eventual value of the
investment, machinery, or o ther assets in order to perform a DCF analysis.
For the DCF model, the investor must also choose an appropriate discount
rate, which will change based on the project or investment being
considered. The discount rate used can be influenced by a number of
variables, including the risk profile of the company or investor and the
state of the capital markets.Alternative models should be used in place of
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126 DISCOUNTED CASH FLOW FORMULA:

CALCULATION OF DCF :
A corporation typically utilises its weighted average cost of capital
(WACC) as the discount rate to assess the DCF when deciding whether to
invest in a particular project or buy new equipment. The average rate of
return an ticipated by business shareholders for the current year is factored
into the WACC. Let's use the example of your organisation wanting to
start a project. WACC for the business is 5%. This indicates that your
discount rate will be 5%. The project will cost $11 million to start, will
last five years, and generate the expected annual cash flows listed below.
Cash Flow
Year Cash Flow
1 $1 million
2 $1 million
3 $4 million
4 $4 million
5 $6 million

Using the DCF formula, the calculated discounted cash fl ows for the
project are as follows.

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127 Discounted Cash Flow
Year Cash Flow Discounted Cash Flow (nearest $)
1 $1 million $952,381
2 $1 million $907,029
3 $4 million $3,455,350
4 $4 million $3,290,810
5 $6 million $4,701,157
The total value of the dis counted cash flows comes to $13,306,727. The
net present value (NPV) is obtained by deducting the initial investment of
$11 million from that sum, giving us $2,306,727.
The project may produce a return greater than the initial cost, or a positive
return on investment, according to the positive number of $2,306,727. As
a result, the project might be worthwhile.
The NPV would have been $693,272 if the project had cost $14 million.
That would suggest that the project would cost more than it would earn in
retur ns. So, it might not be worthwhile to make.
ADVANTAGES OF DCF:
 Investors and businesses can get a sense of whether a proposed
investment is worthwhile through discounted cash flow analysis.
 It is analysis that can be used for a variety of capital investmen ts and
projects where it is possible to predictably estimate future cash flows.
 Its projections can be changed to provide multiple what -if scenarios
with varied outcomes. Users can utilise this to take into account
various projections that could be made.
DISADVANTAGES OF DCF :
 The major limitation of discounted cash flow analysis is that it
involves estimates, not actual figures. So, the result of DCF is also an
estimate. That means that for DCF to be useful, individual investors
and companies must estimate a discount rate and cash flows correctly.
 Furthermore, future cash flows rely on a variety of factors, such as
market demand, the status of the economy, technology, competition,
and unforeseen threats or opportunities. These can't be quantified
exactly. I nvestors must understand this inherent drawback for their
decision -making.
 Even if accurate estimations can be generated, DCF shouldn't always
be relied upon completely. When evaluating an investment
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128 other, well -known factors. Other typical valuation techniques that
might be employed include prior transactions and similar company
analysis.
INTERNAL RATE OF RETURN :
In financial analysis, the internal r ate of return (IRR) is a statistic used to
calculate the profitability of possible investments. IRR is a discount rate
that, in a discounted cash flow analysis, reduces all cash flows' net present
values (NPV) to zero.
The same formula is used for NPV calc ulations and IRR calculations.
Remember that the project's true financial value is not represented by the
IRR. The annual return is what brings the NPV to a negative value.
Generally speaking, the higher an internal rate of return, the more
desirable an in vestment is to undertake. IRR is uniform for investments of
varying types and, as such, can be used to rank multiple prospective
investments or projects on a relatively even basis. In general, when
comparing investment options with other similar characteri stics, the
investment with the highest IRR probably would be considered the best.
FORMULA FOR IRR:

Source:https://th.bing.com/th/id/OIP.esldqCwiDwHK4E_6X8qZaQHaEk
?w=285&h=180&c=7&r=0&o=5&dpr=1.3&pid=1.7
CALCULATION OF IRR:
1. To find the discount rate, or I RR, one would use the formula, setting
NPV equal to zero.
2. Because the original investment is an outflow, it is always negative.
3. Depending on the predictions of what the project would deliver or
require in terms of a capital infusion in the future, each suc ceeding
cash flow may be positive or negative. 11.3 PROJECT IRR, NPV AND PAY-BACK PERIOD
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129 4. IRR must be determined iteratively through trial and error or by using
software designed to calculate IRR because of the nature of the
formula, which makes it difficult to calculate analytically.
NET PRESENT V ALUE (NPV):
The difference between the current value of cash inflows and withdrawals
over a period of time is known as net present value (NPV). To evaluate the
profitability of a proposed investment or project, NPV is used in capital
budgeting and investm ent planning.
Using the appropriate discount rate, computations are performed to
determine the current value of a stream of future payments, or NPV.
Projects that have a positive NPV are generally worthwhile pursuing,
whereas those that have a negative NPV are not.
FORMULA FOR NPV:

A project or venture has a positive net present value (NPV) if its expected
earnings, discounted for their present value, are more than their expected
costs, also expressed in current dollars. An investment with a positive
NPV is presumed to be successful.
A negative NPV investment will result in a net loss. The net present value
rule, which states that only investments with a positive NPV should be
taken into consideration, is based on this idea.
CALCULATION OF NPV:

PAYBACK P ERIOD :
The time it takes to recoup the cost of an investment is referred to as the
payback period. It is simply the amount of time it takes an investment to
break even. The payback period is crucial since people and businesses
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130 more appealing the faster its payoff is. Everyone may benefit from
knowing the payback period, which can be calculated by dividing the
initial investment by the typical cash flows.
FORMULA FOR PAYBACK PERIOD:

Source: https://th.bing.com/th/id/OIP.HVghHs92Ywk -
cyYevD5TrgHaDz?w=334&h=179&c=7&r=0&o=5&dpr=1.3&pid=1.7
CALCULATION OF PAYBACK PERIOD :
The investment is more enticing the faster the payback. On the other hand,
the longer the payout, the less appealing it is . For instance, it would take
4.2 years to meet the payback period if solar panels cost $5,000 to install
and the savings are $100 each month. Most of the time, this is a relatively
good payback period because, according to experts, it may take a
residenti al homeowner in the United States up to eight years to break even
on their investment.
IRR VS NPV VS PAYBACK PERIOD:

The price that one division of a firm charges another division for the
goods and services rendered is known as transfer pricing in accounting.
Transfer pricing enables the determination of costs for the exchange of
goods and services between subsidiaries, affiliates, or businesses under
shared ownership that are a component of the same larger firm. Corporate 11.4 IMPACT OF TRANSFER PRICING munotes.in

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Investment Decisions
131 tax benefits may result from transfer pricing, although tax authorities may
challenge these assertions.
Transfer pricing is an accounting and taxation technique that permits
pricing exchanges between subsidiaries that share common ownership or
control or with in businesses. Both domestic and international transactions
are subject to the transfer pricing practise.
To calculate the amount to bill another division, subsidiary, or holding
company for services delivered, a transfer price is utilised. Transfer
pricin g frequently reflect the going rate for that commodity or service.
Research, patents, and royalties are examples of intellectual property that
might be subject to transfer pricing.
The transfer pricing method may be used by multinational corporations
(MNCs ) to distribute earnings among the different affiliate and subsidiary
businesses that make up the parent company. However, businesses
occasionally have the ability to abuse this method by changing their
taxable income, which lowers their overall tax burden . Companies can
transfer their tax liabilities to countries with low tax rates by using the
transfer pricing mechanism.
IMPACT:
Let's think about the following example to better understand how transfer
pricing affects a company's tax burden. Let's imagine that a vehicle
manufacturer has two divisions: Division A produces software, and
Division B produces automobiles. In addition to its parent firm, Division
A also sells the software to other automakers. Usually at the going rate
that Division A bills other automakers, Division B pays Division A for the
software.
Consider a scenario in which Division A chooses to charge Division B a
lesser fee as opposed to using the going rate. Due of the decreased pricing,
Division A's sales or revenues are consequently low er. Conversely,
Division B's profits are higher because of reduced COGS (cost of goods
sold). In other words, Division A's sales are reduced by the same amount
as Division B's cost savings, thus the firm as a whole doesn't suffer
financially.
Let's assume, then, that Division A is located in a nation with greater taxes
than Division B. By increasing Division B's profitability and decreasing
Division A's, the corporation as a whole can reduce its tax burden.
Division B will pay less tax if Division A sets lo wer pricing and transfers
those savings to Division B, increasing Division B's profits by lowering
COGS. In other words, Division A's choice to not charge Division B
market price enables the corporation as a whole to avoid paying taxes.
EXAMPLES:
 Coca -Cola Co. (KO) maintains that the $3.3 billion transfer pricing of
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132 marketing, and sales are primarily focused in a number of international
markets. Between 2007 and 2009, the business transfer red IP value to
subsidiaries in South America, Europe, and Africa. Coca -Cola and the
IRS are still engaged in court proceedings, and the case has not been
concluded.
 The IRS claims that Meta (META), previously Facebook, transferred
$6.5 billion in intangib le assets to Ireland in 2010 in order to
dramatically reduce its tax liability. This is a high -stakes lawsuit. Meta
might be forced to pay up to $9 billion in addition to interest and
penalties if the IRS prevails in the legal dispute. The U.S. Tax Court
trial, which was scheduled to begin in August 2019, has been
postponed to give Meta more time to negotiate a settlement with the
IRS.
11.5 SUMMARY
 The difference between the current value of cash inflows and
withdrawals over a period of time is known as net present value
(NPV).

 In a discounted cash flow analysis, IRR acts as a discount rate to bring
all cash flows' net present values (NPV) to zero.

 The time it takes to recoup the cost of an investment is referred to as
the payback period. It is simply the amount of time it takes an
investment to break even.

 Discounted cash flow (DCF) is a term used to describe a way of
valuing an investment by using its anticipated future cash flows. Using
estimates of how much money an investment will make in the future,
DCF analysis seeks to evaluate the value of an investment today.

 The procedure a company uses to assess potential big projects or
investments is called capital budgeting. Before a project is accepted or
denied, capital budgeting is necessary. Examples of such projects
include the construction of a new plant or a significant investment in a
third -party enterprise.
11.6 QUESTIONS
 Explain the Discounted Cash Flow Capital Budgeting technique in
detail with an example.
 Explain the NPV Capital Budgeting techniqu e in detail with an
example.
 Explain the Payback Period Capital Budgeting technique in detail with
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133  Explain the IRR Capital Budgeting technique in detail with an
example.
 Explain the term Capital Budgeting and also comment why it is
needed.
 ____ __ is the difference between the present value of cash inflows
and the present value of cash outflows over a period of time.
 ______ is a discount rate that makes the net present value (NPV) of
all cash flows equal to zero in a discounted cash flow analysis .
 The term ______ refers to the amount of time it takes to recover the
cost of an investment. Simply put, it is the length of time an
investment reaches a breakeven point .
 ________ refers to a valuation method that estimates the value of an
investment usin g its expected future cash flows. Itanalysis attempts to
determine the value of an investment today, based on projections of
how much money that investment will generate in the future.
 ______ is the process a business undertakes to evaluate potential
major projects or investments. Construction of a new plant or a big
investment in an outside venture are examples of projects that would
require capital budgeting before they are approved or rejected.
11.7 REFERENCES
 International Financial Management book (Sev enth Edition) by Cheol.
S. Eun and Bruce.G.Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 JeffMadura, International Financial Management
 Siddaiah, International Financial Managemen t : An Analytic
Framework
 www.investopedia.com


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134 12
RISK MANAGEMENT
Unit Structure
12.0 Objectives
12.1 Introduction
12.2 Meaning
12.3 Importance of Risk Management
12.4 Process involved in Risk Management
12.5 Managemen to friskin International Trade/ Business Operations
12.6 Summary
12.7 Questi ons
12.8 References
12.0 OBJECTIVES
 To understand Risk Management.
 To study how risks can be managed in international trade or Business
Operations.
12.1 INTRODUCTION
Economic activity is inescapably replete with risk and risk management.
People often mana ge their affairs to be as content and safe as their
surroundings and resources permit. But regardless of how meticulously
these things are run, there is danger because the outcome, whether positive
or negative, is rarely completely predicted. Almost everyt hing we do
carries some level of risk, but this chapter will concentrate on economic
and financial risk, particularly as it relates to investment management.
Whether consciously or unconsciously, all organisations and investors
manage risk in the decisions they make. Business and investment are
fundamentally about allocating resources and capital to certain risks.
These businesses may take steps to avoid some risks, pursue the risks that
offer the highest rewards, measure and manage their exposure to these
risks as appropriate during their decision -making process in an
unpredictable environment. In an uncertain environment, tackling
challenging business and financial issues is made simpler by risk
management techniques and tools. Risk is not merely a matter of chance;
organisations can actively control it through their choices and a framework
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135 The process of doing business or making investments involves risk.
Investment return is directly correlated with risk even in the earliest
models of current portfolio theory, such as mean -variance portfolio
optimization and the capital asset pricing model, but risk must be
efficiently controlled. One of the most important aspects of managing
businesses and investments is accurately identifying and mea suring risk as
well as maintaining risks in line with the aims of the firm. More value for
the firm, portfolio, or individual is more likely to occur as a result of
effective risk management.
12.2 MEANING OF RISK MANAGEMENT
The detection, analysis, and rea ction to risk elements that are inherent in a
business's operations are all included in risk management. Effective risk
management is acting proactively rather than reactively in an effort to
influence future events as much as feasible. As a result, good r isk
management has the potential to lessen both the likelihood of a risk
happening and its possible consequences.
12.3 IMPORTANCE OF RISK MANAGEMENT
Because it equips a company with the tools it needs to effectively identify
and manage possible hazards, ri sk management is a crucial activity. When
a danger is recognised, it is simple to mitigate it. Additionally, risk
management gives a corporation a foundation on which to make wise
decisions.
The greatest method for a firm to be ready for events that can im pede
progress and growth is to identify and manage risks. A company's chances
of success increase when it assesses its strategy for dealing with potential
challenges and then creates structures to meet them.
Progressive risk management also makes ensuring that issues with a high
priority are handled as aggressively as feasible. Additionally, the
management will be armed with the data they need to decide wisely and
maintain the company's profitability.
12.4 RISK MANAGEMENT PROCESS
The steps that must be done are outlined in the risk management process.
The risk management process, which consists of these five fundamental
components, is used to manage risk. Starting with risk identification, it
then moves on to risk analysis, risk prioritisation, solution impl ementation,
and risk monitoring. Each stage in manual systems requires a significant
amount of administration and paperwork.

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12.5 MANAGEMENT OF RISK IN INTERNATIONAL
TRADE/ BUSINESS OPERATIONS
Businesses engaged in international trade must manage risks related to
business development, including those related to ethics, transportation,
intellectual property, credit, currency, and many other factors. Since these
risks ha ve the potential to hinder the smooth operation of the company,
proper steps must be made to reduce their impact. Here are six dangers
that companies engaged in international trade frequently encounter, along
with practical solutions for managing them.
1. Credit Risk :

The danger of failing to collect an account receivable is known as
counterparty or credit risk. Businesses can protect themselves against this
risk in a variety of ways while entering international markets. To save
administrative costs and fina nce fees, the whole amount owing, or a
reasonable portion of it, can be collected at the moment the order is placed
before the services are rendered. This removes the possibility of non -
payment. Even while this could be challenging for exporters and new
enterprises, it can be resolved with minimal negotiation.This is a promise
made by a financial institution to pay a specific sum to a service or
product supplier in return for delivery within a specific term. Both the
buyer and the seller are protected by th is. It contains the terms of the
transaction as well as a thorough description of the shipment.

2. Intellectual Property Risk :

This risk involves unauthorised third parties using a company's strategic
knowledge or property in a way that has an impact on th e value of the
services or goods the company offers, either directly or indirectly. Due to
the challenges in remotely violating corporate rights, these risks multiply
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137 by registering th e company names and trademarks before concluding a
contract in any nation. To stay ahead of the competition, it will also be
beneficial to continuously adapt and enhance your services or products.

3. Foreign Exchange Risk :
The accounts payable and receivabl e for contracts that are currently or
soon will be in force are often the subject of this. Foreign exchange rates
are continually changing. Businesses would therefore be forced to convert
monies generated abroad at rates that are less than what is budgeted .Due
to this, it is essential that businesses have a suitable exchange policy in
place. The stabilisation of profit margins relative to sales will be aided by
this.Enhancing cash flow control, reducing the negative effects of rate
fluctuations on sales and purchases, and streamlining domestic and
international pricing. To create a successful policy, businesses must
understand their exposure to foreign exchange risks. It's also critical to be
aware of the tools available for hedging these risks and to regula rly
conduct comparative analysis to determine which option is optimal.
4. Ethics Risk :
Any product or service sold in a worldwide market must uphold a high
ethical standard. While engaging in international trade, companies may at
any time encounter specific issues relating to their values. Because social
norms and conditions differ from one country to the next, it is important to
exercise extra caution. No matter where they are located, you must make
sure that your international partners and suppliers uphold your principles.
5. Shipping Risk:
You could run into problems including contamination, seizure, accident,
vandalism, theft, loss, and breakage whether you're delivering items
locally or abroad. Before sending any products to the buyers, you must
confirm that you have enough insurance. For each party engaged in
international trade, the International Chamber of Commerce has
established guidelines outlining their responsibilities with relation to
shipping risk. It is advisable to review the guidelines and adopt the
appropriate safety precautions.
6. Country and Political Risks:

These include dangers like non -tariff trade barriers, monetary policy
restrictions, or restrictions on the export of particular goods to certain
nations. For instance, a number of nations ha ve banned the sale of goods
made from endangered animal species. Sanctions are an example of
something that would never be in your control, therefore you would need
to be ready to deal with them. By visiting the official website of the
relevant country's M inistry of Foreign Affairs and Trade, you may learn
more about these limitations.


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138 12.6 SUMMARY
 Risk and risk management is an inescapable part of economic activity.
 Risk management encompasses the identification, analysis, and
response to risk factors t hat form part of the life of a business.
 Effective risk management means attempting to control, as much as
possible, future outcomes by acting proactively rather than reactively.
12.7 QUESTIONS
 Define Risk Management. Explain the Importance of Risk
Manage ment.
 Explain the process involved in Risk Management.
 Explain the 6 types of Risks faced by businesses while doing
international trade and how they manage them.
 Risk and _____ is an inescapable part of economic activity.
 _______ encompasses the identifica tion, analysis, and response to risk
factors that form part of the life of a business.
 _________ means attempting to control, as much as possible, future
outcomes by acting proactively rather than reactively.
12.8 REFERENCES
 International Financial Manage ment book (Seventh Edition) by Cheol.
S. Eun and Bruce.G.Resnick
 Prakash G Apte, International Finance : A Business Perspective
 Moosa, International Finance : An Analytic Approach
 JeffMadura, International Financial Management
 Siddaiah, International Finan cial Management : An Analytic
Framework
 www.cfainstitute.org
 www.corporatefinanceinstitute.com
 www.360factors.com
 www.universalcargo.com
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