2 a.

Write a note on emerging challenges in the area of international finance

concerning a firm I-29 to 31 3 marks
Emerging challenges:
A firm as a dynamic entity has to continuously adapt to changes in its
operating environment and in its goals and strategy
During 1980s and 1990s there was unprecedented environmental
changes for most of Indian firms
Political uncertainties at home and abroad, economic liberalisation at
home, greater exposure to international markets, increase in
exchange rates and interest rates, increased competition, threat of
hostile takeover have forced firms to rethink their strategic posture
21st century saw even greater acceleration of environmental changes
and increase in uncertainties facing the firm
As we approach WTO deadlines pertaining to removal of trade
barriers firms have to face even more competition at home and abroad
Capital account convertibility of the rupee is expected any time
Ceilings on foreign portfolio investment are being revised upwards
and barriers for foreign direct investment are being steadily lowered
Indian banking sector is being opened up to significant increase in
foreign stake
On the whole integration of India in the global economy is expected to
accelerate hence exposure of Indian firms to global financial markets is
certainly going to increase in future.

b. Write a note on foreign exchange exposure and risk II-6 to 12 7 marks

Classification of foreign exchange exposure and risk:

Firms around the world are aware that fluctuations in exchange rates
expose their revenues, costs, operating cash flows and hence their
market value to substantial fluctuations
Firms which have cross-border transactions- exports and imports of
goods and services, foreign borrowing and lending, foreign portfolio
and direct investment are directly exposed
Purely domestic firms which have no cross-border transactions are
also exposed because their customers, suppliers and competitors are
exposed
 Efforts are devoted to identify and categorize currency exposure and
developing methods to quantify it
In currency exposure, firms are faced with two types of exposures in
short term viz., accounting exposure and operating exposure

Consider a Firm that has certain contractually fixed payments and

receipts in foreign currency as import payables, interest payable on
foreign currency loans, export receivables etc., which are settled within
in an year.
An unanticipated change in the exchange rate has an impact-favorable
or adverse-on its cash flows which is known as transactions exposures
The foreign currency values of assets and liabilities are contractually
fixed they do not vary with exchange rate, hence also called as
contractual exposure
Transaction risk can be defined as a measure of variability in the
value of assets and liabilities when they are liquidated.
Two Important points;
1. transactions exposure usually have short time horizons,
2. operating cash flows are affected
The other short-term exposure is known as translation exposure also
called accounting exposure
A firm may have assets and liabilities denominated in a foreign
currency
 These are not going to be liquidated in foreseeable future
Accounting standards require the firm must translate these values into
home currency and report in balance sheet
Translation risk is the related measure of variability
The key difference is that, the transaction exposure has impact on cash
flows and translation exposure has no direct effect on cash flows
Accounting treatment of transaction and translation exposure:
The transaction and translation exposure give rise to exchange gains
and losses, real or notional

c Write a note on recent changes in the global financial markets

I-37 to 46 10 marks
Recent changes in global financial markets:
1980s witnessed unprecedented changes in financial markets around
the world
The emergence of Euromarkets in 1960s which were free from
regulations, led to internationalization of banking business
These markets grew in 70s and pioneered a number of innovative
funding techniques
The outstanding feature of changes during 1980s was integration
The boundaries between national markets and those between national
and offshore markets blurred leading to emergence of global unified
financial market
Banks in major industrialized countries have increased their presence in
each other countries
Major markets such as US, Europe and Japan are being tapped by
non-resident borrowers
Non resident investment banks are allowed to access national bond
and stock markets
In addition to geographical integration across markets, there has been a
strong trend towards functional unification across various types of FIs
within individual markets
The traditional segmentation between commercial banking, investment
banking, consumer finance is disappearing and everybody does
everything
 The driving force behind this functional integration were i.
liberalisation in cross-border transactions and ii. Deregulation
within the financial systems of major industrial nations
The most significant liberalisation measure was lifting exchange
controls in France, UK and Japan (US, Germany, Switzerland, Holland
were already free from most controls)
Withholding taxes on interest paid to non-residents were removed,
domestic financial markets were opened to foreign borrowers and
domestic borrowers were allowed access to foreign financial markets
Thus in the portfolios of investors around the world, assets
denominated in various currencies became nearly substitutable
Investors could optimise their portfolios considering estimates of
return, risk and their own risk preferences
Borrowers could optimise their liability portfolios considering
estimates of funding costs, interest rate and exchange rate risks and
their risk preferences
Deregulation involved action on two fronts
i. eliminating the segmentation of markets for financial services with
specialised services and fostering greater competition such as abolition
of fixed brokerage charges, breaking up bank cartels etc.,
ii. Permitting foreign FIs to enter national markets and compete on
an equal footing with domestic institutions in offering services to
borrowers and investors
Because of liberalisation and deregulation, a number of non-resident
firms are listed on major stock exchanges like New York and
London
Liberalisation and deregulation has led competition with in financial
service industry, Spreads on loans, underwriting commission, and
fees of various kinds have become thin
The attainment of the Economic and Monetary Union (EMUabout 12
countries same currency) and birth of Euro at end of 1990s have led to
emergence of large capital market competing with US financial
markets which is provider of capital to firms and governments around
the world
The financial innovations from last 15 years resulted in options, swaps,
futures and their innumerable combinations comes from both demand
side and supply side
 Many of these new products are not even understood by the bankers
themselves
Liberalisation and deregulation are ongoing process giving rise to re-
composition of some controls and barriers to cross border capital
movements
The quality and rigor of banking system in many developing countries
needs improvement
US and most Europe have more or less free financial markets

5. a. Explain the components of balance of payments III-12,13 3 marks

The BOP is a collection of accounts conventionally grouped into three
main categories with subdivisions in each.
1. current account: imports and exports of goods and services and
unilateral transfer of goods and services are included
2. capital account: transactions leading to changes in foreign financial
assets and liabilities of the country are included
3.reserve account: in principle this is capital account. However only
reserve assets are included in this category. These assets are used by
monetary authority of the country to settle the deficit and surplus that
arise on the other two categories taken together
Reserve assets are financial assets acceptable as a means of payment in
international transactions and are held by and exchanged between the
monetary authorities of trading countries.
They consist of monetary gold*, assets denominated in foreign
currencies, special rights and reserve positions in the IMF
Deficits and surpluses on the other two categories lead to decumulation
and accumulation of reserves respectively

b. Explain Accounting principles in Balance of Payments (BOP) III- 9 to

11 7 marks
Accounting principles in Balance of Payments (BOP):
The BOP is a standard double entry accounting record and as such is
subject to all the rules of double entry book keeping
Viz., for every transactions two entries must be made, one credit (+)
and one debit (-) and leaving aside errors and omissions, the total
credits must exactly match total of debits
 That is balance of payment must balance
Valuation and timing:
IMF recommends the use of market prices i.e., price paid by the
willing buyer to a willing seller, where they are two independent
parties
IMF recommends FOB price for valuation
In India exports are valued on FOB and imports on CIF basis
Theoretically exchange rates prevailing at the time of transaction to be
used, however in practice, in most cases, for transactions during a a
particular month, the average exchange rate for the month is used
The two sides of transaction are to be recorded in the same period of
time
For this purpose conventions have been established such as:
Exports are recorded when cleared by customs
Imports are recorded when payment is made etc.,

c. Write a note on importance of BOP statistics III- 39 to 42 10 marks

Importance of BOP statistics:
In BOP deficits or surpluses may have an immediate impact on the
exchange rate
BOP records all transactions that create demand for and supply of a
currency
When exchange rates are market determined, BOP figures indicate
excess demand or supply of currency and possible impact on exchange
rate
Taken in conjunction with past data they confirm or indicate a reversal
of perceived trends
They may signal a policy shift on the part of monetary authorities of the
country, unilaterally or in concert with trading partners
For instance a country facing a current account deficit may rise interest
rates to attract short-term capital inflows to prevent depreciation of its
currency, or tighten credit and money supply and make it difficult to
borrow money to make investments abroad
It may force exporters to realize export earnings quickly and bring
home foreign currency
Movements in a countrys reserves have implications for the stock of
money and credit circulating in the economy
 Central banks purchases of foreign exchange in the market will add to
the money supply and vice versa unless the central bank sterlises the
impact by compensatory actions such as open market sales and
purchases
Countries suffering from chronic deficit may find their credit ratings
being down graded
Finally BOP accounts are intimately connected with over all saving-
investment balance in a countrys national account
Continuing deficits or surpluses may lead to fiscal and monetary
actions designed to correct the imbalance, which in turn will affect the
exchange rates and interest rates in the country

10. a. Explain broken date or odd date contracts IV- 64 3 marks

Though standard forward maturities are in a whole number of months,
banks routinely offer forward contracts for maturities which are not
whole months
For ex,. delivery can be 73 days from the date of transaction
Such contracts are called broken date or odd date contracts
For some currency pairs forward contracts extending to five years are
available

b. Describe swap transaction, forward-forward swap, outright forward

contract, in foreign exchange market IV-64 to 67 7marks
A swap transaction in the foreign exchange market is a combination of
a spot and a forward in the opposite direction
Thus a bank will buy Euros against US dollar and simultaneously enter
into a forward transaction with the same counterparty to sell Euros
against US dollar
A spot 60-day Dollar-Euro swap consist of a spot purchase (sale) of
dollars against the Euro coupled with a 60-day forward sale (purchase)
of dollar against Euro
When both the transactions are forward transactions, we have forward-
forward swap
Thus a 1-3 month dollar-sterling swap will consist of purchase (sale) of
sterling versus dollar one month forward coupled with a sale (purchase)
of sterling versus dollar three months forward.
 As the term swap implies, it is a temporary exchange of one currency
for another with an obligation to reverse it at a specific future date.
Forward contracts without an accompanying spot deal are know as
outright forward contracts to distinguish them from swaps
It s estimated that about 40% of the turnover in the market is in the spot
segment, 50% in swaps and the rest in outright forward contracts
Outright forwards are most often used by corporations to cover their
transactions exposures

c. Write a note on Types of transactions and settlement dates IV-53 to

63 10 marks
Types of transactions and settlement dates:
The settlement of a transaction takes place by transfer of deposits
between the two parties
The day on which these transfers are effected is called settlement date
or the value date
To effect the transfers, banks in the countries of the two currencies
involved must be open for business
The relevant countries are called settlement locations
The locations of the banks involved in the trade are dealing locations
which need not be the same as settlement locations
Thus a London bank can sell Swiss francs against US dollar to a Paris
bank
Settlement locations may be New York and Geneva, while dealing
locations are London and Paris
The transaction can be settled only on a day on which both US and
Swiss banks are open
Depending upon the time elapsed between the transaction date and the
settlement date, foreign exchange transaction can be categorised into
spot and forward transactions
A third category called swaps are combination of a spot and a forward
transaction (or forward-forward swap i,.e., a combination of two
forward transactions)
In a spot transaction the settlement or value date is usually two business
days ahead for European currencies and Asian currencies traded against
dollar
 Thus if a London bank sells yen against dollar to a Paris bank on
Monday, the London bank will turn over a yen deposit to the Paris
bank on Wednesday and the Paris bank will transfer a dollar deposit to
the London bank on the same day
If SBI sells dollars against Rupee to HDFC bank on a Tuesday, on the
following Thursday SBI will turn over a dollar deposit to HDFC and
HDFC will turn over a Rupee deposit to SBI
The time gap is necessary for conforming and clearing the deal through
the communication network such as SWIFT (note that by the two
business days ahead rule, deals done on a Thursday will be cleared on
the following Monday, while deals done on Friday will have Tuesday
of the following week as the value date if, Saturday and Sunday are
bank holidays as they are in most financial centers)
To reduce credit rate risk (i.e., one of the parties failing to deliver on its
side of the trade), both transfers should take place on the same day
In Dollar-Yen trade between the London and Paris banks done on
Monday, if the following Wednesday happens to be a bank holiday in
either Japan or US, the value date is shifted to the next available
business day, in this case Thursday
What about holidays in the dealing location? If Wednesday is a holiday
in either UK or France, settlement day is again postponed to Thursday
What if Tuesday is holiday in UK but not in France?
Then two business days would mean Wednesday for the Paris bank
but Thursday for London Bank
In such cases the normal practice is, if the Paris bank made the
market i.e., London bank called for a quote, the value date would be
Wednesday while if London made the market it would be Thursday
The settlement is reduced to one day for trades between currency pairs
such as US dollar and Canadian dollar and US dollar and Mexican Peso
Value dates for forward transactions: in a 1-month (or 30 days)
forward purchase of say pounds against rupees, the rate of exchange is
fixed on the transaction date; the value date is arrived as follows:
First find the value date for a spot transaction between the same
currencies done on the same day and add one calendar month to arrive
at the value date
 Thus for a one month forward transaction entered into on say June 20,
the corresponding spot value date is June 22 and one month forward
value date is July 22, two months forward would be August 22 etc.,
Standard forward contract maturities are 1 week, 2 weeks, 1, 3, 6, 9 and
12 months
The value dates are obtained by adding the relevant number of calendar
months to the appropriate spot value date
If the value date arrived at in such a manner is ineligible because of
bank holidays, then like in spot deal it is shifted forward to the next
eligible business day
Important difference, roll forward must not take you into the next
calendar month, in which case you must shift backward.
Ex. Suppose 3-month forward contract struck on November 26, spot
date is November 28, 3- months takes you to February 28, if February
28 is holiday (not a leap year), it must be rolled back to February 27
Though standard forward maturities are in a whole number of months,
banks routinely offer forward contracts for maturities which are not
whole months
For ex,. delivery can be 73 days from the date of transaction
Such contracts are called broken date or odd date contracts
For some currency pairs forward contracts extending to five years are
available

11. a. Explain short date transactions IV- 67 3 marks

Short date transactions are transactions which call for settlement
before the spot date
cash transactions are for settlement same date while some deals will
involve settlements tomorrow i.e., one business day ahead when a
spot deal would be settled two business days later

b. Discuss price takers, government interventions and speculation IV-

47 to 52 7 marks
Finally there are price takers who take the prices quoted by primary
makers and buy or sell currencies for their own purposes but do not
make a market themselves
 Corporations use the foreign exchange market for a variety of purposes
related to their operations
Among these are payments for imports, conversion of export receipts,
hedging of receivables and payables, payment of interest on foreign
currency loans, placement of surplus funds etc.,

c. Discuss Exchange rate quotations and arbitrage IV- 70 to 80 10

marks
Codes of selected currencies given below:
USD: US dollar ; CHF: Swiss Franc
GBP: British pound ; AUD: Australian dollar
JPY: Japanese Yen ; MEP: Mexican Peso
CAD: Canadian Dollar; SAR: Saudi Riyal
SEK: Swedish Kroner
INR: Indian rupee; NZD:New Zealand Dollar
EUR: Euro
IEP: Irish Pound (Punt)
Spot Rate Quotations:
European Terms: quotes given as number of units of a currency per US
Dollar.
Thus EUR 1.0275 per USD, CHF 1.4500 per USD, INR 46.75 per USD
(CHF=swiss franc)
American Terms: quotes given as number of US dollars per unit of
currency
Thus USD 0.4575 per CHF, USD 1.3542 per GBP
Direct quotes: are those that give units of the currency of that country
per unit of a foreign currency
Thus INR 46.00 per USD is direct quote in India, USD 0.9810 per EUR
is direct quote in US
Indirect quotes: indirect or reciprocal quotes are stated as number of
units of a foreign currency per unit of home currency
thus USD 2.2560 per INR 100 is an indirect quote in India (note unit
for rupee is 100), similarly Japanese Yen, Indonesian Rupiah may be in
terms of 100 (reason is other wise we have to deal with small numbers)
The inter-bank market uses quotation conventions adopted by
Association Cambiste International
 The currency pair is denoted by three letter SWIFT (Society for
Worldwide International Financial Telecommunication) codes for the
two currencies separated by oblique or hyphen
Ex. USD/CHF: US Dollar- Swiss Franc
GBP/JPY: Great Britain Pound Japanese Yen
The first currency in the pair is the base currency; the second is the
quoted currency
Thus in USD/CHF, US Dollar is the base currency, Swiss Franc is the
quoted currency.
The exchange rate quotation is given in number of units of the
quoted currency per unit of the base currency
Thus a USD/INR quotation will be given as a number of rupees per
dollar, a GBP/USD quote will be given as number of dollars per pound
A quotation consists of two prices
the price shown on the left of the oblique or hyphen is the bid
price, the one on the right is the ask or offer price
The bid price is the price at which the dealer is giving the quote is
prepared to buy-is bidding for one unit of the base currency against
the quoted currency
In other words it is the amount of quoted currency the dealer will give
in return for one unit of the base currency
For most currencies, quotation are given in European terms i.e., the
base currency is the US dollar
The major exception are EUR, GBP, AUD and NZD.
These are quoted in American terms i.e., USD becomes the quoted
currency against these
In market parlance, a cross rate or just a cross is a quotation
between two non-dollar currencies
Thus GBP/CHF is a cross rate and so is EUR/INR
In the US financial press gives quotations in both European and
American terms
Quotations in interbank markets are usually given up to five or six
significant digits or four decimal places
The last digit thus corresponds to (1/100)th of (1/100)th unit of the
quoted currency
Thus in USD/CHF bid rate 1.4550/1.4560 the last two digits viz 50
correspond to 0.0050 CHF
 The last two digits are called points or pips
The difference between the offer rate and the bid rate is called the bid-
offer spread or the bid-ask spread
We say the bid ask spread in USD/CHF rate is ten points or ten pips
If the USD/CHF rate moves to 1.4553/63, we say USD has moved
three pips
For small denominations currencies like JPY quotes are given up to 2
decimals only
In such cases a point or pip has the value 0.01 or (1/100) of the quoted
currency
The quotations are usually shortened as follows:
USD/CHF:1.4550/1.4560 given as 1.4550/60
When two dealers are conversing with each other this may be further
shortened to 50/60
The first three digits viz., 1.45 are known as big figure and
professional dealers are supposed to know what the big figure is at all
times
GBP/USD: 1.5365/72 means 1.5365/1.5372
This may further abbreviated to 65/72
Remember offer rate must always exceed bid rate

12. a. Explain spot rate quotations IV- 71,72 3 marks

Spot Rate Quotations:
European Terms: quotes given as number of units of a currency per US
Dollar.
Thus EUR 1.0275 per USD, CHF 1.4500 per USD, INR 46.75 per USD
(CHF=swiss franc)
American Terms: quotes given as number of US dollars per unit of
currency
Thus USD 0.4575 per CHF, USD 1.3542 per GBP
Direct quotes: are those that give units of the currency of that country
per unit of a foreign currency
Thus INR 46.00 per USD is direct quote in India, USD 0.9810 per EUR
is direct quote in US
Indirect quotes: indirect or reciprocal quotes are stated as number of
units of a foreign currency per unit of home currency
 thus USD 2.2560 per INR 100 is an indirect quote in India (note unit
for rupee is 100), similarly Japanese Yen, Indonesian Rupiah may be in
terms of 100 (reason is other wise we have to deal with small numbers)

b. Discuss forward quotations IV-90 to 94 7 marks

Forward quotations:
Outright Forwards: quotations for outright forward transactions are
given in the same manner as spot quotations
Thus quote like; (SEK=Swidish Krone)
USD/SEK 3-month Forward;9.1570/9.1595
Means, as in the case of a similar spot quote, the bank will give SEK
9.1570 to buy a USD and require SEK 9.1595 to sell a dollar, delivery
3 months from the corresponding spot value date
Discounts and premiums in the forward market: consider the
following pair of spot and forward quotes:
GBP/USD spot : 1.5677/1.5685
GBP/USD 1-month forward: 1.5575/1.5585
The pound is cheaper for delivery one month hence compared to spot
pound
The pound is said to be at a forward discount in relation to dollar or
equivalently, the dollar is at a forward premium in relation to the pound
With two-way quotations there is no unique way to quantify the
discount or premium
Let us define the annualized percentage discount on the pound implied
in the above quotations as:
[forward (GBP/USD)mid- Spot(GBP/USD)mid x 12 x 100/
Spot(GBP/USD)mid
(1.5580-1.5681) x 12months x 100 % / 1.5681=
= ( -)7.73%
With this definition, for any quotation (A/B), a negative answer would
indicate that currency B is at a forward premium vis--vis currency A
whereas a positive answer would imply that B is at a forward discount
against A
The practitioners terminology may differ across markets
When dealer says GBP on USD is at a premium it is usually
interpreted to mean that the USD is at premium.
NOTE: This usage is not universal
 Option forwards
a standard forward contract calls for delivery on a specific day, the
settlement date for the contract.
In the inter-bank market, banks offer what are know as optional
forward contracts or option forwards
Here the contract is entered into at some time t0 , with the rate and
quantities being fixed at this time but buyer has option to take or make
delivery on any day between t1 and t2 with t2>t1>t0

c. Write a note covered interest arbitrage V-2 to 10 10 marks

Covered Interest Arbitrage:
All interest rates in Euromarkets are given as annualised rates and interest
calculations are done on as simple interest basis
Thus an interest rate of 10% on 90-day Euro dollar deposit means that $1 put
in such deposit gives $[1+0.10(90/360)] at the end of 90 days
For some currencies, the basis is 365 and not 360 (for Euro dollar it is 360)
Consider a Britisher who is choosing between Eurodollar deposits and
Eurosterling deposit to place some surplus funds
The investor does not want to incur any exchange rate risk
To begin with we will assume there are no transaction costs
This means that in foreign exchange market there are no bid-ask spreads and
in the money market there is no difference between borrowing and lending
rates
We use following notation:
S: the GBP/USD spot rate
Fn: the GBP/USD forward rate for n-year maturity (n=1/12, 1/6, etc., for
1,2,3 months)
iGBP=Annualised interest rate, stated as a fraction, on Eurosterling deposits
of maturity n years
iUSD: Annualised interest rate, stated as a fraction, Eurodollar n-year deposits
If the investor puts GBP 1 in a n-year Eurosterling deposit, at maturity the
value will be = GBP(1+niGBP)
If the investor chooses to invest in Eurodollar and eliminate all exchange
risk he must do the following:
1. convert sterling into dollars spot. Each sterling sold will give S dollars
2. invest the S dollars in n-Eurodollar deposit will have grown to
$[(S)(1+niUSD)]
3. simultaneously enter into a n-year forward contract to sell the dollar
proceeds of the deposit for sterling
 For sterling invested in this fashion, the maturity value is:
GBP[(S)(1+niUSD)/(Fn)]
S=amount of dollars obtained by converting GBP 1 spot, S(1+niUSD) is the
maturity value of the dollars, which sold forward at Fn dollar per GBP yields
the maturity value in sterling
Suppose these are unequal, specifically suppose
(1+niGBP)>(S/Fn)(1+niUSD) ----- eqn. x
ie., [(1+ni GBP) (Fn/S)] > (1+niUSD)]----eqn. y
Then British investor would find it profitable to invest in Eurosterling
Not only that, all investors would find it profitable to liquidate dollar
deposits or borrow dollars and invest in Euro sterling with forward cover
To see this in Eurodollar deposit gives $(1+ni USD) at maturity while the
same dollar invested on a covered basis in Eurosterling deposit gives
$[(1/S)(1+niGBP)(Fn)]
If Eqn y holds the Eurosterling exceeds
If the rates are such that eqn.- y holds, and there are no restrictions on funds
flow a large number of arbitragers would want to:
1. liquidate dollar deposits or borrow dollars
2. sell dollars and buy sterling in the spot market
3. invest sterling so acquired in Eurosterling deposits
4. Enter into forward contracts to sell the sterling in their deposit accounts
against dollars
The resulting market forces give rise to one or more of the following:
1. the dollar interest iUSD will tend to rise
2. dollar will tend to depreciate against sterling in the spot market i.e., S
would increase
3. the Eurosterling interest rate iGBP, would fall
4. dollar would rise against the sterling in the n-year forward market i.e., Fn
would fall
these changes would continue till eqn-y hold equality
In reverse case i.e., if (1+niGBP)<(S/Fn)(1+niUSD)
Then covered investment in Eurodollar is more attractive and opposite forces will be
initiated till again equality is stored
Thus in efficient markets, covered investment in either currency would give the same
return.
There are no riskless arbitrage profits to be had
This is the famous Covered Interest Parity Theorem