IFM Question Bank Solved Final

SRN ADRASH COLLEGE International Financial Management(IFM) REVISION QUESTIONS(RB)
Section A (Two Marks Questions)
1. What are invisibles in the balance of payments

A. The current account records all exports and imports of merchandise and invisibles.
Invisibles include (a) Services b) income flows iii) unilateral transfers
Services earnings/payments include earnings on royalties, transportation and
communication. Income flows includes payments made or payments received on
foreign borrowings, earnings in the form of interest, dividends and rent. Unilateral
transfers like contributions to international institutions, gifts or aid to the foreigners.
2. What is the law of one price

A. The law of one price states that if a commodity or product can be sold in two
different markets, its price should be the same in both the markets.
3. What is foreign exchange risk?

A. The risk that the one currency will appreciate or depreciate against another currency
over a period of time.
4. What is forward rate?

A. Forward rate is the rate negotiated agreement between two parties for selling/buying
specified amount of a specified currency at a fixed rate and date. If the exchange of
currencies takes place after a certain period from the date of the deal (more than two
working days) it is called forward rate.
5. What is a currency futures contract?

A. A currency futures contract is a standardized agreement to deliver or receive a
specified amount of a specified currency at a fixed rate and date
6. What is functional currency and reporting currency?

A. Functional currency is defined as the currency in which the affiliate operates and in
which it generates cash flows. Generally it is the local currency of the country in
which the affiliate conducts most of its business. Under certain circumstances the
functional currency may be the parents firms home currency or some third country
currency.
The reporting currency is the currency in which the parent firm prepares its own
financial statements. This currency is normally the home currency, i.e the currency of
the country currency i.e the currency of the country in which the parent is located and
conducts most of its business
7. The US-Thai Bath rate is USD 0.2334 /Bath and the US Dollar Indian Rupee
exchange rate is USD 0.02234/ Rupee. What is Rs/Bath exchange rate?
A.
8. What is covered interest rate arbitrage?

A . The covered Interest arbitrage is the act of making profits by exploiting the lack of
equality between forward premium /discount on a foreign currency and the interest rates
in the two currencies. Th movement of money to take advantage of a covered interest
differential is known as covered interest rate arbitrage.
9. What is marking to market?
Prepared by Ravindra Babu (RB)

A. Settling changes in the value of futures contracts on a daily basis. When the futures are
marked to market at the end of each trading day, the previous trading days futures
contract is settled. The counterparties realize their profits or losses on a day-to-day
basis rather than all at once upon the maturity of the contract. The daily settlement as
per the marked-to-market procedure reduces the default risk of the futures contract.
10. What is PPP?

A. PPP states that the home currency price of a commodity in different countries
when converted into a common currency at the spot exchange rate, is the same in
all the countries across the world.
11. Distinguish between Direct and Indirect quotation.

A. Direct Quote: A direct quote is the number of units of home currency that can be
exchanged for one unit of a foreign currency.
1 FX (foreign currency) = no of units of DX (domestic currency)
Indirect Quote: is the number of units of the foreign currency exchanged for one unit
of home currency.
1 DX (Domestic currency) = no of units of FX(foreign currency)
12. What is clean and direct float?

A. Dirty Float: It is an exchange rate system in which exchange rates are allowed to
fluctuate without set boundaries and government intervene as they wish
Clean Float: It is an exchange rate system in which exchange rates are allowed to
fluctuate as per the demand and supply and government/monetary authority do not
intervene.
13. Who are the participants in the foreign exchange market?

A. The participants of the foreign exchange market are
i. Retail Customers: Tourists, Students seeking education, restaurants, shops
hotels, importers and exporters.
ii. Foreign Exchange dealers (Wholesalers) which include large commercial banks
investments banks, corporations, HNI(High Net-worth Individuals)
iii. Foreign exchange brokers who buy/sell currencies for commission
iv. Nations Central Banks like RBI
14. Define translation exposure?

A. Translation exposure is also called as Accounting exposure. It is exposure which
measures the effect or impact of the exchange rate changes/fluctuations on the
financial statements. It effects both the income statement and balance sheet items
15. What is syndicated loan?

A. Syndicated loans are different from general loans in that one of the lending banks is
the lead manager who originates the transaction, structures it, selects the lending
members, supervises the documentation and in many cases services the loan after
agreement is complete. It serves as a link between the borrower and the other banks of
the syndicate. It collects interest and principal from the borrower and disburses the
collected amount among the co-lenders at an additional fee.
16. Distinguish between absolute and relative PPP theory?
A. Absolute PPP: The absolute version of the PPP theory is also called the law of one
price, suggests that prices of identical products in two different countries should be equal

when measured in common currency. The assumption of the absolute PPP is that there are
no transaction costs or trade barriers.
The relative form of PPP is an alternative version that accounts for the possibility of
market imperfection such as transportation costs, tariffs and quota. According to this
version prices of similar products of different countries will not necessarily be the same
when measured in a common currency because of these market imperfections.
The percentage change in the foreign currency (ef)
ef = (1 + Ih ) / (1+ If) 1
Ih Inflation rate of the home currency
If Inflation rate of the foreign currency
17. Write the structure of current Account in BOP?

A. The current account consists of all exports and imports of merchandise and invisibles.
Merchandise includes agricultural commodities and industrial components and
products. Invisibles include services, income flows in and out of the country and
unilateral gifts. Export of services include various banking, insurance, consulting and
accounting undertaken by individuals and firms. Import of services include residents
tourists spending abroad, payments made to the firms for their services and royalties
on foreign books etc.
18. Who are authorised dealers?

A. Authorised dealers are wholesale dealers of the currencies of different countries.
These are authorised by the central banks of that particular country to deal with
currencies. They normally deal with large amounts of currencies.
19. State three benefits of centralised cash management system?

A. i. Maintaining minimum cash balance during the year.
ii. Judiciously manage the liquidity requirements of the centre
iii. Optimally utilize the various hedging strategies so as to minimize the MNCs
foreign exchange exposure
iv. Helping the centre to take complete advantage of multinational netting so as to
minimize the MNCs foreign transaction costs and currency exposure.
v. Achieve maximum utilization of the transfer pricing mechanism so as to enhance
the profitability and growth by the firm
20. Explain the terms bid rate and offer rate
A. Bid rate: Is the rate at which the bank (dealer) buys one unit of the foreign currency
Ask rate: Is the rate at which the bank (dealer) sells one unit of the foreign currency
21. What do you mean by short position?

A. A market commitment is the number of contracts bought or sold for which no
offsetting transaction has been entered into. The buyer of an asset (currency) is said to
have a long position, and the seller of an asset (currency) is said to have a short position.
One has a long position when one owns something, while one has a short position when
something is sold, especially sold short
22. What is country risk?

A. Is the risk which emanates from political, social, and economic (financial) instability
of a country and manifests in the form of more or less strong hostility towards foreign
investments

23. What is economic exposure?

A. Economic exposure measures the impact of unanticipated currency changes on
monetary transactions as well as the uncertain future cash-flows generated by the firms
income-generating real assets.
24. Contrast the speculative and hedging motives for usage of derivatives
A. Speculators are the class of investors who willingly take price risks to profit from
price changes in the underlying. They want to make quick fortune by
anticipating/forecasting future market movements.
Hedgers wish to eliminate or reduce the price risk to which they are already exposed.
Hedging is a mechanism to reduce price risk inherent in open positions. A hedging
can help lock in existing profits.
25. Consider the value of the DEM relative to the USD. The spot rate is DEM 1.82.
The interest rates in the US and Germany are 5% and 3% respectively. Estimate
the price on a 4-month forward contract on DEM.
A.
26. Assume that US inflation rate is 8% and the Mexicos inflation rate is 10% per
year. What is the NPV of the investment in Mexico if the real value of the Peso is
unchanged over the period
A.
27. What do you mean by balance of payments?

A. The BOP(Balance of Payments) of a country can be defined as a systematic record of
all economic transactions between the residents of a country and the residents of the
other countries of the world over a specified period of time(usually one year). It
accounts for transactions by individuals, businesses and government.
28. If the inflation rate in the country is 6.5% and expected real interest rate is 5%,
then what is the nominal interest rate an investor should earn?
A. 1 + Nominal rate = (l + Real rate) (l + Expected inflation rate)
1 + Nominal rate = ( 1 + 5) ( 1 + 6.5) = 45
Nominal rate = 44%
29. Differentiate between risk and exposure?

A. Foreign Exchange Risk is the uncertainty or variance of the domestic currency value
of assets, liabilities, unanticipated changes in the foreign exchange rates while Foreign
exchange exposure is the measure of the sensitivity of the changes in the real domestic
currency value of assets, liabilities or operating incomes. Exposure is a measure of
sensitivity of value of the financial items to change in variables like exchange rates,
Inflation rates, relative prices etc.
30. What do you mean by soft or weak and hard or strong currency?
A. Soft or weak Currency: It is the currency which is expected to depreciate rapidly or
that it is difficult to convert into other currencies.

Hard or Strong Currency: It is currency which is expected to appreciate and can

serve as a reliable and stable value.
31. What is interest rate parity? Explain the terms with examples bid and ask quote.
A. The interest rate parity theory states that the difference in the interest rates( risk-free)
on two currencies should be equal to the difference between the forward exchange rate
and the spot exchange rate if there are to be no arbitrage opportunities.
32. What is the difference between a put on British pounds sterling and call on
sterling
A. A put on British Pounds provides the holder with the right to sell the underlying
currency. A call on sterling provides the holder with the right to buy the underlying
currency
33. Define the terms hedging and currency risk

A. Hedging is an instrument made in order to reduce the risk of adverse price movements
in a security, by taking an offsetting position in a related security such as an option or a
short sale.
34. What do you mean by political risk?

A. Political risk is the exposure to a change in the value of an investment or cash-flows of
a foreign firm arising out of unexpected change in the political environment of the host
country. Political risks are caused by the unanticipated changes in the tax laws, labour
laws and other laws that hurt the profitability and viability of the foreign projects.
35. What is dollarization

A. Dollarization is system of adopting the currency (dollar or not) of another nation in
place of a domestic currency. For example panama has been using the U.S
39. What is triangular Arbitrage?

A. If three currencies are involved in an arbitrage operation, it is called a three point
arbitrage. In a triangular arbitrage one currency is traded for another currency, which
is traded for the third currency, which is then traded for the first currency. Triangular
arbitrage exists when the currency direct quotes are not in alignment with the cross
exchange rates.
40. What is foreign exchange market?

A. The foreign exchange market is a market where one currency is traded for another. It
allows currencies to be exchanged in order to facilitate international trade or financial
transactions.
41. What is International Capital Budgeting?

A. It refers to the analysis of cash inflows and outflows associated with prospective long-
-term foreign investment projects. It helps in identifying the cash flows put to risk and
estimate cash flows to be derived over time
42. What is foreign Direct Investment?
A. Foreign Direct Investment is any form of investment and the parent company builds
productive capacity in a foreign country and processes foreign ownership of an enterprise.
The IMF defines Foreign Investment as FDI when the investor holds 10% or more of the
equity of an enterprise. FDI is an important source of capital.

43. What is multilateral Netting? What is Bilateral Netting

A. It refers to offsetting exposure in one currency with exposure in the same or another
currency whose exchange rates are expected to move in such a way that loss or gain on
first exposed position will be offset by gain or loss in the second exposed position.
Bilateral netting is done between two parties and two currencies.
44. What is CTA?

A. The gains or losses caused by translation adjustment are not included in the net income
but reported separately and accumulated in a separate equity account known as
Cumulative Translation Adjustment (CTA). The CTA account helps in balancing the
balance sheet.
45. What are Depository Receipts (DRs)

A. It is a type of negotiable (transferable) financial security that is traded on a local stock
exchange but represents a security, usually in the form of equity that is issued by a
foreign publicly listed company.
46. What is Euro-currency?

A. It refers to the currency held by non-residents and placed on deposit with the banks
outside the country of the currency. Eg US dollars owned by a ABN AMRO Bank and
deposited in London.
47. What is Back-to-Back Loan?

A. It is a type of loan where by two companies in different companies borrow offsetting
amounts from one another in each others currency. The purpose of this transaction is to
hedge against currency risk. Nowadays these are replaced by Currency swaps.
48. What is SWIFT?

A. It refers to Society For World Wide Inter Bank Financial Telecommunication. The
SWIFT operates a worldwide financial messaging network which exchanges messages
between banks and financial institutions.
49. What is the difference between Reciprocal rate and cross rate?
A. Reciprocal Rate: It is also known as Indirect quote. It is the number of units of the
foreign currency exchanged for one unit of home currency.
1 DX (Domestic currency) = no of units of FX(foreign currency)
Cross rate: When quotations are not available for a pair of currency, third currency is
used to find out the exchange rate between the pair of the currency. Determining the
exchange rate for two unpopular traded currencies by using a third popular currency is
called Cross rate.
50. Distinguish between Spot, Forward and Future market.

A. The spot market is where securities or currencies are characterised by simultaneous
delivery and payment. The payment for the transaction takes place immediately or in T+2
days.
Forward Transactions: are transactions in which the price, number and delivery date of
the securities to be traded are agreed upon between the buyer and the seller. It is done
over the counter (OTC) consisting of tailor made contracts.

Future Market: is a market where the price, number and delivery date of the securities to
be traded are standardized and are traded over the exchange and the contract agreed upon
will be executed at a future date.
51. What is currency call and put option?

A. The right bit not the obligation to buy one currency against another currency is known
as Call Option.
The right but not the obligation to sell one currency against another currency is known as
Put Option
52. Distinguish between Leading and Lagging?

A. Leading and lagging involves an adjustment in the timing of the payment or
disbursement to reflect expectations about the future currency movements. Leading
means fastening (paying or receiving early) and lagging means delaying (paying or
receiving late)
53. What do you mean by SDR?

A. The SDR (Special Drawing Rights) is an international reserve asset, created by the
IMF in 1969 to supplement the existing official reserves of member countries. SDRs are
allocated to member countries in proportion to their IMF quota. The SDR also serves as
the unit of account of the IMF and some other international organizations. Its value is
based on a basket of key international currencies. SDR is a composite reserve asset to
supplement existing reserve asset.SDR is valued with a basket of 5 countrys currencies
with the largest share of world exports of goods and services. SDRs can used by countries
to reduce the deficits in the balance of payments
54. Define exposure netting.

A. Exposure netting involves offsetting exposures in one currency with exposures in the
same or another currency, where exchange rates are expected to move in such a way that
losses /gains on the first exposed position should be offset by gains/ losses on the second
currency exposure.
55. What is money market hedge?

A. A money market hedge involves simultaneous borrowing and lending activities in two
different currencies to lock the home currency value of a foreign currency cash flow.
56. What do you mean by double Taxation?

A. Double taxation means taxation of same income of an individual in more than one
country. This results due to countries following different rules for taxation.
57. Explain the meaning of cross-rate consistency?

A. The exchange rate for a non-US currency expressed in terms of another US currency is
referred to as cross rate. Cross-rate consistency refers to the stability of exchange rate
over a period of time.

Section-B
1. Explain the three types of transactions takes place in forex market?
A. i. Spot Market:
These are the quickest transactions involving currency in foreign markets. These
transactions involve immediate payment at the current exchange rate, which is also
called the spot rate. The trades usually take place within two days of the agreement.
This does leave the traders open to the volatility of the currency market, which can
raise or lower the price between the agreement and the trade.
ii. Forward Transactions: In this type of transaction, money does not actually change
hands until some agreed upon future date. A buyer and seller agree exchange rate for any
date in the future date. The date can be days, months or years.
Examples include: i) Futures ii) Swap
Futures Market: These transactions involve future payment and future delivery at an
agreed exchange rate, also called the future rate. These contracts are standardized, which
means the elements of the agreement are set and non-negotiable. It also takes the volatility
of the currency market, specifically the spot market, out of the equation. These are popular
among traders who make large currency transactions and are seeking a steady return on
their investments.
Forward Market: These transactions are identical to the Futures Market except for one
important difference---the terms are negotiable between the two parties. This way, the
terms can be negotiated and tailored to the needs of the participants. It allows for more
flexibility. In many instances, this type of market involves a currency swap, where two
entities swap currency for an agreed-upon amount of time, and then return the currency at
the end of the contract.
iii. Options: This transaction overcomes the problems of forward transactions, an option
provides its owner the right to sell/buy a specified amount of foreign currency at a
specified price.
2. State the main features of currency futures?

A. The main features of currency futures are
Is a standardized agreement to sell or buy a specified amount of currency at a fixed
rate and date
Currency futures trade on a quarterly cycle, being in the month of March, June,
September and December. The future maturing on the Monday before the third
wednesday of the month
Every trader who desires to buy or sell futures contracts must open an account with
his or her broker and deposit some amount before the transaction is executed. The
amount thus deposited is known as Initial Margin. The initial margin is a certain
percentage of futures contract.
Unlike a forward contract future contract are settled every trading day at the
settlement price. This process is called marking to market. At the end of the day a
partys gain (loss) is added to (subtracted) from the margin account.
The balance in the margin account of the investor should never be negative. In order
to ensure that another kind of margin, known as the maintenance margin or
maintenance performance bond. If the balance goes down below the maintenance
margin a margin call is given to the trader to replenish or rather square-off.

Currency futures transactions can be closed out either through delivery of the
underlying foreign currency on full settlement or by an offsetting trade.
3. State the methods of managing transaction exposure

OR
Bring out the various internal strategies a firm can take if it anticipates
depreciation /appreciation of home currency against the foreign currency
A. Transaction exposure can be hedged by financial contracts like

i) Forward Market Hedge
ii) Future Hedge
iii) Money Market Hedge
iv) Options Market Hedge
i) Forward contracts can be used to lock in the futures exchange rate at which
an MNC can buy or sell a currency. A forward rate at which a MNC can buy or
sell a currency. A forward market are used for large transactions whereas the
futures market hedge are used for small contracts.
ii) Currency Futures can be used by firms that desire to hedge transaction
exposure either by purchasing currency futures or by selling a currency future for
a stated price on a specified date.
iii) Money market hedge involves simultaneous borrowing & lending activities
in two different currencies to lock in the home currency value of a future foreign
currency cash flow. The simultaneous borrowing & lending activities enable a
company to create a home-made forward contracts. The firm seeking money
market hedge borrows in one currency & exchanges the proceeds for another
currencies
iv) Options market hedge: Forward hedge and Money market hedge can
backfire when a payable currency depreciates (or) a receivables currency
appreciates over the hedge period. In such situations an un-hedged strategy would
likely outperform the forward hedge or money market hedge. The ideal type of
hedge would insulate the firm from adverse exchange rate movements but also
allow the firm to benefit from favourable exchange rate movements.
The other alternative Hedging Techniques for transaction exposure are:
a) Leading or lagging b) Currency swaps c) Cross Hedging
d) Pricing of transactions e) Currency Diversification f) Matching of cash
flows g) Risk Sharing h) Parallel Loans or Back-to-Back loans
4. Why do discrepancies arises in the balance of payment?

A. Discrepancies may arise in the balance of payments because there is no single source
for balance of payments data and no way to ensure that data from different sources are
fully consistent. Sources include customs data, monetary accounts of the banking
systems, external debt records, information provided by enterprises, surveys to
estimate service transactions and foreign exchange records. Differences in recording
methods for example in the timing of transactions in definitions of residence and
ownership and in the exchange rate used to value transactions contribute to net errors
and omissions. In addition smuggling and other illegal or quasi-legal transactions may
be unrecorded or misrecorded.
5. What factors influencing pricing of a currency option?

A. The factors affecting the Currency Options are

i. Exercise price and the share/underlying asset price: If the underlying asset is a
currency the value of the call option would increase as the value of the currency
increase
ii. Volatility of an underlying asset: The greater the risk of the underlying asset, the
greater the value of an option.
iii. Interest rate: The present value of the exercise price will depend on the interest
rate (and the time until expiration of the option) . The value of a call option will
increased with the rising interest rate since the present value of the exercise price will
fall. The buyer of the put option receives the exercise price and hence, with increasing
interest rate the value of put option declines
iv. Time and date to option expiration: The present value of the exercise price will
be less if the time to expiration is longer and consequently the value of the option will
be higher.
v. Strike Price
vi. Whether it is a call or put
6. Distinguish between currency futures and options?

A.
Currency Options Currency Futures
1.obligations An currency option gives the buyer A futures contract gives the
the right, but not the obligation to buyer the obligation to
buy (or sell) a certain currency at a purchase a specific Currency,
specific price at any time during the and the seller to sell and
life of the contract deliver that asset at a specific
future date
2.commission/ Besides commission an investor can an options position does
premium enter into a futures contract with no require the payment of a
upfront cost premium
3. underlying Comparatively lesser for options is much larger for futures
position contracts
4. Gain The gain on a option can be realized gains on futures positions are
in the following three automatically 'marked to
ways: exercising the option when it market' daily, meaning the
is deep in the money, going to the change in the value of the
market and taking the opposite positions is attributed to the
position, or waiting until expiry and futures accounts of the parties
collecting the difference between at the end of every trading day
the asset price and the strike price - but a futures contract holder
can realize gains also by going
to the market and taking the
opposite position.
7. Explain the different types of transactions takes place in forex market.

OR
Briefly describe the foreign exchange derivatives market?
A. The common derivatives products are forwards, futures, options and swaps.
Currency Market Hedges

To hedge currency exposure is through devices of several currency markets-forward

contracts, futures contracts, currency options, and currency swaps.
Currency Futures
Closely related to the use of a forward contract is a futures contract. A currency futures
market exists for the major currencies of the world. For example, the Australian dollar, the
Canadian dollar, the British pound, and the Swiss franc, and the yen. A futures contract is a
standardized agreement that calls for delivery of a currency at some specified future date,
either the third Wednesday of March, June, September, or December. Contracts are traded on
an exchange, and the clearinghouse of the exchange interposes itself between the buyer and
the seller. This means that all transactions are with the clearinghouse, not made directly
between two parties. Very few contracts involve actual delivery at expiration. Rather, a buyer
and a seller of a contract independently take offsetting positions to close out a contract. The
seller cancels a contract by buying another contract, while the buyer cancels a contract by
selling another contract.
Currency Options
Forward and futures contracts provide a "two-sided" hedge against currency movements.
That is, if the currency involved moves in one direction, the forward or futures position
offsets it. Currency options, in contrast, enable the hedging of "one-sided" risk. Only adverse
currency movements are hedged, either with a call option to buy the foreign currency or with
a put option to sell it. The holder has the right, but not the obligation, to buy or sell the
currency over the life of the contract. If not exercised, of course" the option expires. For this
protection, one pays a premium.
There are both options on spot market currencies and options on currency futures
contracts. Because currency options are traded on a number of exchanges throughout the
world, one is able to trade with relative ease. The use of currency options and their valuation
are largely the same as for stock options. The value of the option, and hence the premium
paid, depends importantly on exchange-rate volatility.
Currency Swaps
Yet another device for shifting risk is the currency swap. In a currency swap two parties
exchange debt obligations denominated in different currencies. Each party agrees to pay the
other's interest obligation. At maturity, principal amounts are exchanged, usually at a rate of
exchange agreed to in advance. The exchange is notional in that only the cash-flow difference
is paid. If one party should default, there is no loss of principal per se. There is, however, the
opportunity cost associated with currency movements after the swap's initiation.
Currency swaps typically are arranged through an intermediary, such as a commercial
bank. Many different arrangements are possible: a swap involving more than two currencies;
a swap with option features; and a currency swap combined with an interest-rate swap, where
the obligation to pay interest on long-term debt is swapped for that to pay interest on short-
term, floating-rate, or some other type of debt. As can be imagined, things get complicated
rather quickly. The point to keep in mind, however, is that currency swaps are widely used
and serve as longer-term risk-shifting devices.
8. Distinguish between futures and forwards

A.
Feature Forward Contracts Future Contracts

Type of contract Customized Standardized
Maturity As desired by contracting There are only few
parties usually in maturity dates such as
multiples of 30 days quarterly in an year

Contract Size Generally large averaging Small enough that it is

more than 1 million accessible to small-scale
dollars per contract forex participants
Security Arrangements Bank forward customers All traders must maintain
must maintain minimum margin deposits that are
deposit balances small % of the contract
values
Cash flows No cash flow until Daily settlement results in
delivery cash payments to some
parties
Final settlement 90% of the forward are Less then 2% is physical
settled physically by delivery remaining 98% is
delivery cash settlement
Default risk There is substantial loss Default risks are taken
can occur if one party care by the margins paid
defaults to the exchange
Variety of currencies Forward are available in Are limited to a small
all currencies of number of currencies
developed countries
9. Why did the fixed exchange regime of 1945-1973 eventually fail?

A. The Bretton woods systems worked without major changes from 1947 to 1971.
During this period the fixed exchange rates were maintained by official intervention
of the foreign exchange market. The system however suffered from a number of
inherent structural problems. Firstly there was much imbalance in the roles and
responsibilities of the surplus and deficit nations. Countries with persistent deficits in
their balance of payments had to undergo tight and stringent economic policy
measures if they wanted to take help from the IMF and stop the drain on their
reserves.
The basic problem here was the rigid approach adopted by the IMF to the balance of
payments. From August-December 1971 most of the major currencies were permitted
to fluctuate. Although the US dollar was not convertible into gold, it was still defined
in terms of gold. The united States agreed to devalue the dollar from $35 per ounce of
gold to $ 38 in return for promises from other members to up-value their relative to
the dollar by specified.
10. How can a MNE minimize its translation and transaction exposure
simultaneously?
A. The methods for managing Translation exposure are
i. Adjusted Fund flows: It involves altering either the amount of currencies or both
cash flows of parent or subsidiary to reduce the firms local currency exposure
If local currency devaluation is expected then exports are priced in hard currency
(foreign currency) and imports are priced in soft currency(local currency)
ii. Entering into forward contracts: It demands a formal market in the respective
local currency. Forward contract creates an offsetting asset or liability in the foreign
currency the gain or loss on the transaction exposure is offset or liability in the foreign
currency the gain or loss on the transaction exposure is offset by a corresponding loss or
gain in forward market

iii. Exposure rating: It refers to offsetting exposure in one currency with exposure in
the same or another currency whose exchange rates rae expected to move in a way such
that loss or gain on first exposed position will be offset by gain or loss to the second
exposed position
The methods of managing transaction exposure are
Price adjustment
Forward Market
Money Market
Currency Market
Borrowing or lending in foreign currency
11. What are a countrys objectives when determining tax policy on foreign source
income
A.
12. Explain the characteristics of Eurocurrency Market and write briefly about its
significance.
A. A Eurocurrency is any freely convertible currency deposited in a bank outside its
country of origin. Pounds which is deposited in US become Eurosterling and dollars
deposited in UK are called Eurodollars. Similar examples are Euroyen, Euromarks.
SECTION - C
1. Compare the IRP and PPP theory
A. Purchasing Power Parity (PPP)

Purchasing power parity (PPP) was first stated in a rigorous manner by the Swedish
economist Gustav Cassel in 1918.
PPP has been widely used by central banks as a guide to establishing new par values for their
currencies when the old ones were clearly in disequilibria. From a management standpoint,
purchasing power parity is often used to forecast future exchange rates, for purposes ranging
from deciding on the currency denomination of long-term debt issues to determining in which
countries to build plants.
There are two popular forms of PPP theory, each of which has its own implications
Absolute PPP
Relative PPP
In its absolute version, purchasing power parity states that exchange-adjusted price levels
should be identical worldwide. It is also called as the Law of One Price. In other words, a
unit of home currency (HC) should have the same purchasing power around the world. This
theory is just an application of the law of one price to national price levels rather than to
individual prices. (That is, it rests on the assumption that free trade will equalize the price of
any good in all countries; otherwise, arbitrage opportunities would exist) However, absolute
PPP ignores the effects on free trade of transportation costs, tariffs, quotas and other
restrictions, and product differentiation.
The relative version of purchasing power parity, which is used more commonly now,
states that the exchange rate between the home currency and any foreign currency will adjust
to reflect changes in the price levels of the two countries. For example, if inflation is 5% in
the United States and 1 % in Japan, then in order to equalize the dollar price of goods in the
two countries, the dollar value of the Japanese yen must rise by about 4%.

This form of PPP theory account for market imperfections such as Inflation, transportation
costs, Tariffs and Quotas. Relative PPP theory accepts that because of market imperfections
prices of similar products in different countries will not necessarily be the same when
measured in a common currency
Formula for PPP is
where ef = % change in the exchange rate Ih and If are the
inflation rate of the home and foreign country.
Interest rate parity (IRP): The interest rate parity is the basic identity that relates interest
rates and exchange rates. It states that the returns from the borrowing in one currency
exchanging that currency for another currency.
Interest rate parity is a relationship that must hold between the spot interest rate of two
currencies if there are to be no arbitrage opportunities. The relationship depends upon spot
and forward exchange rates between the two currencies
m
f 1 + r a
= where S spot rate f- forward rate , ra and rb are the interest rates for the
S 1 + rb
respective currencies
In other words the currency of a high interest rate country will be at a forward discount
relative to the currency of a low interest rate country and vice-versa. This implies that
exchange rate (forward and spot) differential will be equal to the interest rate differential
between the two countries.
Interest rate differential = Exchange rate (forward or spot) differential
IRP works fairly well in the international capital markets where no restrictions exists for the
flow of funds from one country to another & no tax symmetries exists.
Theory Key variables of theory Summary of Theory
Interest Rate parity (IRP) Forward rate Interest The forward rate of one
premium or differential currency with respect to
discount another will contain a
premium (or discount) that is
determined by the differential
in interest rates between the
two countries. As a result,
covered interest rate arbitrage
will provide a return that is
no higher than a domestic
return
Purchasing Power Percentage Inflation The spot rate of one currency
Parity(PPP) change in the rate with respect to another will
spot exchange differential change in reaction to the
rate differential in reaction to the
differential in inflation rates
Consequently the purchasing
power for consumers when
purchasing goods in their
own country will be similar
to their purchasing power

when importing goods from

the foreign country
2. Briefly explain the important factors that should be assessed from the points of
view of Income tax, while entering into foreign collaboration agreement.
A. i. Choose the right country: It is very essential to choose the right country from
where investment should be made. Such a choice would be depend upon the effective rate of
taxation in the hands of the foreign company on dividend income and capital gains tax
income.
ii. Tax Credit: Double taxation avoidance agreements provide for tax credit in respect of
taxed paid in other country. Tax credit is normally a benefit which accrues to the foreign
collaborator and should be taken into account in fixing the consideration payable to the
foreign collaborator.
iii. Dependent service: Generally salaries, wages and other remuneration received by the
foreign personnel deputed to India, are not taxable if the period of stay does not exceed 181
days in the fiscal year.
iv. Split up of total consideration payable to foreign party: In case of many treaties,
different rates are provided for royalty and technical service fees.
v. Take advantage of the examples given in the treaty.
vi. Tax Sparing: Tax sparing provisions in the treaties should be carefully considered.
vii. Royalty via business profits:
viii. Presumptive tax:
ix. Accommodation/living expenses provided to technicians
3. FDI flows into India are around 3.4% which is very low when compared to china and
Hong-kong. What policy measures do you think the regulatory authorities should
initiate to attract more FDI flow into the country
4. What do you mean by Depository Receipt and also explain the mechanism of
depository receipt, what are its advantages.
A. Depository Receipts is a negotiable certificate that usually represents a companys

publicly traded debt or equity. Depository receipts are created when a broker
purchases the companys shares on the home stock market and delivers those to the
Depositorys local custodian bank, which then instructs the depository bank, to issue
Depository Receipts. Depository receipts are quoted and traded in the currency of the
country in which they are trade and are governed by the trading and settlement
procedures. The ease of trading and settling DRs makes them an attractive investment
opinion for the investor wishing to purchase shares in the foreign companies.
Depository receipts may trade freely, just like any other security, either on an
exchange or in the over-the-counter market and can be used to raise capital.
The most common DRs are the American Depository Receipts (ADRs) and the Global
Depository Receipts (GDRs). A GDR is issued in America is called as American
Depository Receipts (ADR).
The mechanism for Depository Receipts

BENEFITS OF A DR PROGRAM
DRs Allow Issuers to:
Access deep international capital markets and flexible funding options
Increase share valuation and liquidity
Diversify and broaden their shareholder base
Prepare for future acquisitions
Express the international commitment of their company
Heighten the profile for their products
DRs Allow Investors to:
Invest in more than 2,000 sponsored depositary receipts from 76 countries
Receive quotes and dividends in U.S. dollars
Clear and settle according to global standards
Overcome foreign investment restrictions
Access improved information flow in English
Increase investment activity in the Company from Institutional Investors.
Buy-side analysts recommend investing in international stocks to their client base.

5. What do you understand by the term International Cash Management?

Briefly elucidate its objective.
A. Cash management is an important aspect of working capital management and effective
cash management is one of the chief concerns of the MNCs. International cash management
is more complicated because it needs to recognise the principles and practices of other
countries. For example many countries require that their exporters repatriate the proceeds of
foreign sales within a specific period or there could be a problem of blocked funds. This
restrictions hinder the free flow of capital and effective cash management.
The Objectives of an effective International Cash Management Systems
Minimise the country exposure risk

Minimise the country political risk
Minimise the overall cash requirements of the company as a whole without disturbing
the smooth operations of the subsidiary or its affiliate
Minimise the transactions costs
Avoidance of foreign exchange losses
Minimization of the tax burden of the firm as a whole
Full benefits of economies of scale as well as the benefits of superior knowledge
The complexity and problems in international cash management decisions arise due to the
conflicting nature of the above mentioned objectives. For example minimizing transaction
costs of currency covers would require that cash balances be kept in the currency in which
they are received, which conflicts with both the currency and political exposure criteria
6. Identify factors to be considered when assessing country risk. Briefly elaborate
how each factor can affect the risk to the MNC.
A. The factors that affect country risk can be of two types
i. Political Risk Factors
Political Stability
Philosophy and Ideology of political parties
Integration into the world system
Ethnic and Religious Stability
Attitude of the Host Country Consumers
Disruptions in operations
Blockage of funds transfer by subsidiary to the parent firm
Loss of Intellectual Property rights
Economic source of political Rights
Corruption
ii. Financial Risk Factors:
Current and potential economic health of the host country
Financial state of the host country
Monetary and Fiscal policies of the Host Country
Unproductive spending by the host country government
Country Risk Analysing Technique
Checklist Method

Delphi Approach
Statistical Techniques
Spot Visits
Combination of Techniques
7. Describe briefly the distinguishing features of international finance.
A. The distinguishing features of international finance are:
i. Foreign Exchange risk
ii. Political risks
iii. Expanded opportunities
iv. Market imperfections
i. Foreign exchange risk: when different national currencies are exchanged for
each other there is a definite risk of volatility in foreign exchange rates
ii. Political risks: ranges from the risk of loss or gain from unforeseen
government action. Since MNCs are exposed to more countries they are
exposed to various types of political risks.
iii. Expanded opportunities: when firms go global, they also tend to benefit
from expanded opportunities which are available. They can raise money from
markets where cost of capital is low.
iv. Market Imperfections: the world markets are highly imperfect due to
differences in the nations laws, tax system, business practices etc
8. Explain briefly the role of international finance manager.

A. i. Making investment decisions: the finance manager has to identify profitable
opportunities for a long term investment by using capital budgeting techniques.
ii. Managing working capital: one very important role of international finance
manager is management of current assets and liabilities and maintain an optimum
working capital.
iii. Making finance decisions
iv. management of assets from cash management
v. Exchange risk measurement
vi. Performance evaluation and control
9. Explain the objectives and Functions of IMF.
A. The objectives of IMF are
a) To promote international monetary co-operation, exchange stability and orderly
exchange arrangement
b) To foster economic growth and a multilateral system of payments and transfers
while eliminating exchange restrictions
c) To provide temporary financial assistance to countries to help ease balance of
payments
d) To facilitate the balanced growth of international trade and to contribute to high
levels of employment, real income and productive capacity.
e) To make financial resources available to members.
The functions of IMF are:

a) Surveillance: is the regular advice IMF provides for its member countries.
b) Technical assistance: and training are offered mostly free of charge to help
member countries strengthen their capacity to design and implement effective
policies.
c) Financial Assistance: is available to give member countries the chance to correct
balance of payments problems. A policy program supported by IMF financing is
designed by the national authorities in close co-operation with the IMF.
10. Briefly describe the evolution of the International Monetary System.
OR
What are the five basic mechanisms for establishing exchange rates? How does
each work?
A. The Gold Standard
This is the older state system, which was in operation till the beginning of the First
World War and for a few years after that. In the version called Gold Specie Standard
the actual currency in circulation consisted of gold coins with a fixed gold content. In
a version called Gold Bullion Standard, the basis of money remains a fixed weight of
gold but the currency circulation consists of paper notes with the authorities standing
ready to convert on demand, unlimited amounts of paper currency into gold and vice
versa, at a fixed conversion ratio.
Thus a pound sterling note can be exchanged for say x ounces of gold, while a dollar
note can be converted into say y ounces of gold on demand. Finally, under the Gold
Exchange Standard, the authorities stand ready to convert, at a fixed rate, the paper
currency issued by them into the paper currency of another country, which is
operating a gold-specie or gold-bullion standard thus if rupees are freely convertible
into dollars and dollars in turn into gold, rupee can be said to be on a gold-exchange
standard. The exchange rate between any pair of currencies will be determined by
their respective exchange rates against gold. This is the so-called "mint parity" rate of
exchange. In practice because of costs of storing and transporting gold, the actual
exchange rate can depart from this mint parity by a small margin on either side. Under
the true gold standard, the monetary authorities must obey the following three rules of
the game:
- They must fix once-for-all the rate of conversion of the paper money issued by
them into gold.
- There must be free flows of gold between countries on gold standard.
The money supply in the country must be tied to the amount of gold the monetary
authorities have reserve. If this amount decreases, money supply must contract
and vice-versa.
The gold standard regime imposes very rigid discipline on the policy makers. Often,
domestic considerations such as full employment have to be sacrificed in order to
continue operating the standard, and the political cost of doing so can be quite high.
For this reason, the system was rarely allowed to work in its pristine version. During
the Great Depression, the gold standard was finally abandoned in form and substance.
In modern times, some economists and politicians have advocated return to gold
standard precisely because of the discipline it imposes on policy makers regarding

reckless expansion of money supply. As we will see later, such discipline can be
achieved by adopting other types of exchange rate regimes.
B. The Bretton Woods System
Following the Second World War, policy makers from the victorious allied powers,
principally the US and the UK, took up the task of thoroughly revamping the world
monetary system for the non-communist world. The outcome was the so- called
"Bretton Woods System and the birth of two new supra- national institutions, the
International Monetary Fund (the IMF or simply "the Fund") and the Word Bank- the
former being the linchpin of the proposed monetary system.
The exchange rate regime that was put in place can be characterized as the Gold
Exchange Standard. It had the following features:
- The US government undertook to convert the US dollar freely into gold at a
fixed parity of $35 per ounce.
- Other member countries of the IMF agreed to fix the parities of their currencies
vis `a - vis the dollar with variation within 1 % on either side of the central parity
being permissible. If the exchange rate hit either of the limits, the monetary authorities
of the country were obliged to "defend" it by standing ready to buy or sell dollars
against their domestic currency to any extent required to keep the exchange rate within
the limits. In return for undertaking this obligation, the member countries were entitled
to borrow from the IMF to carry out their intervention in the currency markets. The
novel feature of the regime, which makes it an adjustable peg system rather than a fixed
rate system like the gold standard was that the parity of a currency against the dollar
could be changed in the face of fundamental disequilibria. Changes of up to 10% in
either direction could be made without the consent of the Fund while larger changes
could be effected after consulting the Fund and obtaining their approval. However, this
degree of freedom was not available to the US, which had to maintain gold value of the
dollar.
C. Exchange Rate Regimes: The Current Scenario
The IMF classifies member countries into eight categories according to the exchange
rate regime they have adopted.
(1) Exchange Arrangements with No Separate Legal Tender: This group includes
(a) Countries which are members of a currency union and share a common currency,
like the eleven members of the Economic and Monetary Union (EMU) who have
adopted Euro as their common currency or
(b) Countries which have adopted the currency of another country as their
currency. This latter group includes among others, countries of the East Caribbean
Common Market (e.g. Grenada, Antigua, St. Kitts & Nevis), countries belonging to the
West African Economic and Monetary Union (e.g. Benin, Burkina Faso, Guinea-
Bisseau, Mali etc.) and countries belonging to the Central African Economic and
Monetary Union (e.g. Cameroon, Central African Republic, Chad etc.). These two latter
groups have adopted the French Franc as their currency. As of 1999, 37 IMF member
countries had this sort of exchange rate regime.
(2) Currency Board Arrangement: A regime under which there is a legislative

commitment to exchange the domestic currency against a specified foreign currency at
a fixed exchange rate, coupled with restrictions on the monetary authority to ensure that
this commitment will be honored. This implies constraints on the ability of the
monetary authority to manipulate domestic money supply. As of 1999, eight IMF
members had adopted a currency board regime including Argentina and Hong Kong
Tying their currency to the US dollar.

(3) Conventional fixed Peg Arrangements: This is identical to the Bretton Woods
system where a country pegs its currency to another or to a basket of currencies with a
band of variation not exceeding 1% around the central parity. The peg is adjustable at
the discretion of the domestic authorities. Forty-four IMF members had this regime as
of 1999. Of these thirty had pegged their currencies in to a single currency and the
rest to a basket.
(4) Pegged Exchange Rates within Horizontal Bands: Here there is a peg but
variation is permitted within wider bands. It can be interpreted as a sort of
compromise between a fixed peg and a floating exchange rate. Eight countries had
such wider band regimes in 1999.
(5) Crawling Peg: This is another variant of a limited flexibility regime. The currency
is pegged to another other currency or a basket but the peg is periodically adjusted. The
adjustments may be pre-an- enounced and according to a well specified criterion, or
discretionary in response to changes in selected quantitative indicators such as inflation
rate differentials. Six countries were under such a regime in 1999. .
(6) Crawling Bands: The currency is maintained within certain margins around a
central parity. Which "crawls" as in the crawling peg regime either in a preannounced
fashion or in response to certain indicators. Nine countries could be characterized as
having such an arrangement in 1999.
(7) Managed Floating with no Pre-announced Path for the Exchange Rate: The
central bank influences or attempts to influence the exchange rate by means of active
intervention in the foreign exchange market-buying or selling foreign currency against
the home currency-without any commitment to maintain the rate at any particular level
or keep it on any pre-announced trajectory. Twenty-five countries could be classified as
belonging to this group.
(8) Independently Floating: The exchange rate is market determined with central
bank intervening only to moderate the speed of change and to prevent excessive
fluctuations, but not attempting to maintain it at or drive it towards any particular level.
In 1999, forty-eight countries including India characterized themselves as independent
floaters. It is evident from this that unlike in the pre-I973 years, one cannot characterize
the international monetary regime with a single label. A wide variety of arrangements
exist and countries move from one category to another at their discretion. This has
prompted some analysts to call it the international monetary "non-system".
11. Mention the different types of exchange rate system and explain them.

A. The different types of
A managed floating rate system is a hybrid of a fixed exchange rate and a flexible
exchange rate system. In a country with a managed floating exchange rate system, the
central bank becomes a key participant in the foreign exchange market.
Under the managed floating regime the central bank holds stocks of foreign currency
known as the foreign exchange reserves
Fixed (pegged) Exchange rate systems: The basic motivation for keeping exchange
rates fixed is the belief that a stable exchange rate will help facilitate trade and
investment flows between countries by reducing fluctuations in relative prices. Here
the central bank stands ready to exchange local currency and at a pre-defined rate.
Under the fixed exchange rate system the central bank remains prepared to absorb the
excess of demand or supply.
12. Explain Balance of payments

A. The balance of payments accounts are those that record all transactions between the
residents of a country and residents of all foreign nations.
The BOP is determined by the country's exports and imports of goods, services,
and financial capital, as well as financial transfers.
It reflects all payments and liabilities to foreigners (debits) and all payments and
obligations received from foreigners (credits).
Balance of payments is one of the major indicators of a country's status in
international trade
BOP consists of
The Current Account
The Capital Account
Official Reserves Account
Errors and Ommisions

Current Account
Includes all imports and exports of goods and services.
Includes unilateral transfers of foreign aid.
If the debits exceed the credits, then a country is running a trade deficit.
If the credits exceed the debits, then a country is running a trade surplus.
Current Account
1. Export & Import of Merchandise & Services
2. Income Account
(The income account accounts mostly for investment income from dividends and
interest on credit and payments on foreign taxes.)
3. Transfer payment (Grants received / given, Pvt.Transfer)
Capital Account
1. Foreign Investment(FDI, FII)
2. Banking Capital (NRI Deposits)
3. Short term credit
4. External Commercial Borrowings(ECB)
Capital Account
If foreign ownership of domestic financial assets has increased more quickly than
domestic ownership of foreign assets in a given year, then the domestic country
has a capital account surplus.
On the other hand, if domestic ownership of foreign financial assets has increased
more quickly than foreign ownership of domestic assets, then the domestic
country has a capital account deficit.
Official international reserves
The official international reserve account records the change in stock of official
international reserve assets (also known as foreign exchange reserves) at the
country's monetary authority.
Official reserves assets include gold reserves, foreign currencies, SDRs, reserve
positions in the IMF.
{Special Drawing Rights (SDRs) are potential claims on the freely usable
currencies of IMF members.}
Net errors and omissions

This is the last component of the balance of payments and principally exists to
correct any possible errors made in accounting for the three other accounts
They are often referred to as "balancing items".
Factors Impacting BoP
Trade Agreement
Trade Policy
Currency Exchange Rate
Tax , Tariff and Trade Barriers
Measures for making BoP Favourable
Diversification of Trade
Development of New Industries
Concentrate on selected sectors
Concentrating on Frugal engineering skills

Incentives related to Trade

What is the Balance of Payments
The Balance of Payments of a country is a systematic accounting record of all
economic transactions during a given period of time between the residents of the
country and residents of foreign countries
What is the Balance of Payments
Purchase or sale of goods or services in return for goods or services or a barter
transaction. Two real transfers.
An exchange of financial items e.g. purchase of foreign securities with
payment in cash or by a cheque drawn on a foreign deposit. Two financial
transfers.
A unilateral gift in kind. One real transfer.
A unilateral financial gift. One financial transfer.
Accounting Principles in Balance of Payments
The BOP is a standard double-entry accounting record and as such is subject to all the
rules of double-entry book-keeping
Some simple rules of thumb
All transactions which lead to an immediate or prospective payment from the
rest of the world (ROW) to the country should be recorded as credit entries.
The payments themselves, actual or prospective, should be recorded as the
offsetting debit entries.
A transaction which results in an increase in demand for or reduction in supply
of foreign exchange is to be recorded as a debit entry while a transaction
which results in an increase in the supply of or reduction in demand for
foreign exchange is to be recorded as a credit entry
Use of forex: debit; Source of forex: credit
Components of the Balance of Payments
Three main categories
The Current Account: Under this are included imports and exports of
goods and services and unilateral transfers of goods and services.
The Capital Account: Under this are grouped transactions leading to
changes in foreign financial assets and liabilities of the country.
The Reserve Account: In this category only "reserve assets" are
included. These are the assets which the monetary authority of the
country uses to settle the deficits and surpluses that arise on the other two
categories take together
The Current Account
Merchandise trade should cover all transactions relating to movable goods,
where the ownership of goods changes from residents to non-residents
(exports) and from non-residents to residents (imports).
The valuation should be on f.o.b. basis so that international freight and
insurance are treated as distinct services and not merged with the value of the
goods themselves.
Exports, valued on f.o.b. basis, are credit entries.
Imports valued at c.i.f.(in practice) are the debit entries.
The difference between the total of credits and debits appears in the "Net"
column. This is the Balance on Merchandise Trade
What are the offsetting entries? Payments for exports increase foreign assets
a use of forex, a debit. Payments we make for imports create foreign
liabilities or reduce foreign assets a source of forex , a credit.

Invisibles
The invisibles account includes services such as transportation and insurance,
income payments and receipts for factor services - labour and capital - and
unilateral transfers.
Credits under invisibles consist of services rendered by residents to non-
residents, income earned by residents from their ownership of foreign
financial assets (interest, dividends), income earned from the use, by non-
residents, of non-financial assets such as patents and copyrights owned by
residents gifts received by residents from non-residents.
Debits consist of same items with the roles of residents and non-residents
reversed.
The net balance between the credit end debit entries under the heads
merchandise, non-monetary gold movements and invisibles taken together is
the Current Account Balance. The net balance is taken as deficit if negative
(debits exceed credits), a surplus if positive (credits exceed debits).
The Capital Account
Records changes in foreign assets and liabilities.
Capital inflows are credits, outflows are debits. Hence increase in foreign assets or reduction
in liabilities are debits; reduction in foreign assets or increase in liabilities are credits.
Loans raised, portfolio investments by foreigners, direct inward investment credits
Loans repaid, investments by residents abroad, disinvestment by foreigners debits.
The Other Accounts
The IMF account contains, as mentioned above, purchases (borrowings) and
repurchases (repayments) from the IMF. Former are credits, latter debits.
The Foreign Exchange Reserves account records increases (debits) and
decreases (credits) in reserve assets (RBI's holdings of gold and foreign
exchange, SDRs - Special Drawing Rights - are a reserve asset created by the
IMF and allocated from time to time to member countries)
Meaning of Deficit and Surplus in the Balance of Payments
The terms "deficit" or "surplus" cannot then refer to the entire BOP but must indicate
imbalance on a subset of accounts included in the BOP
In popular parlance, BOP deficit or surplus refers to deficit or surplus on current
account.
An economically meaningful distinction is between autonomous and
compensating transactions. Balance on autonomous transactions- above the line;
on compensating transactions- below the line
13. Explain the foreign exchange market.

A. The foreign exchange market is an over-the-counter market; this means that there is no
single physical or electronic market place or an organized exchange (like a stock
exchange) with a central trade clearing mechanism where traders meet and exchange
currencies, The market itself is actually a worldwide network of inter-bank traders,
consisting primarily of banks, connected by telephone lines and computers. The market
functions virtually 24 hours enabling a trader to offset a position created in one market using
another market. The five major centers of inter-bank currency trading, which handle more
than two thirds of all forex transactions, are London, New York, Tokyo, Zurich, and
Frankfurt. Transactions in Hong Kong, Singapore, Paris and Sydney account for bulk of the
rest of the market.

Foreign Exchange Market Participants: The participants may include hedgers,

arbitrageurs, speculators, institutional investors, individual investors and financial institutions
such as commercial banks, investment banks , retail agents such as tourists, hotels etc.
The market participants that comprise the FX market can be categorised into five groups:
International banks , bank customers, non-bank dealers, FX brokers, and central banks. Most
interbank trades are speculative or arbitrage transactions where market participants attempt to
correctly judge the future direction of price movements in one currency versus another
Bid ask price: Bid price is the price to buy currency and ask price is the price to sell
currency. The interbank market is a network of correspondent banking relationships with
large commercial banks maintaining demand deposit account with another, called
correspondent bank accounts.
The foreign exchange market is unique because:

Its trading volume
Its extremely liquidity in the market
The large number of and variety of traders in the market
The geographical dispersion
Its long trading hours: 24 hrs a day
The variety of factors that affect the exchange rate
The low margins of profit compared with other markets of fixed income..
Central banks sometimes intervene in the foreign exchange market in an attempt to influence
the price of the currency against that of a major trading partner or country that it fixes or pegs
its currency against.
Bid-ask spread: The difference b/w the bid rate and ask rate is referred as the bid-ask rate.
Ask rate - Bid rate

Spread = x 100
Ask rate
Foreign Exchange rate: The rate at which the home currency is exchanged for a foreign
currency
Direct quote: is the number of units of home currency that can be exchanged for one unit of
a foreign currency
For ex 1$ = Rs 45.54
Indirect Currency: is the number of units of a foreign currency that can be exchanged for
one unit of the home currency. For example 0.0022 Rs/S is an indirect quote.
Forward rates of currency are either quoted as out- right rates or a discount/premium
Forward rate - Spot rate 360

Forward rate premium/discount = x x100
Spot rate n
20. Explain the various theories of exchange rate determination.

A. The various theories of exchange rate determination are
Purchasing power parity (PPP)
Fisher Effect (FE)
International Fisher Effect (IFE)
Interest rate parity (IRP)
Purchasing Power Parity
Purchasing power parity (PPP) was first stated in a rigorous manner by the Swedish
economist Gustav Cassel in 1918.

PPP has been widely used by central banks as a guide to establishing new par values for their
currencies when the old ones were clearly in disequilibria. From a management standpoint,
purchasing power parity is often used to forecast future exchange rates, for purposes ranging
from deciding on the currency denomination of long-term debt issues to determining in which
countries to build plants.
In its absolute version, purchasing power parity states that exchange-adjusted price levels
should be identical worldwide. In other words, a unit of home currency (HC) should have the
same purchasing power around the world. This theory is just an application of the law of one
price to national price levels rather than to individual prices. (That is, it rests on the
assumption that free trade will equalize the price of any good in all countries; otherwise,
arbitrage opportunities would exist) However, absolute PPP ignores the effects on free trade
of transportation costs, tariffs, quotas and other restrictions, and product differentiation.
The relative version of purchasing power parity, which is used more commonly now,
states that the exchange rate between the home currency and any foreign currency will adjust
to reflect changes in the price levels of the two countries. For example, if inflation is 5% in
the United States and 1 % in Japan, then in order to equalize the dollar price of goods in the
two countries, the dollar value of the Japanese yen must rise by about 4%.
The Fisher effect states that the nominal interest rate r is made up of two components: (I) a
real required rate of returns a and (2) an inflation premium equal to the expected amount of
inflation i. Formally, the Fisher effect is
1 + Nominal rate = (l + Real rate)(l + Expected inflation rate)
1 + r = (1 +a) (l +i)
or
r = a + i + ai
In equilibrium, then, with no government interference, it should follow that the nominal
interest rate differential will approximately equal the anticipated inflation rate differential, or
(1+rh ) / (1+rf ) = (1+ih ) / (1+if )
where rh and rf are the nominal home- and foreign-currency interest rates, respectively.
If rf and if are relatively small.
In effect, the generalized version of the Fisher effect says that currencies with high rates of
inflation should bear higher interest rates than currencies with lower rates of inflation
The International Fisher Effect
The key to understanding the impact of relative changes in nominal interest rates among
countries on the foreign exchange value of a nation's currency is to recall the implications of
PPP and the generalized Fisher effect. PPP implies that exchange rates will move to offset
changes in inflation rate differentials. Thus, a rise in the U.S. inflation rate relative to those of
other countries will be associated with a fall in the dollar's value. It will also be associated
with a rise in the U.S. interest rate relative to foreign interest rates.
Combine these two conditions and the result is the international Fisher effect:
(1 + rh) t / (1 + rf ) t = et / e0
where et is the expected exchange rate in period t. The single period analogue to above
Equation is
(1 + rh) / (1 + rf ) = e1 / e0
Note the relation here to interest rate parity. If the forward rate is an unbiased predictor of
the future spot rate-that is,f l = e1 -then Equation becomes the interest rate parity condition:
(1 + rh) / (1 + rf ) = f1 / e0

Interest rate parity (IRP): The interest rate parity is the basic identity that relates interest
rates and exchange rates. It states that the returns from the borrowing in one currency
exchanging that currency for another currency.
Interest rate parity is a relationship that must hold between the spot interest rate of two
currencies if there are to be no arbitrage opportunities. The relationship depends upon spot
and forward exchange rates between the two currencies
m
f 1 + r a
= where S spot rate f- forward rate , ra and rb are the interest rates for the
S 1 + rb
respective currencies
Theory Key variables of theory Summary of Theory
Interest Rate parity (IRP) Forward rate Interest The forward rate of one
premium or differential currency with respect to
discount another will contain a
premium (or discount) that is
determined by the differential
in interest rates between the
two countries. As a result,
covered interest rate arbitrage
will provide a return that is
no higher than a domestic
return
Purchasing Power Percentage Inflation The spot rate of one currency
Parity(PPP) change in the rate with respect to another will
spot exchange differential change in reaction to the
rate differential in reaction to the
differential in inflation rates
Consequently the purchasing
power for consumers when
purchasing goods in their
own country will be similar
to their purchasing power
when importing goods from
the foreign country
International Fisher Effect Percentage Interest rate The spot rate of one currency
(IFE) change in the differential with respect to another will
spot rate change in accordance with
the differential in interest
rates between the two
countries. Consequently the
return on uncovered foreign
money market securities will
on an average be no higher
than the return on the
domestic money market
securities from the
perspective of investors in
the home country

14. Explain briefly the four methods of Translation exposure.

A. The four methods of foreign currency translation are
i. The current rate method
ii. The monetary/non-monetary method
iii. The temporal method
iv. The current /non-current method
i. The current rate method: All items of the balance sheet and income statement are
translated at the current spot rate exchange
ii. Monetary and Non-monetary method: Under this method monetary items are
translated at the current spot exchange rate and the no-monetary items are
translated at the historical rates.
iii. The temporal method: Under this method if an item is originally stated at historical
cost its translation is carried out at the historical spot rate of exchange. If the item
is originally stated at its market value the translation is carried out at the current
spot exchange rate.
iv. The current/Non-current method: According to this method all the current assets
and current liabilities of a foreign subsidiary are translated into the home currency
of the parent company at the current spot exchange rate. In non-current asset or
liabilities are translated at historical rate of exchange.
Particulars C and NC N and NM T Method CR
method method Method
Cash CR CR CR CR
Bill receivable(BRs) CR CR CR CR
Inventory CR HR MP = CR CR
CP = HR
Fixed Assets HR HR HR CR
Creditors CR CR CR CR
Long term loan HR CR CR CR
Net worth HR HR HR HR
17. How can you manage economic exposure? Give the marketing and production
initiatives of managing economic exposures?
A. Economic exposure is the change in value of a company that accompanies an
unanticipated change in exchange rates. Note that we distinguish anticipated from
unanticipated. Anticipated changes in exchange rates are already reflected in the market value
of the firm. One method of measuring an MNCs economic exposure is to classify the cash
flows into different items on the income statement and predict the movements of each item in
the income statement based on a forecast of exchange rates.
The various marketing and production initiatives are
Marketing Initiatives
Market selection
Product strategy
Pricing strategy
Promotional strategy
Production initiatives
Product sourcing
Input mix
Plant location

Raising productivity
15. Describe the various methods of capital budgeting that are normally adopted by
MNCs
A. Once a firm has compiled a list of prospective investments, it must then select from among
them that combination of projects that maximizes the company's value to its shareholders.
This selection requires a set of rules and decision criteria that enables managers e to
determine, given an investment opportunity, whether to accept or reject it. It is generally
agreed that the criterion of net present value is the most appropriate one to use since its
consistent application will lead the company to select the same investments the shareholders
would make themselves, if they had the opportunity.
Net Present Value
The net present value (NPV) is defined as the present value of future cash flows discounted at
an appropriate rate minus the initial net cash outlay for the project. Projects with a positive
NPV should be accepted; negative NPV projects should be rejected. If two projects are
mutually exclusive, the one with the higher NPV should be accepted. The discount rate,
known as the cost of capital, is the expected rate of return on projects of similar risk. For
now, we take its value as given.
In mathematical terms, the formula for net present value is
n
NPV = - I0 + CFt / (1 + K)t
t=1
Where I0 = the initial cash investment
CFt = the net cash flow in period t
k = the project's cost of capital
n = the investment horizon
The most desirable property of the NPV criterion is that it evaluates investments in the same
way the company's shareholders do; the NPV method properly focuses on cash rather than on
accounting profits and emphasizes the opportunity cost of the money invested. Thus, it is
consistent with shareholder wealth maximization.
Another desirable property of the NPV criterion is that it obeys the value additively principal.
That is, the NPV of a set of independent projects is just the sum of the NPVs of the individual
projects. This property means that managers can consider each project on its own. It also
means that when a firm undertakes several investments, its value increases by an amount
equal to the sum of the NPV s of the accepted projects
The NPV of a project is the present value of all cash inflows, including those at the end of the
projects life, minus the present value of all cash outflows.
The decision criteria is to accept a project if NPV 0 and reject if NPV< 0
The Adjusted Present Value (APV) Framework

The APV framework" allows us to disentangle the financing effects and other special features
of the project from the operating cash flows of the project. It is based on the well-known
value additively principal. It is a two-step approach:
1. In the first step, evaluate the project as if it is financed entirely by equity. The rate of
discount is the required rate of return on equity corresponding to the risk class of the project.
2. In the second step, add the present values of any cash flows arising out of special financing
features of the project such as external financing, special subsidies if any, and so forth. The
rate of discount f used to find these present values should reflect the risk associated with each
of the cash flows.

In APV approach each cash flow is discounted at a rate of discount consistent with the risk
inherent in that cash flow
n n
CFt Tt
APV = I 0 + t
+ t
t +1 (1 + k ) t +1 (1 + i d )
Where T tax savings id = cost of debt
16. Discuss the difference between cost of capital for MNCs and domestic firms.
A. The difference between cost of capital for MNCs and domestic firms include:
i. Size of the firms: Firms that operate internationally are usually much bigger in size than
firms which operate only in domestic market.
ii. Foreign exchange risk: A firm more exposed to exchange rate fluctuations would have a
wider spread of possible cash flows in future periods. Thus exposure to exchange rate
fluctuations could lead to higher cost of capital.
iii. Access to international capital markets: The fact that MNCs can normally access the
international capital market helps them to attract funds at a lower cost than the domestic
firms. This form of financing helps to lower the cost of capital and will generally not increase
the MNCs exposure to exchange rate risk.
iv. International diversification effect: If a firms cash inflows come from sources all over the
world , there might be more stability in them. MNCs by their virtue of their diversification
operations, can reduce their cost of capital compared to domestic firms
v. Political risk: can be accounted for in the cost of capital calculations by adding an
arbitrary risk premium to the domestic cost of capital for a project of comparable risk.
vi. Country risk: Country risk represents the potentially adverse impact of a countrys
environment on the MNCs cash flows. If the countrys risk level of a particular country
increase, the MNC may consider divesting its subsidiaries located there.
vii. Tax Concessions: MNCs generally choose countries where the tax laws are favourable
for them as their net income is substantially influenced by the tax laws in the locations
where they operate.
17. Explain the distinguishing features of multinational cash management and discuss
the techniques used to optimise cash flows.
A. Though the principles of domestic and international cash management are the same
international cash management is wider in scope and is more complicated because it needs to
recognise the principles and practices of other countries. Other important complicating
factors in international cash management include multiple tax jurisdictions and currencies
and the relative absence of internationally integrated interchange facilities as are available
domestically in the United States
The basic objectives of an effective international cash management system are:

1. Minimise the currency exposure risk.
2. Minimise the country and political risk
3. Minimise the overall cash requirements of the company as whole without disturbing
the smooth operations of the subsidiary or its affiliate
4. Minimise the transactions costs
5. Full benefits of economies of scale as well as the benefit of superior knowledge
A centralised cash management group may be needed to monitor and manage the parent
subsidiary and inter-subsidiary cash flows.
International cash management requires achieving two basic objectives:
1. Optimising cash flow movements

2. Investing excess cash

Techniques to optimise cash flow
The various ways by which cash inflows can be optimised are:
1. Accelerating cash inflows
2. Managing blocked funds
3. Leading and lagging strategy
4. Using netting to reduce overall transaction costs by eliminating a number of
unnecessary conversions and transfer of currencies
5. Minimising the tax on cash flow through international transfer pricing
Accelerating cash inflows: is the first objective in cash management, quicker recovery of
inflows assures that they are available with the firm for use or for investment
Managing blocked funds: the host country may block funds that the subsidiary attempts to
send to the parent. The parent may also instruct the subsidiary to obtain financing from a
local bank rather than from the parent. This also helps the subsidiaries as they may be able to
better utilise blocked funds by repaying the local loan.
Leading and Lagging: The leading and lagging technique can be used by subsidiaries for
optimising cash flow movements by adjusting the timing of payment to reflect expectations
about the future currency movements. MNCs can accelerate (lead) or delay(lag) the timing of
foreign currency payments by modifying the credit terms extended by one unit to another.
Leading and lagging is adopted by MNCs in order to reduce foreign exchange exposure or to
increase available working capital.
Netting: Netting is a technique of optimising cash flow movements with the joint efforts of
subsidiaries. The process involves the reduction of administration and transaction costs that
result from currency conversion.
Advantages of Netting:
It reduces the number of cross-border transactions between subsidiaries thereby
reducing the overall administrative costs of such cash transfers.
The technique reduces the need for foreign exchange conversion and hence reduces
transaction costs associated with foreign exchange conversion
It helps in improved cash flow forecasting since only net cash transfers are made at
the end of each period
Netting is of two types:
1. Bilateral Netting setting: A bilateral netting system involves transactions between
the parent and a subsidiary or between the two subsidiaries.
Pay $ 30,000
US parent German affiliate
Pay $ 40,000
After Bilateral Netting
Pay $ 10,000
US parent US parent
2. Multilateral Netting: Under a multilateral netting system, each affiliate nets all its
inter-affiliate receipts against all its disbursements. It then transfers or receives the
balance, depending on whether it is a net receiver or a payer. A multinational netting
system involves a more complex interchange among the parent and its several

affiliates but it results in a considerable saving in exchange and transfer costs.

However for multinational netting to be effective there is a need for centralised cash
management from the side of MNCs.
$ 20 m
$ 20 m
Z Y
$ 20 m
Here multilateral netting would eliminate inter-affiliate funds transfers completely.
An effective cash management system should be based on a cash budget that projects
expected cash inflows and outflows over some planning horizon.
18. What are the fundamental considerations which are taken into consideration while
evaluating Foreign projects.
A. The basic steps involved in evaluation of a project:
Determine net investment outlay
Estimate net cash flows to be derived from the project over time, including an estimate of
salvage value.
Identify the appropriate discount rate for determining the present value of the expected
cash flows
Apply NPV or IRR techniques to determine the acceptability or priority ranking of
potential projects

8. Summarize the various considerations that enter into decision to choose the currency,
market and vehicle for long-term borrowing.
9. Explain the different methods by which a foreign exchanger dealer can hedge a
forward transaction.
10. Discuss the general functions involved in international cash management..
11. Why is it important to study International Financial Management? How is it different
from Domestic Financial Management?
12. Define International Fischer effect. Explain to what extent do empirical tests confirm
that the international Fisher effect exists in practice.
13. What are the main disadvantages for a firm located in an illiquid market and also in a
segmented market.
14. Explain the OLI paradigm in relation to FDI. Explain the behavioural approach to
FDI.

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SRN ADRASH COLLEGE International Financial Management(IFM) REVISION QUESTIONS(RB)

Section A (Two Marks Questions)

1. What are invisibles in the balance of payments

2. What is the law of one price

3. What is foreign exchange risk?

4. What is forward rate?

5. What is a currency futures contract?

6. What is functional currency and reporting currency?

8. What is covered interest rate arbitrage?

Prepared by Ravindra Babu (RB)

10. What is PPP?

11. Distinguish between Direct and Indirect quotation.

12. What is clean and direct float?

13. Who are the participants in the foreign exchange market?

14. Define translation exposure?

15. What is syndicated loan?

Prepared by Ravindra Babu (RB)

17. Write the structure of current Account in BOP?

18. Who are authorised dealers?

19. State three benefits of centralised cash management system?

21. What do you mean by short position?

22. What is country risk?

Prepared by Ravindra Babu (RB)

23. What is economic exposure?

27. What do you mean by balance of payments?

29. Differentiate between risk and exposure?

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Hard or Strong Currency: It is currency which is expected to appreciate and can

33. Define the terms hedging and currency risk

34. What do you mean by political risk?

35. What is dollarization

39. What is triangular Arbitrage?

40. What is foreign exchange market?

41. What is International Capital Budgeting?

Prepared by Ravindra Babu (RB)

43. What is multilateral Netting? What is Bilateral Netting

44. What is CTA?

45. What are Depository Receipts (DRs)

46. What is Euro-currency?

47. What is Back-to-Back Loan?

48. What is SWIFT?

50. Distinguish between Spot, Forward and Future market.

Prepared by Ravindra Babu (RB)

51. What is currency call and put option?

52. Distinguish between Leading and Lagging?

53. What do you mean by SDR?

54. Define exposure netting.

55. What is money market hedge?

56. What do you mean by double Taxation?

57. Explain the meaning of cross-rate consistency?

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2. State the main features of currency futures?

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3. State the methods of managing transaction exposure

A. Transaction exposure can be hedged by financial contracts like

4. Why do discrepancies arises in the balance of payment?

5. What factors influencing pricing of a currency option?

Prepared by Ravindra Babu (RB)

6. Distinguish between currency futures and options?

7. Explain the different types of transactions takes place in forex market.

Prepared by Ravindra Babu (RB)

To hedge currency exposure is through devices of several currency markets-forward

8. Distinguish between futures and forwards

Feature Forward Contracts Future Contracts