NAME ROLL NO.

DRIVE PROGRAM/SEMESTER SUBJECT CODE & NAME

SHRIKANT SHARMA 521121970

FALL 2013 MBA (SEM 4) MF0015 & INTERNATIONAL FINANCIAL MANAGEMENT

Question:-1 Explain the goals of international financial management. Give omplete explanation on
Gold Standard 1876-1913. List down the advantages and disadvantages of Gold Standard. Ans:- The International Monetary Fund (IMF) Since its establishment in 1944, the International Monetary Fund has been the centerpiece of the world monetary order though its supervisory role in exchange rate arrangements has been considerably weakened after the advent of floating rates in 1973. The IMF was given the responsibility for collecting and allocating reserves. The role of supervising the adjustable peg system, offering advice to the member countries on their international monetary affairs, promoting research in different areas of monetary and international economics were also given to the IMF. It also offers the member countries a forum for consultation and discussion. Funding Facilities As we have seen above, operation of the peg requires a country to intervene in the foreign exchange markets to support its exchange rate when it threatens to move out of the permissible band. If a country faces a BOP deficit, reserves are needed for carrying out the intervention and for this; it must take the step of selling foreign currencies and buying its own currency. In case its own reserves are inadequate, it must borrow from other countries or from the IMF. (Note that the country which has a surplus does not face this problem.) International Liquidity and International Reserves The stock of means of international payments are referred to as international liquidity refers to the. On the other hand, the assets that the country can make use of when settlement of payment imbalances arises in its transactions with other countries are known as international reserves. The monetary authority of the company takes care of the reserves and uses them while carrying out interventions on the foreign exchange markets. In addition, liquidity can be provided by the private markets by lending to deficit countries out of funds that are deposited with them by the surplus countries. This sort of private financing of BOP deficits took place on a large scale during the post oil-crisis years and has come to be known as recycling of petrodollars. Gold Standard 1876-1913 From the ancient times, gold has been used as a medium of exchange as it is durable, portable and easily tradable. Increase in the trade activity during the free-trade period in the 19th century led to the need for a more formalized system for settling business transactions. This made gold desirable to be used as a standard to determine the value of currency. The rules of the game under the gold standard were that each country would establish the rate at which its currency

could be converted to the weight of gold. Each country's government agreed to buy or sell gold at its own fixed rate of demand. This served as a mechanism to preserve the value of each individual currency in terms of gold. Each country had to maintain adequate reserves of gold in order to back its currency's value. There was a limit to the rate at which any individual country could expand its supply of money. The growth in the money was limited to the rate at which additional gold could be acquired by official authorities.

Question 2:- Give an introduction on capital account with its sub-categories. Discuss about capital
account convertibility.

Ans. Capital Account

It is an accounting measure of the total domestic currency value of financial transactions between domestic residents and the rest of the world over a period of time. This account consists of loans, investments and other transfers of financial assets and the creation of liabilities. It includes financial transactions associated with international trade as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits. It includes three categories: direct investment, Portfolio investment and other capital flow. The detail of these three sub-categories is presented as follows: Direct investment: It occurs when the investor acquires shares of a company acquires the entire firm or the establishment of new subsidiaries. FDI takes place when the firms tend to take advantage of various market imperfections. Firms also undertake FDI when the expected returns from foreign investment exceed the cost of capital, allowing for foreign exchange and political risks. The expected returns from the foreign profits can be higher than those from domestic projects due to lower material and labor costs, subsidized financing, investment tax allowances, exclusive access to local markets etc. An example of direct investment is an Indian firm doing business in a foreign country. Portfolio investment: This represents the sales and purchases of foreign financial assets such as stocks and bonds that do not involve a transfer of management control. A desire for return, safety and liquidity in investments is the same for international and domestic portfolio investors. International portfolio investments have seen a boom in the recent years as the investors have become aware about the risk diversification that can be reduced if they invest in various financial assets globally. The increased returns from the foreign markets have also given a boost to such category of investors. An example is a foreign institutional investor buys the equity stock of an Indian company. Capital flows: It represents the claim with a maturity of less than one year. Such claims include bank deposits, short-term loans, short-term securities, money market investment etc. these investments are sensitive to both changes in relative interest rates between countries and the anticipated change in the exchange rate. Let us understand with the help of an example. If the interest rate increases in India then it will experience a capital inflow as investors would like to take advantage of the situation by buying bonds when prices are low, since interest rates on bonds and inversely proportional to the bond prices.

Capital Account Convertibility:-

When free inflows and outflows are allowed abroad except for capital purposes like loans and investments, it is referred to as Current Account Convertibility. This really means that residents of a country can make or receive trade related payments, for example dollars, for exporting goods and services. They can also pay dollars for import of goods and services to make sundry remittances, access foreign currency for studying abroad, or undergoing medical treatments, gifts or for travel purpose. Current Account Convertibility in India was established with the acceptance of the obligations under Article VIII of the IMFs Articles of Agreement in August 1994. The term capital account convertibility means relaxing control on capital account transactions. For instance, it could mean quantitative restriction on the movement of capital, a multiple exchange rate system suggesting different exchange rates for commercial/financial transactions or explicit/implicit tax on international financial transactions for discouraging the flow of capital. Thus, CAC gives way to an absence of quantitative taxes on capital account transactions or the presence of a market-based exchange rate system. Capital account convertibility (CAC) permits the local currency to be exchanged for foreign currency and no restrictions are put on the limit. Through this, the local merchants can easily conduct transnational business without the need for foreign currency exchanges in order to carry out small transactions. However, questions also arise whether the monetary authorities of a country should go for CAC or not. According to the advocates of capital control, there are three basic advantages of control. They are: .

Question:-3 Explain the concept of Swap. Write down its features and various types of interest rate
swap.

Ans:- SWAP:Swap is an agreement between two or more parties to exchange sets of cash flows over a period in future. The parties that agree to swap are known as counter parties. It is a combination of a purchase with a simultaneous sale for equal amount but different dates. Swaps are used by corporate houses and banks as an innovating financing instrument that decreases borrowing costs and increases control over other financial instruments. It is an agreement to exchange payments of two different kinds in the future. Financial swap is a funding technique that permits a borrower to access one market and then exchange the liability for another type of liability. The first swap contract was negotiated in 1981 between Deutsche Bank and an undisclosed counter party. The International Swap Dealers association (ISDA) was formed in 1984 to speed up the growth in the swap market by standardizing swap documentation. In 1985, ISDA published the standardized swap code. Features of swap Swaps are contracts of exchanging the cash flows and are tailored to the needs of counter parties. Swaps can meet the specific needs of customers. Counter parties can select amount, currencies, maturity dates etc. Exchange trading involves loss of some privacy but in the swap market privacy exists and only the counter parties know the transactions.

 There is no regulation in swap market. There are some limitations like (a) Each party must find a counter party which wishes to take opposite position. (b) Determination requires to be accepted by both parties. (c) Since swaps are bilateral agreements the problem of potential default exists. There are two kinds of swap, they are as follows: 1. Currency swap: It is an agreement whereby currencies are exchanged at specified exchange rates and at specific intervals. The reason is to lock in the exchange rate. Large commercial banks that serve as an intermediary agree to swap currencies with a firm. Two currencies are exchanged in the beginning and again at the maturity, they are reexchanged because one counter party is able to borrow a particular currency at a lower interest rate than the other counter-party. 2. Interest rate swap: It is an arrangement whereby one party exchange one set of interest rate payments for another. Most common arrangement is an exchange of Fixed Interest rate payment for another rate of over a period of time. Features The following are the features: The principal value upon which the interest rate is to be applied should be known Fixed interest rate to be exchanged for another rate. Formula type of index is used to determine the flowing rate. Frequency of payment is agreed upon. Life time of swap. Various types of interest rate swap Following are the most important types of interest rate swap: Plain vanilla swap: This swap involves the periodic exchange of fixed rate payments for floating rate payments. It is sometimes referred as fixed for floating swaps. Forward swap: This involves an exchange of interest rate payments that does not begin until a specified future point in time. It is a swap involving fixed for floating interest rates. Callable swap: Another use of swap is through swap options (swaptions). A callable swap provides a party making the fixed payments it the right to terminate the swap prior to its maturity. It allows a fixed rate payer to avoid exchanging future interest rate payments if its so desired. Putable swap: It provides the party making the floating rate payments with a right to terminate swap. Extendable swap: It contains an extendable feature that allows fixed for floating party to extend the swap period. Zero coupon for floating swap: In this swap, the fixed rate pair makes a bullet payment at the end and floating rate pair makes the periodic payment throughout the swap period. Rate capped swaps: This involves the change of fixed rate payments for floating rate payments whereby the floating rate payments are capped.

An upfront fee is paid by the floating rate party to fixed rate party for the cap. Equity swaps: An equity swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. Cost of swap While there is no exchange risk involved in swap transactions, there is a cost involved. The swap cost depends on the currency being in premium or discount in the forward markets. A currency is said to be at premium against the other currency if it is costlier in the forward and it is said to be at discount against the other currency, if it is cheaper in the forward. When a currency is at a premium against the other currency, then the currency will be costlier in the forward so in the vent of swap, i.e. when the buying and selling transaction is undertaken then the swap cost will be favourable. Suppose, $/Rupee quote in value on 1/9/2011 = 51.87 and $/Rupee quote in value on 31/10/2011 = 52.93 The currency is bought at 51.87 and sold at 52.93, so the swap cost will be received. Alternatively, when swap is reversed, that is selling and buying transaction takes place, the swap cost is to be paid.

Question-4

Elaborate on measuring exchange rate movements. Explain the factors that influence exchange rates.

Ans:- Measuring Exchange Rate Movements:Exchange rates respond quickly to all sorts of events - both economic and noneconomic. The movement of exchange rates is the result of the combined effect of a number of factors that are constantly at play. Economic factors, also called fundamentals, are better guides as to how a currency moves in the long run. Short-term changes are affected by a multitude of factors which may also have to be examined carefully. In recent years, global interdependence has increased to an unprecedented degree. Changes in one nation's economy are rapidly transmitted to that nation's trading partners. These fluctuations in economic activity are reflected almost immediately in fluctuations of currency values. These changes in exchange rates expose all those firms having export import operations as also multinationals with integrated cross border production and marketing operations. It is useful to be aware of the various factors that influence exchanges rates. By a study of these factors and the trend of movements in the value of particular currency, an experienced businessman may be able to forecast the possible future movement of that currency. This will enable him to: (i) estimate his risk and (ii) make an informed, prudent decision as to whether it would be worthwhile for him to carry the risk or to take some appropriate steps to

reduce that risk. The demand for foreign exchange comes from importers of goods and services; outflow of capital through foreign direct investment and portfolio investment; profits, interest, dividend and other incomes earned by foreigners/ corporate bodies and repatriated to their country; Indian travelers going abroad for education, medical treatment; pleasure trips, etc.; expenditures incurred by our embassies abroad; bilateral loans/aids granted to other countries; subscription payment to international organizations; grants and gifts to other friendly countries; repayment of foreign loans and interest payments; etc. All these transactions can be classified in three classes: (1) Purchases and sales for trading purposes; (2) Speculative deals by professional dealers; (3) Protective movements by substantial holders. Interest rate differentials Foreign exchange markets and exchange rates are quite sensitive to movements in interest rates. This is because financial markets were becoming more closely linked due to (i) Growing interest in international investment; (ii) Elimination or constraints on mobility of capital to a large extent; (iii) More rapid means of communications. Most investors would like to move their funds from a country having lower interest rates to a country having higher interest rates. Such funds are usually termed as 'hot money'. If the interest rate in the UK is higher than the interest rate in the USA, investors would find it profitable to invest funds in the UK and would purchase pounds and sell dollars in the spot market, leading to an upward movement in pound sterling. In fact, the UK very often uses interest rate as a weapon to push up the 'pound'. However, if the rise in interest rates is due to people expecting a higher inflation rate or bigger budget deficits, there is reason to doubt the strength of the currency. Thus it would not lead to higher investment. The role of interest rate differences thus depends upon what is causing them.

Question-5 Write short notes on:

A:-International Credit Markets B:-International Bond Markets

A:-International Credit Markets

International credit markets are the forum where companies and governments can obtain credit (loans in various forms) from the creditors/investors. These markets are an important part of international capital markets. International capital market is that financial market or world financial centre where shares, bonds, debentures, currencies, mutual funds and other long term securities are purchased and sold. These markets provide the opportunity for international companies and investors to deal in shares and bonds of different companies from various countries. Two very important aspects of international credit market are the syndicated loans and impact of credit crisis on the credit market, which are explained below.

6.5.1 Syndicated Loans Syndicated loans are credits granted by a group of banks, called a syndicate to a borrower who may be a company or the government. Interest rates can be fixed for the term of the loan or floating based on a benchmark rate such as the London Interbank Offered Rate (LIBOR).These are hybrid instruments combining features of relationship lending and publicly traded debt. These allow sharing of credit risk between various financial institutions without the disclosure and marketing burden that bond issuers face. Syndicated credits are a very significant source of international financing, these accounting for more than a third of all international financing, including bonds, commercial papers and equity issues. Two or more banks agree jointly to make a loan to a borrower. There is a single loan agreement. Every member of the syndicate has a claim on the debtor. The creditors can be many syndicate members led by one or several lenders, acting as lead managers or agents. Leading banks are selected by the borrower to form a syndicate who is willing to lend money at specified terms. Syndicate leaders are generally borrowers relationship banks, who provide major portion of loan and join in with other participants for relatively smaller portions of loan. The number and size of the syndicate member banks depends on the size of the loan, the terms involved and concurrence of the borrower.

B:-International Bond Markets

Although debt financing has always been international in nature, there is still no unified international bond market. The international bond market is divided into three bond market groups: 1. Domestic bonds: They are issued locally by a domestic borrower and are usually denominated in the local currency. 2. Foreign bonds: They are issued on a local market by a foreign borrower and are usually denominated in the local currency. Foreign bond issues and trading are under the supervision of local market authorities. 3. Eurobonds: They are underwritten by a multinational syndicate of banks and placed mainly in countries other than the one in whose currency the bond is denominated. These bonds are not traded on a specific national bond market. 6.6.1 Euro Bond Markets This is an international market for borrowing capital by any countries government, corporate and institutions. The centre of activity of borrowing and lending in London and Europe is called as Euro bond market. The borrowers and lenders can come from all over the world. A Bond market is a long term market in which the International Banks transact. It was developed in the 1960s when there was huge surplus of US Dollars in countries other than US. Euro bond is defined as a debt instrument underwritten by an international syndicate and offered for sale simultaneously in a number of countries. Therefore, it is usually denominated in a currency that is foreign. There are different names for particular segments of the foreign bond markets, for example, Yankee bonds are the bonds issued by the US companies in US markets. It is a telephone and telex market depending upon the means of communication for trading. The main features are as follows: The bonds issued by the issuer range from medium to long term. Repayment of principal amount in these instruments takes place in two forms; one is by means of agreed amortization over a period of time and the other is one lump sum payment at the end of the given maturity of the bond called as bullet payment. Bonds are issued in the form of bearer instruments that are transferable by delivery. Bonds are characterized by annual servicing and settlements are done through international clearing house mechanism. Placement of bonds There are two ways in which issuer can issue their bonds to the investors. They are discussed as follows: 1. Public offering: In this mode, the issue is opened to general public to invest in the issue and the issue is placed in the market by a syndicate of international banks that make elaborate arrangements to market the issue to their clients. Once the public offering is over, they are listed on any of the international stock exchanges. 2. Private placement: In this mode, the issue is made on a retail basis with individual investors in certain markets and the investors who generally

invest in these issues are of professional in nature. Listing arrangement is done away as the issue is to be placed privately. The instrument is traded by leading banks on OTC market or through bank dealing rooms.

Question:-6 Country risk is the risk of investing in a country, where a change in the business environment adversely affects the profit or the value of the assets in a specific country. Explain the country risk factors and assessment of risk factors.

Assessment of Risk Factors

We can define country risk as the risk of losing money due to changes that can occur in a countrys government or regulatory environment. The most common examples are acts of war, civil wars, terrorism and military coups, etc. It comes in various forms: for example, change in the government of a country, a new president or prime minister, some new laws, a ruling party becoming minority, and so on. Such changes do impact a countrys economic environment. They have a great impact on the investors perception about a countrys prospects. Political stability means the frequency of changes in the government of a country, the level of violence in the country, etc. A country is called politically stable if there are no frequent changes in the government and the level of violence is low or nil. For example, Australia was considered a dream destination by Indians earlier. Now the country is being avoided due to the instances of violence against Indians. In some countries, government can expropriate either a legal title to property or the stream of income it generates. Such countries are said to be high political risk countries. Political risk is also said to exist if property owners may be constrained in the way they use their property. Host government may enact laws to prevent foreign companies from taking money out of the country or from exchanging the host countrys currency for any other currency. This can be called financial form of country risk. It is difficult to calculate the exact value of country risk like any economic or financial variables. The calculation of country risk scores is difficult, but there are many important financial decisions that are based on the assessment of the country risk of a country. A company will have to do its own calculations for taking financial decisions. There are risk assessment agencies that provide country risk indices which try to assess the political stability of a country. The factors from which the political instability occurs can be classified into three categories: 1. Economic factors: These factors include inflation, unemployment, fiscal deficit, trade policies, large external debt, etc.

Stephen Kobrin (1982) has classified country risk as: Macro or country-specific risk Micro or firm-specific risk Factors determining the extent of political risk for a country The factors determining the extent of political risk for a country are broadly classified into: Country-related factors Company-related factors Country-related factors: These have three broad categories that have been discussed in detail. (a) Economic factors Fiscal discipline: This is indicated by the ratio of the fiscal deficit of a country to its GNP. Higher the ratio, the more government is promising to its population relative to resources it is obtaining from them. Controlled exchange rate system: This system increases the problem of BOP and makes fiscal discipline difficult. Government uses currency controls to fix exchange rates. This provides little flexibility to respond to changing prices. Wasteful government expenditure: This is an indicator of financial problems. Resource base: If a country has natural resources, it is considered economically stable. Countrys capacity to adjust to external shocks: If a country has a vast resource base, it possesses greater capacity to respond to external shocks. (b) Geographical factors: The best example in this case would be Sri Lanka, where due to the presence of the LTTE, there was a border issue. (c) Sociological factors: These include religious diversity, language diversity, ethnic diversity, etc. (i) Company-related factors Nature of industry: Government of a country controls certain critical industries that affect the economy of the country, e.g. oil and petroleum Level of operations: An MNC with a global presence is safe from government interventions. Level of technology and research and development: Companies using sophisticated technology and having high degree of R&D content are difficult to be regulated. Level of competition: Companies that have little or no competition are not regulated by government. Form of ownership: Local ownership is favoured by government. Nationality of management: Foreign management is more vulnerable to hostile treatment from the government.

2. Geographic factors: These include border disputes, natural calamities, etc. 3. Sociological factors: These include religious diversity, diversity in language, etc. When a firm has to do business in a foreign country, it has to be doubly sure about the uncertainties that it can face. It has to analyse all the risks that are theoretically said to exist. MNCs have to assess the country risk both qualitatively and quantitatively. Qualitative approach: This approach involves interpersonal contact. MNCs may know influential people in a foreign country. They may know politicians, bureaucrats, officials, etc. who might make MNCs aware about the political environment present in their country. They might update the MNC about the future prospects of business in their country. The entire process is based on judgement and there is no data to support such decisions. The MNC may send a team of experts for the on-the-spot study of the political situation in a particular country. This is a preparatory step taken to start talks with companys management. The qualitative approach involves examination and interpretation of diverse secondary facts and figures. On the past trends of events, future trends are assessed (Kramer, 1981). Quantitative models: There are specific quantitative tools for estimating country risk. One such tool is a computer program named Primary Risk Investment Screening Matrix (PRISM) that has 200 variables and reduces them to general ratings. It represents an index of economic viability as also an index of country stability. The variables include the level of violence in a country, frequency of changes in government, number of armed insurrections, conflict with other nations and economic factors such as inflation rate, external balance deficit and growth rate of the economy. The other commonly used tool is the decision tree approach used by Stobaugh (1969) which finds out the probability of nationalization. He has done his analysis by taking two cases, i.e. whether the government will change or not. If there is a change, a new government may or may not go in for nationalization. If it goes in for nationalization, then again there are two possibilities: whether it will pay adequate compensation or not. Thus, each possibility has many possible sub-events. The probabilities are indicated along tree branches. Probabilities are multiplied along the tree branches. Then they are summed up.