Q.1.

Explain Globalization, Advantages of Globalization and disadvantages

of Globalization.
Answer:
Meaning:
By the term globalization we mean opening up of the economy for world market by
attaining international competitiveness. Thus the globalization of the economy
simply indicates interaction of the country relating to production, trading and
financial transactions with the developed industrialized countries of the world.
Accordingly, the term globalization has four parameters:
(a) Permitting free flow of goods by removing or reducing trade barriers between
the countries,
(b) Creating environment for flow of capital between the countries,
(c) Allowing free flow in technology transfer and
(d) Creating environment for free movement of labour between the countries of the
world. Thus taking the entire world as global village, all the four components are
equally important for attaining a smooth path for globalization.
The concept of Globalization by integrating nation states within the frame work of
World Trade Organization (WTO) is an alternative version of the Theory of
Comparative Cost Advantage propagated by the classical economists for assuming
unrestricted flow of goods between the countries for mutual benefit, especially from
Great Britain to other less developed countries or to their colonies.
In this way, the imperialist nations gained much at the cost of the colonial countries
who had to suffer from the scar of stagnation and poverty. But the advocates of the
policy of globalization argue that globalization would help the underdeveloped and
developing countries to improve their competitive strength and attain higher growth
rates. Now it is to be seen how far the developing countries would gain by adopting
the path of globalization in future.
In the meantime, various countries of the world have adopted the policy of
globalization. Following the same path India had also adopted the same policy since
1991 and started the process of dismantling trade barriers along with abolishing
quantitative restrictions (QRs) phase-wise.
Accordingly, the Government of India has been reducing the peak rate of customs
duty in its subsequent budgets and removed QRs on the remaining 715 items in the
EXIM Policy 2001-2002. All these have resulted open access to new markets and
new technology for the country.
Advantages of Globalization:
The following are some of the important advantages of globalization for a
developing country like India:

(i) Globalization helps to boost the long run average growth rate of the economy of
the country through:
(a) Improvement in the allocative efficiency of resources;
(b) Increase in labour productivity; and
(c) Reduction in capital-output ratio.
(ii) Globalization paves the way for removing inefficiency in production system.
Prolonged protective scenario in the absence of globalization makes the production
system careless about cost effectiveness which can be attained by following the
policy of globalization.
(iii) Globalization attracts entry of foreign capital along with foreign updated
technology which improves the quality of production.
(iv) Globalization usually restructure production and trade pattern favoring laborintensive goods and labor-intensive techniques as well as expansion of trade in
services.
(v) In a globalized scenario, domestic industries of developing country become
conscious about price reduction and quality improvement to their products so as to
face foreign competition.
(vi) Globalization discourages uneconomic import substitution and favor cheaper
imports of capital goods which reduces capital-output ratio in manufacturing
industries. Cost effectiveness and price reduction of manufactured commodities will
improve the terms of trade in favor of agriculture.
(vii) Globalization facilitates consumer goods industries to expand faster to meet
growing demand for these consumer goods which would result faster expansion of
employment opportunities over a period of time. This would result trickle-down
effect to reduce the proportion of population living below the poverty line
(viii) Globalization enhances the efficiency of the banking insurance and financial
sectors with the opening up to those areas to foreign capital, foreign banks and
insurance companies.
Disadvantages of Globalization:
Globalization has its disadvantages also.
The following are some of these disadvantages:
(i) Globalization paves the way for redistribution of economic power at the world
level leading to domination by economically powerful nations over the poor nations.
(ii) Globalization usually results greater increase in imports than increase in exports
leading to growing trade deficit and balance of payments problem.
(iii) Although globalization promote the idea that technological change and increase
in productivity would lead to more jobs and higher wages but during the last few

years, such technological changes occurring in some developing countries have

resulted more loss of jobs than they have created leading to fall in employment
growth rates.
(iv) Globalization has alerted the village and small scale industries and sounded
death-knell to it as they cannot withstand the competition arising from wellorganized MNCs.
(v) Globalization has been showing down the process to poverty reduction in some
developing and underdeveloped countries of the world and thereby enhances the
problem of inequality.
(vi) Globalization is also posing as a threat to agriculture in developing and
underdeveloped countries of the world. As with the WTO trading provisions,
agricultural commodities market of poor and developing countries will be flooded
farm goods from countries at a rate much lower than that indigenous farm products
leading to a death-blow to many farmers.
(vii) Implementation of globalization principle becoming harder in many industrially
developed democratic countries to ask its people to bear the pains and
uncertainties of structural adjustment with the hope of getting benefits in future.
Q2. In foreign exchange market many types of transactions take place.
Discuss the meaning and role of forward, future and options market.
Solution:
Forward market: In the forward market, contracts are made to buy and sell
currencies for future delivery, say, after a fortnight, one month, two months and so
on. The rate of exchange for the transaction is agreed upon on the very day the
deal is finalized. The rate of exchange for the transaction is agreed upon on the very
day the deal is finalized. The forward rates with varying maturity are quoted in the
newspapers and those rates form the basis of the contract. Both parties have to
abide by the contract at the exchange rate mentioned therein irrespective of
whether the spot rate on the maturity date resembles the forward rate or not. The
value date in case of a forward contract lies definitely beyond the value date
applicable to a spot contract.
Sometimes the value date is structured to enable one of the parties to the
transaction to have freedom to select a value date within the prescribed period. This
happens when the party does not know in advance the precise date on which it
would be able to deliver the currency, for instance, an exporter who sells a foreign
currency forward without knowing in advance the precise date of shipment.
Futures Market
The foreign exchange market involving forward contracts has a long history but the
market for currency futures has a comparatively recent origin. It came into being in
1972 when the Chicago Mercantile Exchange has set up its international monetary
market division for trading of currency futures. Currency futures are traded only in a
limited number of currencies. A forward contract is finalized on telephone, etc.

meaning that it represents an over-the-counter market. But in case of currency

futures, brokers strike the deals sitting face to face under a trading roof, known as
pits. The brokers can trade for themselves as well as on behalf of the customers.
When they trade for themselves, they are called locals or floor traders. On the other
hand, when the brokers trade on behalf of their customers, they are known as
commission brokers or floor brokers. When a trader has to enter a currency futures
contract, he informs his agent who in turn informs the commission broker at the
stock exchange. The commission broker executes the deal in the pit for a
commission/fee. After the deal is executed, the commission broker confirms the
trade with the agent of the trader. There are different costs associated with the
transactions in the market for currency futures. The first is the brokerage
commission that is charged by the commission brokers and covers both the opening
and the reversing trade. The second is the floor trading and clearing fee charged by
the stock exchange and its associated clearing house. Normally, this fee is included
in the brokerage commission but when the locals trade for themselves, the fee is
quite exclusively found. The third is the delivery cost that is related to the delivery
of the currencies but since actual delivery of the currencies seldom takes place,
such cost is not common.
Options Market
The market for currency options is the other form of the derivatives market
representing large-scale sale and purchase of currencies. This form of market
possesses some distinguishing features and also the methods of operation are
different. There are three different types of option market. They are listed currency
options market, currency futures options market and over-the-counter options
market.
Since most money now exists in the form of electronic records rather than in the
form of paper, open market operations are conducted simply by electronically
increasing or decreasing (crediting or debiting) the amount of base money that a
bank has in its reserve account at the central bank. Thus, the process does not
literally require new currency. However, this will increase the central banks
requirement to print currency when the member bank demands banknotes, in
exchange for a decrease in its electronic balance.
When there is an increased demand for base money, the central bank must act if it
wishes to maintain the short-term interest rate. It does this by increasing the supply
of base money. The central bank goes to the open market to buy a financial asset,
such as government bonds. To pay for these assets, bank reserves in the form of
new base money (for example newly printed cash) are transferred to the sellers
bank and the sellers account is credited. Thus, the total amount of base money in
the economy is increased. Conversely, if the central bank sells these assets in the
open market, the amount of base money held by the buyers bank is decreased,
effectively reducing base money.

Q.3. Explain swap, its features and types of swap.

Answer:
Derivatives contracts can be divided into two general families:
1. Contingent claims, e.g. options
2. Forward claims, which include exchange-traded futures, forward contracts and
swaps.
Swaps are derivative instruments that involve an agreement between two parties to
exchange a series of cash flows over a specific period of time .
There are multiple reasons why parties agree to such an exchange:

Investment objectives or repayment scenarios may have changed.

It may be financially beneficial to switch to newly available alternate stream
of cash flows compared to the existing one.
Hedging can be achieved through swaps, like mitigation of risk associated
with a floating rate loan repayment.

Usually, at the time the contract is initiated, at least one of these series of cash
flows is determined by a random or uncertain variable, such as an interest rate,
foreign exchange rate, equity price or commodity price. Conceptually, one may view
a swap as either a portfolio of forward contracts, or as a long position in one bond
coupled with a short position in another bond. This article will discuss the two most
common and most basic types of swaps: the plain vanilla interest rate and currency
swaps.

Features of swap

Most involve multiple payments, although one-payment contracts are

possible

A series of forward contracts.

When initiated, neither party exchanges any cash; a swap has zero value at
the beginning.

One party tends to pay a fixed rate while the other pays on the movement of
the underlying asset. However, a swap can be structured so that both parties
pay each other on the movement of an underlying asset.

Parties make payments to each other on a settlement date. Parties may

decide to agree to just exchange the difference that is due to each other. This
is called netting.

Final payment is made on the termination date.

Usually traded in the over-the-counter market. This means they are subject
credit risk.

Common types of swap include:

(1) Currency swap: simultaneous buying and selling of a currency to convert debt
principal from the lender's currency to the debtor's currency.
(2) Debt swap: exchange of a loan (usually to a third world country) between
banks.
(3) Debt to equity swap: exchange of a foreign debt (usually to a Third World
country) for a stake in the debtor country's national enterprises (such as power or
water utilities).
(4) Debt to debt swap: exchange of an existing liability into a new loan, usually with
an extended payback period.
(5) Interest rate swap: exchange of periodic interest payments between two parties
(called counter parties) as means of exchanging future cash flows.
Q.4. Explain in detail the types of exposure and measuring economic
exposure.
Answer:
The foreign exchange exposure of a firm can be defined as a measure of the
sensitivity of its cash flows to changes in exchange rates. Due to the difficulty of
measuring cash flows, exposure is examined by most of the researchers through the
study of how a firms market value responds to the changes in the exchange rates.
There are different types of exposure to which a particular company-domestic or
internationalis exposed to. The types of exposure are related to two parameters:
1. One is related to the time of the transactions, the transactions and the flows
of money (payment and receivables) related to them and the other one to the
aspect of conducting international business in host countries.
2. The second one is based on the analysis of how to reconcile the balance
sheet of the subsidiary company with that of the parent companys balance
sheet.
The types of exposure are broadly divided into economic and translation exposure.
Economic exposure is further divided into transaction exposure and operating
exposure.
Economic Exposure
The potential changes in all future cash flows of a firm resulting from unanticipated
changes in the exchange rates are referred to as economic exposure. The monetary
assets and liabilities, in addition to the future cash flows, get influenced by the
changes in foreign exchange rates.

Of all the three exposures, economic exposure is the most important, as it has an
impact on the valuation of a firm. Suppose a Japanese company imports children
toys from India. The same product is also available from China but it is costly. If the
rupee appreciates against the yen and the Chinese currency decreases against yen,
Japan will prefer to import the toys from China as it will get at a cheaper rate. Since
economic exposure comes from unanticipated changes, its measurement is not as
precise as those of transaction and translation exposures. There are two
components of economic exposure transaction.
(a) Transaction exposure
Transaction exposure is concerned with the impact of change in exchange rate on
present cash flows. Transaction exposure emerges mainly on account of export and
import of commodities on open account, borrowing and lending in a foreign
currency and intra-firm flows within an international company.
Transaction exposure measures profits or losses that occur once the existing
financial obligations as per the terms of reference are settled. Given that the
transaction will result in a future foreign currency cash inflow or outflow, any
unanticipated changes in the exchange rate between the time the transaction is
entered into and the time it is settled in cash will lead to a change value of the net
cash flow in terms of the home currency. Examples of a transaction exposure of an
Indian company would be the account receivable associated with a sale
denominated in US dollars or the obligation of an account payable in Euro debt.
(b) Operating exposure
Operating exposure has an impact on the firms future operating costs and cash
flows. Since the firm is valued as a going concern entity, its future revenues and
costs are to be affected by the exchange rate changes. If the firm succeeds in
passing on the impact of higher input costs fully by increasing the selling price, it
does not have any operating risk exposure as its operating future cash flows are
likely to remain unaffected. In addition to supply and demand elasticity, the firms
ability to shift production and sourcing of inputs is another major factor affecting
operating risk exposure.
Sensitivity of future operating cash flows to unexpected changes in the foreign
exchange rate is known as the operating exposure. In other words, it arises when
the changes in the exchange rate in addition to the rates of inflation changes the
risk element and the amount of the companys future revenue and cost stream. The
word operating means the change in the operating cash flow which leads to
change in the value of the firm. It is not very easy to measure real operating
exposure as far as the measurement of the inflation rate differential is not easy,
more so when countries are going through a phase when they experience a highly
volatile rate of exposure. Operating exposure analysis assesses the impact of
changing exchange rates on a firms own operations over coming months and years
and on its competitive position vis--vis other firms. The goal is to identify strategic
moves or operating techniques that the firm might wish to adopt to enhance its
value in the face of unexpected exchange rate changes.

Some firms face operating exposure without even dealing in foreign exchange.
Consider an Indian perfume manufacturer who sources and sells only in the
domestic market. Since the firms product competes against imported perfumes
(say from Paris) it is subject to foreign exchange exposure. It faces severe
competition when rupee gains against other currencies (here, euro), lowering the
prices of imported perfumes.
Q.5. Elaborate on the tools of foreign exchange risk management and
techniques of exposure management.
Answer:
The various tools used for foreign exchange risk management are given as follow:
Forward Contract: In the forward market, contracts are made to buy and sell
currencies for future delivery, say, after a fortnight, one month, two months and so
on. The rate of exchange for the transaction is agreed upon on the very day the
deal is finalized. The rate of exchange for the transaction is agreed upon on the very
day the deal is finalized. The forward rates with varying maturity are quoted in the
newspapers and those rates form the basis of the contract. Both parties have to
abide by the contract at the exchange rate mentioned therein irrespective of
whether the spot rate on the maturity date resembles the forward rate or not. The
value date in case of a forward contract lies definitely beyond the value date
applicable to a spot contract.
Sometimes the value date is structured to enable one of the parties to the
transaction to have freedom to select a value date within the prescribed period. This
happens when the party does not know in advance the precise date on which it
would be able to deliver the currency, for instance, an exporter who sells a foreign
currency forward without knowing in advance the precise date of shipment.
Future Contract: The foreign exchange market involving forward contracts has a
long history but the market for currency futures has a comparatively recent origin. It
came into being in 1972 when the Chicago Mercantile Exchange has set up its
international monetary market division for trading of currency futures. Currency
futures are traded only in a limited number of currencies. A forward contract is
finalized on telephone, etc. meaning that it represents an over-the-counter market.
But in case of currency futures, brokers strike the deals sitting face to face under a
trading roof, known as pits. The brokers can trade for themselves as well as on
behalf of the customers. When they trade for themselves, they are called locals or
floor traders. On the other hand, when the brokers trade on behalf of their
customers, they are known as commission brokers or floor brokers. When a trader
has to enter a currency futures contract, he informs his agent who in turn informs
the commission broker at the stock exchange. The commission broker executes the
deal in the pit for a commission/fee. After the deal is executed, the commission
broker confirms the trade with the agent of the trader. There are different costs
associated with the transactions in the market for currency futures. The first is the
brokerage commission that is charged by the commission brokers and covers both
the opening and the reversing trade. The second is the floor trading and clearing

fee charged by the stock exchange and its associated clearing house. Normally, this
fee is included in the brokerage commission but when the locals trade for
themselves, the fee is quite exclusively found. The third is the delivery cost that is
related to the delivery of the currencies but since actual delivery of the currencies
seldom takes place, such cost is not common.
Options: The market for currency options is the other form of the derivatives
market representing large-scale sale and purchase of currencies. This form of
market possesses some distinguishing features and also the methods of operation
are different. There are three different types of option market. They are listed
currency options market, currency futures options market and over-the-counter
options market.
Since most money now exists in the form of electronic records rather than in the
form of paper, open market operations are conducted simply by electronically
increasing or decreasing (crediting or debiting) the amount of base money that a
bank has in its reserve account at the central bank. Thus, the process does not
literally require new currency. However, this will increase the central banks
requirement to print currency when the member bank demands banknotes, in
exchange for a decrease in its electronic balance.
When there is an increased demand for base money, the central bank must act if it
wishes to maintain the short-term interest rate. It does this by increasing the supply
of base money. The central bank goes to the open market to buy a financial asset,
such as government bonds. To pay for these assets, bank reserves in the form of
new base money (for example newly printed cash) are transferred to the sellers
bank and the sellers account is credited. Thus, the total amount of base money in
the economy is increased. Conversely, if the central bank sells these assets in the
open market, the amount of base money held by the buyers bank is decreased,
effectively reducing base money.
Currency swap: An agreement to swap a series of specified payment obligations
denominated in one currency for a series of specified payment obligations
denominated in a different currency. Usually fixed for fixed.
In a currency swap, the parties to the contract exchange the principal of two
different currencies immediately, so that each party has the use of the different
currency. They also make interest payments to each other on the principal during
the contract term.
In many cases, one of the parties pays a fixed interest rate and the other pays a
floating interest rate, but both could pay fixed or floating rates. When the contract
ends, the parties re-exchange the principal amount of the swap.
Originally, currency swaps were used to give each party access to enough foreign
currency to make purchases in foreign markets. Increasingly, parties arrange
currency swaps as a way to enter new capital markets or to provide predictable
revenue streams in another currency.
Techniques of exposure management:

Managing Transaction Exposure:

Transaction exposure calculates gains or losses which occur after the current
financial compulsions according to terms of reference are resolved. Taken that the
deal would lead to a future inflow or outflow of foreign currency cash, any
unprecedented alterations in rate of exchange amid the period in which transaction
is entered and the time taken for it to settle in cash would guide to a change in
worth of net flow of cash in terms of the home currency. For example, a transaction
exposure of an Indian company will be the account receivable which is associated
with a sale denominated in US dollars or the compulsion of an account payable in
Euro debt.
Presume an Indian firm sells goods with an open account to a German buyer for
1,800,000 payment of which is to be done in 2 months. The current exchange rate
is ` 50/, and the Indian seller expects to exchange the euros received for `
90,000,000 when payment is received. If euro weakens to `45/ when payment is
received, the Indian seller will receive only `81,000,000, or some `9,000,000 less
than anticipated. Opposite will be the case should euro strengthen. Thus exposure is
a chance of either gain or loss.
Alternative 1: Invoice the German buyer in rupees; but the Indian firm might not
have obtained the sale in the first place.
Alternative 2: Invoice the German buyer in dollars; both the parties are exposed
should an unanticipated change in exchange rate between dollar and the respective
home currency.
Managing Operating Exposure:
Operating exposure is alternatively known as economic exposure. It evaluates the
changes that occur in the current value of the firm. The change in the current value
may be a result of the change that takes place in predicted operating cash flows on
account of fluctuations in exchange rates.
They are similar in that they both deal with future cash flows. They differ in terms of
which cash flows management considers. Transaction exposure deals with the
predicted cash flows for future that have already been contracted and hence
accounted for. At the same time, the operating exposure focuses on the predictedbut not yet contracted-cash flows in future. These future cash flows may undergo
changes in case of a major fluctuation in the exchange rate, resulting in changes in
the overall competitiveness at international level.
Suppose an Indian MNC, such as Videocon, has sales in India, United States, China
and Europe and therefore, posts a continuing series of foreign currency receivables
(and payables). Sales and expenses that are already contracted for are traditional
transaction exposures. Sales that are highly probable based on the Videocons
historical business line and market share but have no legal basis yet are anticipated
transaction exposures. Let us extend the analysis of the firms exposure to
exchange rate changes even further into the future. The analysis of this longer term
where exchange rate changes are unpredictable and, therefore, unexpected is

the goal of operating exposure analysis. Broadly speaking, operating exposure and
its implications are not limited to the sensitivity and dependability of the future cash
flows of a firm upon the unpredictable fluctuations in foreign exchange rates. It is
also directly affected by other chain macroeconomic variables. This phenomenon is
often known as macroeconomic uncertainty.
Some firms face operating exposure without even dealing in foreign exchange.
Consider an Indian perfume manufacturer who sources and sells only in the
domestic market. Since the firms product competes against imported perfumes
(say from Paris) it is subject to foreign exchange exposure. It faces severe
competition when rupee gains against other currencies (here, euro), lowering the
prices of imported perfumes.
Suppose that an Indian manufacturer has contracted to sell 100 pairs of jeans per
year to Britain at `1200 per pair and to buy 200 yards of denim from Britain in this
same period for 2 per yard. Suppose that 2 yards of denim are required per pair
and that the labour cost for each pair is `400. Suppose that at the time of
contracting the exchange rate is S (`/) = 80 and the rupee is then devalued to S(`/
) = 81. Suppose also that the elasticity of demand for Indian jeans in Britain is -2
and that after the contract expires the Indian manufacturer raises the price of jeans
to `1205 per pair. What are the gains/losses from the devaluation on the jeans sold
and on the denim bought at the pre-contracted prices? (i.e., what are the
gains/losses from transaction exposure on payables and receivables?) What are the
gains/losses from the extra competitiveness of Indian jeans, that is, from operating
exposure?
Q.6. Write short notes on:
a. Adjusted present value model (APV model)
b. Economic and political risk
Answer:
Adjusted present value model:
Adjusted present value refers to the net present value (NPV) or investment adjusted
for the interest and tax advantages of leveraging debt provided that equity is the
only source of financing.
HOW IT WORKS (EXAMPLE):
A company may finance a project or investment using shareholders' equity alone
(i.e., without leveraged, or borrowed, cash flows). Under these circumstances, the
company repays associated debts using the unleveraged cash flow from
shareholder's equity. As a result, the company is entitled to significant tax
deductions on the interest component of these payments. These tax deductions put
the company at an advantage as far as the project's ultimate profitability, because
they help to increase the project's bottom line. For this reason, a company can
analyze such a project's profitability using the adjusted present value (APV). This

measure reflects the project or investment's NPV adjusted for the tax benefits from
interest obligations on outstanding debts associated with the project or investment.
To illustrate, suppose company XYZ invests $1,000 in a project, $800 of which is
equity and $200 of which is debt. The annual cash flow year after a year is projected
to be $146. The tax rate is 25%, and both the interest and cost of debt are each 7%,
while the return on equity is 15%.
APV = NPV + PV of debt financing advantages
NPV = -$1000 init. invest. + ($146 ann. ret. / 0.15 ret. on eq.) = -$26.67
PV of debt fin. adv. = (0.25 tax rate ($200 debt * 0.07 debt int.)) / (1 (1 / (1 + 0.07
debt cost)))
= $3.5 / 0.0655
= $53.44
APV = -$26.67 NPV + $53.44 PV of debt fin. adv.
APV = $26.77
In this instance, the tax advantages to company XYZ for financing with equity alone
make the project profitable as reflected in the positive APV. Were it not for these
advantages, the project would not have been accepted on the basis of its negative
NPV.
b. Economic and political risk:
Economic risk is the chance that macroeconomic conditions like exchange rates,
government regulation, or political stability will affect an investment, usually one in
a foreign country.
For example, let's assume American Company XYZ invests $1,000,000 in a
manufacturing plant in the Congo. Aside from the business risk associated with
making the plant profitable, Company XYZ is exposed to economic risk.
The political environment could shift quickly, perhaps prompting the Congolese
government to seize the plant or significantly change laws that affect Company
XYZ's ability to operate the plant.
Likewise, hyperinflation could make it impossible to pay workers, or exchange rate
circumstances could make it unprofitable to move profits out of the country.
The risk that an investment's returns could suffer as a result of political changes or
instability in a country. Instability affecting investment returns could stem from a
change in government, legislative bodies, other foreign policy makers, or military
control.
Political risk is also known as "geopolitical risk," and becomes more of a factor as
the time horizon of an investment gets longer.