Q: 1: What Is International Monetary System? Discuss The Alternatives

Q: 1: What is international monetary system? Discuss the alternatives exchange rate System. International I monetary system:

International monetary system refers primarily to the set of policies, institutions, practices, regulations and mechanisms that determine the rate at which one currency is exchanged for another. Alternatives exchange rate system:The alternatives exchange rate systems are: 1. Free float 2. Manages float 3. Target – Zone arrangement 4. Fixed – rate systems 5. Hybrid system Free float:In a free float system of exchange rate, the currency exchange rate is determined by the interaction of currency demand and supply. The supply and demand schedules, in turn, are influenced by price level exchange, interest rate differentials, and economic growth. In a free float exchange rate system, as the economic parameters change, the market participants adjust their current and expected future currency needs. Managed float: Managed float refers to the exchange rate system where the floating currencies, through central bank intervention, are managed to smooth out the exchange rate fluctuations, Such system of managed exchange rate is also known as the dirty float. The entity of managed float are; A)

S moothing out daily fluctuations

B)

Le aning against the wind C) Un official pegging Target Zone Arrangement: Under a target zone arrangement, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed upon, fixed exchange rates. Such a system existed for major European currencies participating in the European monetary System and was the precursor to the euro.Fixed rate System: Under a fixed rate system governments are committed to maintain target exchanges rates. Each central bank actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than the agreed on percentage. Current Hybrid System: The current international monetary system is a hybrid, with major currencies floating on a managed basis; some currencies are freely floating, and other

currencies moving in and out of various types of pegged exchange rate relationship. Q: 2: What is the various currency control mechanism. The various currency control mechanism are as follows: 1. Restriction or prohibition of certain remittance categories such as dividends or royalties 2. Ceiling on direct foreign inve3stment outflows 3. Control on overseas portfolio investment 4. Import restrictions 5. Required surrender of hard currency export receipts to central bank 6. Limitations on prepayments for imports 7. Requirements to deposit in interest free accounts with central bank, for a specific period, some percentage of the value of imports or remittances. 8. Foreign borrowings restricted to a minimum or maximum maturity 9. Ceilings on granting or credit to foreign firms 10. Imposition of taxes and limitations on foreign owned deposits 11. Multiple exchange rates for buying and selling of currencies depending on category of goods or services each transaction falls into.

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, than Q: 3: Discuss the brief history of IMF the dollar value IMF (International monetary fund) of Japanese yen The United Nations monetary and financial must rise by 4 conference held in Briton Woods, New Hampshire, in % to equalize July 1977, was called to develop a structuredthe dollar price international monetary system. As a result of this of goods in the conference, the international monetary fund (IMF) two countries. was formed. The major objectives of the IMF, as set Formally if in by its charter, are to: and if are the a) promote cooperation among countries onperiodic priceinternational monetary issues level change b) promote stability in exchange rates increases (rates c) provide temporary funds to memberof inflation) for countries attempting to correct imbalances ofthe home international payments country and the d) promote free mobility of capital fundsforeign across countries country, e) Promote free trade. respectively, It is clear from these objectives that the IBM’s goals eO is the dollar encourage increased internationalization of business. (HC) value of Before 1973, when exchange rates were maintainedone unit of within tight boundaries, the IMF concentrated onforeign removing currency exchange restrictions and ensuring currency at the currency convertibility, with the goal of encouraging beginning of international trade. With the inception of floating the period; and exchange rates in 1973 and the onset of the 1974-et is the spot 1975 recessions, the IMF offered financingexchange rate arrangements to countries experiencing large balance at period t, then of trade deficits. The value of et During the international debt crisis that erupted in appearing in august 1982, the IMF provided financing to many ofEquation 4.3 is the countries experiencing debt repayment difficulties. known as the The IMF worked with each country individually to PPP rate. For develop and implement policies that would improve example, if the its balance of trade positions. United -States and Switzerland are running annual inflation rates of 5% and 3% respectively, and the spot rate is SFr 1 = $0.75, then according to Equation 4.3. the PPP rate for the Swiss Franc in three should be The one year version of the PPP is commonly used. It is The purchasing power parity is often represented by following approximation Q: 4: What is arbitrage? PPP, IRP, IFE theory. of Equation Arbitrage: Arbitrage is ordinarily defined as the4.4:The simultaneous purchase and sale of the same assets orexchange rate commodities on different markets to profit from price change during a differentials. The concepts of arbitrage is of particularperiod should the importance in international finance because so many equal of the relationships between domestic andinflation international financial markets, exchange rates,differential for interest, rates, and inflation rates depend on arbitragethe same time period. In for their existence Purchasing power parity theory- Explain.(PPP) effect, PPP says Purchasing Power Parity: In absolute version, PPPthat currencies states that price levels should be equal worldwide with high rates inflation when expressed in a common currency. In other of words, a unit of home currency should have the equal should devalue to purchasing power around the world. This theory is relative just and application of one price law to national price currencies with lower rates of levels rather than to individual prices. The relative version of PPP: The relative version ofinflation. *4 PPP is used more commonly. It states that exchange rate between the home currency and any foreign

*4 The Lesson of Purchasing Power Parity: The PPP bears an important message: just as the price of goods in one year cannot be meaningfully compared with the price of goods in another year without adjusting for interim inflation, so exchange rate change indicates the reality of inflation rates differentials. Real exchange rate, not the nominal exchange rate, should be the focus of the real competitiveness analysis. If the changes in the nominal exchange rate are fully offset by the changes in the relative price levels between two countries, then the real exchange rate remains unchanged. Specifically, if PPP holds, then we can substitute the value of e1 from equation 4.2 into equation 4.6. Making this substitution yields elO = eO. Alternatively a change in the real exchange rate is equivalent to the deviation from PPP. Interest rate parity theory? (IRP) Interest Rate Parity (IRP): Once market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible, there is an equilibrium state referred to as interest rate parity theory (IRP). In equilibrium, the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies. According to IRP theory, the currency of the country with lower interest rate should be at a forward premium in terms of the currency of the country with the higher rate. More specifically, in an efficient market with no transaction costs, the interest rate differential should be (approximately) equal to the forward differential. When this condition is met, the forward rate is said to be at interest rate is parity, an equilibrium prevails in the money markets. It can be expressed in the following equality: Where, P = forward premium or discount F = forward rate S = spot rate ih = home interest rate if = foreign interest rate. If the forward premium is equal to the interest rate differential, covered interest arbitrage is not feasible. Exception to the IRP: The covered interest arbitrage will not hold under the following circumstances: Transaction costs: if an investor wishes to account for transaction costs, the actual point reflecting the

interest rate differential and forward rate premium must be farther from the IRP line to make covered interest arbitrage worthwhile. Political Risk: Even if covered interest arbitrage appears feasible after accounting for transaction cost, investing funds overseas is subject to political risk. A crisis in foreign currency could cause its government to restrict any exchange of the local currency for other currencies. In this case, investors would be unable to use these funds until the foreign government eliminated the restriction. Differential Tax Law: Because tax laws vary among countries, investors and firms that set up deposits in other countries must be aware of the existing tax laws. Covered interest arbitrage might be feasible when considering before-tax returns but not necessarily when considering after-tax returns. International Fisher Effect?(IFE) International Fisher Effect: The International Fisher Effect states the relationship between the interest rates and expected exchange rates between two countries. It is the combination of PPP and Fisher Effect. The following equation shows this relationship: Where et is the expected exchange rate in period t. the single-period analogue to the Equation 4.14 IS: Forward Premium or Discount =Forward rate spot rate x 360 ---------------- x-------------Spot rate Forward number of days

According to Equation 4.15, the expected return from investing at home, 1 +rh, should equal the expected HC return from investing abroad, (1+rf)e1/eO. If it is relatively small, Equation 4.16 provides a reasonable approximation to international. Q: 12: Option pricing method.Currency option pricing method: Currency option pricing is based on the following formula: Ct = as (t) B * (t,T) + bB (t,T) Where, C (t) = call option premium at time t for an option that expires at t + T. T = Time to expiration of the option expressed in fractions of a year. a = Amount of foreign currency.S (t) = Spot value of foreign currency at times t.B* (t,T) = Price of a pure discount foreign bond that pays one unit of foreign currency at t + T. b = Amount of the domestic currency.

B (t,T) = Price of a pure discount domestic that pays3. Co one unit of domestic currency at t + T. mmercial t = Time to exercise customers Q: 5: What is balance of payment; explain its primarily various components. Multination Balance of payments: al The balance of payments is an accounting statement Corporation. that summarizes all the economic transactions 4. Go between residents of the home country and residents vernment, of all other countries. In other words it is the summary mainly the of transactions between domestic and foreign central residents for specific country over a specified period Bank. of time. It represents an accounting of a country’s In addition to international transactions for a period, usually a this some quarter or a year. It accounts for transactions byspecific businesses, individuals, and government. participant in Currency inflows are recorded as credits, andforward outflows are recorded as debits. Credits show up with markets are: a plus sign, and debits have a minus sign. Balance of a) arb payments generally follows the double entry itragers accounting procedures. b) Tr Components of balance of payments: aders The various component of balance of payments are as c) He follows: dgers 1. Current Account d) Sp 2. Capital Account eculator 3. Official Reserves Account Current Account: Q: 13: What The balance of current account reflects the net flow of are the various goods, services, income, and unilateral transfers, it payment terms includes in a) exports and imports of merchandiseinternational (trade balance), trade? b) service transactions (invisibles), and The various c) income transfers payment terms d) unilateral transfer in international Unilateral transfer: trade are as It includes pensions, remittances and other transfers follows: overseas for which no specific services are rendered. 1. Cash in Capital Account: advance The capital account represe3ntrs a summary of flow2. Letter of of funds resulting from the sale of assets between one credit (L/C) specific country and all other countries over a specific 3. Draft / bill of period of tike. The major components of the capital exchange account are: 4. Consignment A) Portfolio investments 5. Open B) Direct investments account Portfolio investments: Q:15: The purchases of financial assets with a maturity Discussing the greater than one year, short term investments involve major securities with a maturity of less than one year. techniques of Direct investments: financing in Direct investments represent investments in fixed International assets in foreign countries that can be used to conductTrade? business operations. Examples of direct foreign Techniques of investment include a firm’s acquisition of a foreign financing company, as construction of a new manufacturingInternational plant, or its expansion of an existing plant in a foreign Trade: country. 1. Ba Official Reserve Account: nkers It measures changes in holdings of gold and foreign acceptance currencies – reserve asses – by official monetary (BA) institutions. The changes in official reserves measure2. Fa a nation’s surplus or deficit on its current and capital ctoring account transactions by netting reserve liabilities from3. Di reserve assets For example, a surplus will lead to an scounting increase in official holdings of foreign currencies or4. Forfeiting gold or both, a deficit will normally cause a reduction in these assets. Because double entry bookkeeping ensures that debits equal credits, the sum of all transudation is zero. That is the sum of the balance on the current account, the capital account, and he official reserves account must equal zero. Current account balance + capital account balance + official reserve account = Balance of payment = 0. Q.8: What is foreign exchange market? Who are the major participants in foreign exchange market? A foreign exchange market is a branch of international financial market; it facilitates the exchange of currencies resulting from international trade and financial transaction. On the other hand foreign exchange market is the mechanism that facilitates the cross border transaction of two currencies, International foreign exchange market exist for international flow of goods, services and capital. The major participant of foreign exchange markets are:1. Large commercial Bank 2. Foreign exchange brokers

at the expiration date. There are other forms of currency options are:a) American option b) European option American option: American option can be exercised at any time up to the expiration date. It is maximum 180 days. European option: European option can be exercised at only maturity date. There are three forms of option based on exercise rate. a) In the money option b) Out of the money c) At the money. In the money option: In the money option is the option for exercising at below the current exchange rate. Out of the money: When option is exercise above the spot rate. At the money: When option is exercise exactly at the spot rate. Q: 9: Discussed the various transaction types in foreign exchange market. The various transaction types in foreign exchange market are:1. Spot market 2. Forward transaction 3. Future contract 4. Currency option. Spot market: Spot market is the exchange of foreign currency according to the prevailing market exchange rate. Forward transaction: Forward transaction specifies the amount of a particular currency which will be bought or sold at a specified future point in time and at a specify exchange rate. Future contract: Future contract specifies a standard volume of particular currency to be exchange on a specified settlement date. (It is purchased on a lot) Currency option: Currency option is a form of foreign exchange derivative transaction in which the holder enjoys a right to sell or buy a financial instrument at a set price, currency option in a foreign exchange market gives the option holder a right but no obligation to buy or sell a foreign currency at a strike or exercise price. There are two types of currency opton. a) currency call option – means buy b) currency put option – means sell Call option: A call option gives the customers the right to purchases a contracted currency at the expiration date. Put option: A put option gives the right to sell a contracted currency

Q: 11: Currency options. What are the various types of currency option? Currency Option: A currency option is a form of foreign exchange derivative transaction in which the holder enjoys a right to sale or buy a financial instrument at a set price. Currency options in foreign exchange market gives the option holders a right but no obligation to buy or sale a foreign currency at a strike or exercise price. Types of Currency Option: There are two types of currency options: 1. Call Option (Buy): A call option gives the customer the right6 to purchase a contracted currency at the expiration date. 2. Put Option (Sale): A put option gives the option holder the right to sale a contracted currencies at the expiration date. There are other forms of currency optiona) American Option: The American option can be exercised at any time up to the expiration dates. (180 days) b) European Option: The European option can be exercised at only maturity dates.

currency per US dollar) 8. Transact ion cost.

Costs of forward contracts are based on bid -ask spread.

9.Margi n

Margins are not required in the forward market.

10. Creddit risk.

The credit risk is borne by each party to a forward contract. Credit limits must therefore be set for each customer.

Q: 10: What is the basic difference between forward and future contract. The basic difference between forward and future contact are Title Forward contact Future contract 1.Tradin Forward Futures g contracts are contracts are traded by traded in a Telephone or competitive telex. arena. 2. Regulati on

The forward market is self regulating.

3.Freque ncy of delivery

More than 90% of all forward contracts are settled by actual delivery.

4. Size of contract

Forward contracts are individually tailored and tend to be much larger than the standardized contracts on the futures market. Banks offer forward contracts for delivery on any date.

5. Delivery date

6.Settle ment

Forward contract settlement occurs on the date agreed on between the bank and the customer.

7.Quotes

Forward prices generally are quoted in European terms (units of local

There are other three types of options based on exercised rate: a) In the Money Option b) Out of the Money Option c) At the Money Option

The IMM is regulated by the commodity futures trading commission. By contracts less than 1% of the IMM futures contracts are settled by delivery. Future contracts are standardized in terms of currency amount.

IMM futures contracts are available for delivery on only a few specified dates a year. Futures contracts settlements are made daily via the exchanges clearing house, gains on position values may be withdrawn and losses are collected daily. This practice is known as marking to marking. Futures contracts are quoted in American terms (dollars

per one foreign currency) Futures contract entails brokerage fees for buy and sell orders. Margins are required of all participants in he futures market. The exchanges clearing house becomes the opposite side to each futures contract, thereby reducing credit risk substantially.