Trade Finance

International Finance by NIJAY GUPTA TASMAC MUMBAI

ECONOMIC SCENARIO  

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Forex Reserves touches USD 267.00 Bio Good Forex inflow earlier (now Outflow) by Exporters/ECB’s/FII’s/- FDI’s leveraging on capital market and less outflow by Importers Rupee remained between 48.50-49.00 Inflation around -1.50% Forward premium around 2.00% for 1 year Libor at 1.50% p.a. for 3 to 6 months

Need & Importance of IF   

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International Trade & Trade Settlement in Foreign Exchange Globalization & Liberalization by countries Integration of Financial Markets with the development of new financial instruments, liberalization of regulations governing the financial markets and increased cross penetration of foreign ownership Cover Trade & Forex Risk with new instruments & Products

Nature of International Financial Management  

Refers to financial function of an overseas business. Deals with  Investment Decision – What activities to finance – • Capital Budgeting, • Cross-border Mergers & Acquisitions.  Financing Decision – How to finance those activities  Money Management Decisions – How to manage firm’s financial resources • International Cash Management • Minimizing Cash balance • Minimizing currency conversion costs • Minimizing foreign exchange risks • Management of accounts receivable • Management of Inventory • International Taxation

International Financial Management Vs. Domestic Financial Management International Financial Management

Domestic Financial Management

Main object is to earn excess return Normal returns are expected on Investments Attempts to maximize returns are Enjoys relative freedom often stopped by several constraints Financial management requires an Domestic financial management is understanding of unique risks e.g. free from such risks. foreign exchange risks and political risks

Environment of IFM Foreign Exchange market

International Financial Markets

Currency Convertibility

International Financial Management

Balance of Payments

International Monetary System

International Monetary System Regional Economic Integration

Foreign Direct Investment

International Financial Markets

International Exchange Market Exchange Regional Economic Integration Rates

Legal System Government Policy International trade

Regional Economic Integration

pital a C t b De ts Marke

In Ec ter s on na om tio En ic na vi /B l ro us nm in en es t

International Monetary/Financial Systems International/National Business Regional Cooperatio n

Exchange Rate Regional Economic Integration Management /Exchange Nationa Rate Market lFinanci al Sector Economic Environment al r e ilat B vs l a er t a l lti u M tems Sys

Basic Ingredient of IF     

Same that of WTO i.e. due to free flows between countries on account of: Trade –Trade Finance Products Capital – Financial Markets and Instruments Arbitrage – Interest Rate between different markets and different countries Movement of People - Need for Money Transfer –Genuine/Non-Genuine

Key Issues    

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How does the Global Monetary System affect exchange rates? How did the current system evolve? What are the differences between the fixed and floating exchange system? What is the role of the International Monetary Fund and the World Bank in the Global Monetary System? What are the implications of the global monetary system for currency management and business strategy?

Trade Theories, Developments, Barriers and Regulations 

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Theory of Absolute Advantage – One country may be more efficient in producing a particular good than another country and that country may be capable of producing some other good more efficiently than the first one Theory of Comparative Advantage – Both countries enjoy comparative advantage in at least one of the products and to be seen from the point of Perfect competition, Productivity, Full employment, Mobility and Technology

Developments, Barriers and Regulations   

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Growth/Developments of International Trade Risks involved in International Trade Emergence of Trading Blocks – Free Trade Area, Custom Union, Common Market, Economic Union, NAFTA, ASEAN, SAARC, The European Union Trade Barriers – Tariff –Custom/import duty, taxes/vat –Non-Tariff Barriers – Quota, Embargo, Subsidies to local goods. Then Technical Barriers, procurement policies, international price fixing and Exchange Control Regulations etc Various Regulations to Trade – FEMA, Exim Policy etc

Globalization and the Multinational Firm 

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Declining trade barriers, Collapse of Communist power in Eastern Europe, move toward free market economies by China and Latin America changes in communication, information and transportation technologies have globalized and integrated world economy ‘IF’ differs from domestic finance due to – Foreign exchange & political risks, market imperfections and expanded opportunity set (firms gaining from greater economies of scale and deployment of assets on global basis) by using proper tools and instruments. Goals for IF - Maximization of Shareholders worth and need for Corporate Governance

Globalization and the Multinational Firm 

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MNC’s produces goods in one country, raise finance from different countries and sell in other countries. Globalization of the World Economy – Emergence of Globalized Financial Markets, Advent of the Euro, Trade Liberalization (WTO, NAFTA, EU) and Economic Integration (MNC’s taking comparative advantage over another country (Theory of comparative advantage) due to their controlling capital and know-how i.e. money & technical know-how power).

International Trade Finance in India – Risk/Exposure        

Risk in Export-Import Business Exposure on: Buyer/Seller – Credit, Capital, Capacity, Character and Conditions of business Country Risk – Political Risk, War or War like situation, Internal Disturbance & Govt. Policy Exchange Rate Risk –Price/Volatility Risk –Translation/Transaction Risk Operation Risk, Settlement Risk Interest Rate Risk –Inflation, Economic conditions/exposure Product Risk - Culture

International Trade Finance in India- FINANCING MECHANISM & CORRESPONDENT BANKS ACCOUNTS

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Permitted currencies for Payment (Trade/Investments) Collection, Purchase, Discounting or Negotiation of Export Documents Nostro Accounts Vostro Accounts ACU Dollar Account Foreign Currency Accounts for Residents: EEFC, RFC account and RFC (Domestic) account

International Trade Finance in India- INCOTERMS –ICC PARIS   

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Most commonly used Terms of Shipment are: FOB - SHIP, AIR, RAIL(FOR), TRUCK(FOT) All cost till the time goods are kept “ON BOARD” ship/air/rail/truck are borne by the exporter CFR:FOB PLUS the freight for the Voyage CIF:CFR PLUS the Insurance for the Voyage

International Trade Finance in India- INCOTERMS –ICC PARIS  

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Other Incoterms not much in use: FAS : Free Along-side Ship (loading/unloading expenses not included) CIFC: Cost, Insurance, Freight & Commission DAF: Deliver at Frontiers DDP: Delivered Duty Paid ICC, Paris have now grouped these Incoterms as ‘C’, ‘D’, ‘E’ and ‘F’.

International Trade Finance in IndiaRISKS ASSOCIATED WITH TERMS OF PAYMENTS 

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ADVANCE PAYMENT : Currency Fluctuations, need to be exported within one year DP: The buyer may not come forward to take up the documents DA: The buyer takes the documents but do not pay on due date To cover these risks the Exporters prefers LC, where a payment is guaranteed by a bank Importers prefer LC in order to maintain delivery schedule by the Exporter

International Trade Finance in India- TERMS OF PAYMENT-LC LC is a sort of Guarantee issued by a Bank, on behalf of the Buyer (applicant) favouring the supplier (Beneficiary), undertakes to pay by authorizing another bank (Negotiating Bank) to pay on complying with the Terms & Conditions mentioned therein.  LC is also known as Documentary Credit as Banks deals in Documents and not in goods  Each LC should mention that “This LC is subject to UCPDC publication no. 600, (2007 Revision) ICC guidelines” to be operative

International Trade Finance in IndiaTYPES OF DOCUMENTARY CREDITS/LC’S   

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REVOCABLE: Which can be cancelled by the applicant without the consent of beneficiary IRREVOCABLE: Which can not be cancelled or amended without the consent of beneficiary Irrv. CONFIRMED: Which has been confirmed by advising, another bank in the same country or another country Irrv. TRANSFERABLE: Which is transferred by the Advising Bank at the request of Beneficiary to third party

International Trade Finance in IndiaTYPES OF DOCUMENTARY CREDITS/LC’S  

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Irrv. Deferred Payment: Wherein the payments are made in Installments and deferred over one year Irr. Red Clause: Wherein the payment is made in advance through an LC mechanism by the buyer’s bank against the Indemnity & undertaking by the Beneficiary to export the goods Irr. Restricted: Wherein the LC is restricted for negotiation to a particular bank

International Trade Finance in IndiaCHECKLIST ON RECEIPT OF LC        

Name & Address of the Applicant & Beneficiary & Amount Should be in English language only Description of goods should be as per LC Terms of Shipment/Payment/Reimbursement Mode of Transport, Part/Trans-shipment Restricted or confirmed, charges thereon Inspection & other Terms & Conditions matches with that of the Performa Invoice or Contract Shipment/ Expiry date and Negotiation Period

International Trade Finance in IndiaEXPORT/IMPORT FINANCE SCHEME     

PRE-SHIPMENT CREDIT: (RUPEES/FC) Upto 180 Days : Not exceeding PLR minus 4.5% Beyond 180 to 270 days: Not exceeding PLR plus 0.5% PCFC upto 180 days: Not exceeding LIBOR plus 3.50% PCFC 181 to 365 days: Not exceeding LIBOR plus 5.50%

International Trade Finance in IndiaEXPORT/IMPORT FINANCE SCHEME       

POST SHIPMENT CREDIT (RUPEES/FC) On DP Bills upto NTP : Not exceeding PLR minus 4.5% On Usance Bills: upto 90 days : Not exceeding PLR minus 4.5% (PLR -4.50% for SME) Beyond 90 to 6 months: Not exceeding PLR plus 0.5% Bills Reds. Scheme : Not exceeding LIBOR plus 3.50% IMPORTERS are not given any concessional Finance, however they take benefit through Buyer’s Credit from overseas Banks/Institutions

International Trade Finance in India-

INTERNATIONAL FACTORING  

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Factoring is purchase of EXPORT receivable (with or without recourse) on an ongoing basis. The management, collection & administration is taken over by the factor for exports on open accounts terms Finance is made available upto 90% of the invoice value Offered by Global Trade Finance a subsidiary of Exim Bank in India, Canfactors & HSBC Factors etc

International Trade Finance in India-

INTERNATIONAL FORFAITING 

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Forfaiting is purchase of medium to long-term export receivables backed by a LC or banker’s acceptance from the buyers bank at a discount on a without recourse basis Exim Bank and Authorized Dealers offers this product to exporters for a minimum amount of USD 50,000/RBI allows banks to pay forfaiting charges in advance

International Trade Finance in India-

FACTORING 

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Suited for on going open a/c sales not backed by LC or accepted Bills of Exchange Provide short-term credit upto 180 days

: FORFAITING 

Single transactions backed by LC or a Bank Guarantee

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For long-term credit upto 10 yeas, though available for Short term too

International Trade Finance in India-

FACTORING 

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Requires regular arrangement for all the sales Separate charges for Financing, collection, Admn, credit protection, providing information and can be with or without recourse

: FORFAITING  

Deals concluded transaction wise Single discount charges for Guaranteeing Bank, Country risk, credit period involved and currency of debt & addl. Charge of commitment fee

International Monetary System 

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It’s a system where Intl payments are made, movement of capital accommodated and exchange rates of currencies determined It went through 5 stages – Bimetallism (coinage in silver & gold lead to Gresham’s law for fixing exchange ratio of 2 metals)), classical gold standard (exchange ratio decided on gold contents of currencies), interwar period (no clear rule lead to 44 nations meeting in 1944), Bretton Woods system (established a par value in relation to USD which was fully convertible to gold) and flexible exchange rate regime (replaced Bretton Woods due to spectacular rise & fall of USD in 1980). 1987 –G-7 countries agreed for Managed-float system for jointly intervening in Forex market to cover over- or undervaluation of currencies

International Monetary System  

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1979 – EEC launched European Monetary System (EMS) to establish ‘zone of monetary stability’ in Europe EMS are ECU (European Currency Unit basket) and ERM (Exchange Rate Mechanism) instruments based on parity grid that member countries required to maintain for EMS accounting. 1999 – 11 countries adopted common currency called Euro. Greece adopted in 2001. Euro -12 helps reduced transactions cost, elimination of exchange rate uncertainty and development of continent wide capital markets European Monetary Union (EMU) common monetary policy for 12 euro countries formulated by ECB located at Frankfurt. European System of Central Banks implements monetary policy of EMU in 12 –euro countries EMU members prefer Fixed Exchange rate whereas US & Japan prefer Flexible exchange rates. Choice between two involves tradeoff between national policy autonomy and international economic integration

International Monetary System  

Currency exchange rates depend on the structure of the international monetary system Generally they are not freely convertible and do not float freely  Only 51 were freely convertible in 1997  Another 50 were pegged to the exchange rate of major currencies such as the US Dollar and the French Franc or to baskets of other currencies  Another 45 currencies were allowed by their governments to float within a range of another currency  This is 153 of 190 UN member nations in 2007

International Monetary System 

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The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates. When the foreign exchange market determines the relative value of a currency, that country is adhering to a floating system. A pegged exchange rate means that the value of a currency is fixed to a reference country’s currency and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate. A dirty float occurs when the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency. Countries that adopt a fixed exchange rate system fix their currencies against each other.

Evolution of the International Monetary System 

Gold Standard  Currencies pegged to the value of gold; convertibility guaranteed  The exchange rate between currencies was determined based on how much gold a unit of each currency would buy  By 1880 most countries were on the gold standard  Achieves balance of trade equilibrium for all countries (value of exports equals value of imports); flow of gold was used to make up differences  Abandoned in 1914; attempt to resume after WWI failed with Great Depression

Bretton Woods (1944 - 1973)  

44 countries met to design a new system in 1944 Established International Monetary Fund (IMF) and World Bank  IMF maintained order in monetary system  World Bank promoted general economic development  Fixed exchange rates pegged to the US Dollar  US Dollar pegged to gold at $35 per ounce  Countries maintained their currencies ± 1% of the fixed rate; government had to buy/sell their currency to maintain level

The Role of the IMF •

Exchange rate discipline – National governments had to manage inflation through their money supply 

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The need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment. A fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation.

Exchange rate flexibility 

Provided loans to help members states with temporary balance-of-payment deficit; • Allowed time to bring down inflation • Relieved pressures to devalue

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Excessive drawing from IMF funds came with IMF supervision of monetary and fiscal policies Allowed up to 10% devaluations and more with IMF

Special Drawing Rights (SDR) 

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To help increase international reserves, The IMF created Special Drawing Right (SDR) in 1969. SDRs are defined in terms of a basket of major currencies used in international trade and finance. At present, the currencies in the basket are the euro, the pound sterling, the Japanese yen and the United States dollar. Before the introduction of the euro in 1999, the Deutsche mark and the French franc were included in the basket. SDRs are used as a unit of account by the IMF and several other international organizations. A few countries peg their currencies against SDRs, and it is also used to denominate some private international financial instruments

The Role of the World Bank 

World Bank (IBRD-International Bank for Reconstruction and Development) role  Refinance

post-WWII reconstruction and development  Provide low-interest long term loans to developing economies 

The International Development Agency (IDA), an arm of the bank created in 1960  Raises

funds from member states  Loans only to poorest countries  50 year repayment at 1% per year interest

Collapse of Bretton Woods 

Devaluation pressures on US dollar after 20 years - Huge balance of payment deficit & depletion of Gold reserves in US  Lyndon

Johnson policies

• Vietnam war financing • Welfare program financing  Nixon

ended gold convertibility of US dollar in

1971  US dollar was devalued and dealers started speculating against it for further devaluation  Bretton Woods fixed exchange rates abandoned in January 1972

Jamaica Agreement 1976  

Floating rates declared acceptable Gold abandoned as reserve asset;  IMF

returned its gold reserves to its members at current prices  Proceeds were placed in a trust fund to help poor nations  IMF quotas – member country contributions – increased; membership now 182 countries  Less-developed, non-oil exporting countries given more access to IMF 

IMF continued its role of helping countries cope with macroeconomic and exchange rate problems

Implications for Business 

Currency management  The

monetary system is not perfect  Both speculative activity and government intervention affect the system  Companies must use risk management instruments 

Business strategy  Minimize

risk by placing assets in different parts of the world, e.g., production  Contract manufacturing  Manage company-government relations

Key Issues    

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What is the form and function of the foreign exchange market? What is the difference between spot and forward exchange rates? How are currency exchange rates determined? What is the role of the foreign exchange market in insuring against foreign exchange risk? Why are some currencies not always convertible into other currencies?

Foreign Exchange 

Foreign exchange is a commodity that consists of currencies issued by countries other than one’s own.

•

The foreign exchange market  Is

the market where one buys (or sells) the currency of country A with (or for) the currency of country B

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A currency exchange rate  Is

simply the ratio of a unit of currency of country A to a unit of the currency of country B at the time of the buy or sell transaction

Determination of Exchange Rates 

Purchasing Power Parity Theory 

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Put forward by Gustav Cassel after First World War - "The rate of exchange between two currencies in the long run must stand essentially on the quotient of the internal purchasing powers of these currencies". The value of one currency in terms of another currency will be determined by the relative values of two currencies as indicated by their relative purchasing power over goods & services.

Balance of Payment Theory  

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Also known as 'Demand & Supply Theory' Holds that the foreign exchange rate, under free market condition, is determined by the conditions of demand & supply in the foreign exchange market (Just like the price of any commodity) Value of a currency appreciates when demand for it increases and depreciates when the demand falls, in relation to its supply in the FOREX market. The extent of demand & supply for a country's currency depends upon its balance of payment position.

Balance of Payments -Current Account Capital Account Official Reserve Transactions 

A country’s balance of payments summarizes all economic transactions that occur during a given time period between residents of a country and residents of other countries.  Balance of payments statements measure a flow because they summarize transactions in a given time period (year).  Transactions that don’t involve money are included. (Example: Food sent by world hunger organizations would be included.)  Accounts are maintained according to double-entry book keeping. (Debits- payments from us to the rest of the world, Credits – payments by the rest of the world to us

Components of Balance of Payment Accounts 

Current account balance:  Balance

on goods and services – The section of a country’s balance of payments account that measures the difference in value between a country’s exports of goods and services and its imports of goods and services. (Includes income earned from foreign assets owned by Indians minus income earned from India’s assets owned abroad.)  Unilateral transfers–payments of gifts and grants among countries (India has negative net unilateral transfers since World War II)

Implications of Current Account Deficit (i.e. trade deficit) Is a trade deficit financed by a capital accounts surplus bad?  The trade deficit as an automatic stabilizer  How could the trade deficit be removed? 

 Exchange

rate devaluation  Economic recession

Current account Includes all transactions involving goods and services, as well as transfers between residents of different countries  Here, India typically runs deficit 

 Exports

< imports (deficit)  Net unilateral transfers mostly deficit

Components of Balance of Payment Accounts (cont 

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Capital account – The record of a country’s international transactions involving purchases or sales of financial and real assets (borrowing, lending, and investments). Official reserve transactions account – The section of a country’s balance-of-payments account that reflects the flow of gold, Special Drawing Rights, and currencies among central banks A negative current account will be offset by a positive capital account if exchange rates are flexible (no intervention of official reserves

Capital account 

Calculates foreign investment  Foreigners’

purchases of India’s financial assets or real assets (India credit)  India purchase of foreign financial assets or real assets (India debit

Convertibility-Definition 

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The ease with which a country's currency can be converted into gold or another currency. Convertibility is extremely important for international commerce. When a currency in inconvertible, it poses a risk and barrier to trade with foreigners who have no need for the domestic currency The quality of being exchangeable (especially the ability to convert a currency into gold or other currencies without restriction Government restrictions can often result in a currency with a low convertibility. For example, a government with low reserves of hard foreign currency often restrict currency convertibility because the government would not be in a position to intervene in the foreign exchange market (i.e. revalue, devalue) to support their own currency if and when necessary

Rupee Convertibility 

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The Indian Rupee is 1) for all intents and purposes, fully Convertible to the US$ on the Trade Account and Current Account. This means Indians can buy US$ for their Trade, Travel, Fees, Education, Interest, Dividend payments etc. US Dollars can also be converted into Rupees 2) largely, NOT convertible to US$ on the Capital Account, especially when the flow of capital is from India to outside However, degrees of convertibility have been brought in. For instance, - Indian companies can invest in/ set up subsidiaries abroad. Limits are placed on the amount of investment - Indian mutual funds, since last year, have been allowed to invest in overseas markets, though we doubt if activity has picked up on this front - Dividend and Interest payments to investors abroad are unhindered

Rupee Convertibility 

Flow of Capital from outside India (investments into India) are unencumbered from the "convertibility" point of view.

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Investors may need to garner various necessary permissions as required to invest in the equity market, debt market or to set up Greenfield projects or buy over existing companies. These are, essentially, outside the ambit of "convertibility"

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Indian Rupee is not legally pegged to the Dollar. It is market traded currency, though the trading itself is controlled by various measures. Technically, the Indian Rupee is in a "Managed Float" or "Dirty Float", like the Yen.

Factors Determining Exchange Rates Fundamental Reasons: - Balance of Trade/Balance of Payment – surplus leads to stronger currency. - Inflation Rate - Forex Reserve - Economic Growth Rates –High/Low growth rate. - Fiscal / Monetary Policy- deficit financing leads to depreciation of currency. - Interest Rates –currency with higher interest will appreciate in the short term. - Political Issues –Political stability leads to stable rates (b). Technical Reasons - Government Control can lead to unrealistic value. - Free flow of Capital from lower interest rate to higher interest rates. (c). Speculation – higher the speculation higher the volatility in rates (d) Developments abroad – Sub- Prime, South-East Asian Crisis (e) Demand & Supply of Foreign Exchange at any given of time (f) Comments from FM/RBI- Governor (g) Ratings by the Rating Agencies

Determinants of Foreign Exchange Rate  

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Foreign exchange is needed to carry out foreign transactions The exchange rate is the price of one country’s currency measured in terms of another country’s currency Currency depreciation lowers the price of your currency to foreigners (and lowers the price of your exports and raises the price of imports) Currency appreciation increases the price of your currency to foreigners (and increases the price of your exports and lowers the price of imports)

Flexible and Fixed Exchange Rates 

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Flexible exchange rates – Rates determined by the forces of supply and demand without government intervention Fixed exchange rates – Rates pegged within a narrow range of values by central banks’ ongoing purchases and sales of currencies The Current System: Managed Float- an exchange rate system that combines features of freely floating rates with intervention by central banks (to moderate fluctuations in exchange rates). The ideal system would foster international trade, lower inflation, and promote a more stable economy

The Foreign Exchange Market 

The Functions & Structure of the Forex Market Foreign Exchange Types of Transactions

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The Spot Market

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Spot Rate Quotations The Bid-Ask Spread Spot FX Trading Cross Exchange Rate Quotations Arbitrage Spot Foreign Exchange Market Microstructure

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The Forward Market

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Settlement Dates Quotes for Various Kinds of Merchant Transactions The Indian Scenario

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Convertibility, Exchange Control The FEDAI Rules Regarding Inter-bank Dealings Forex Dealing Room Operations

Structure of the Forex Market Decentralized, over-the-counter market, also known as the 'interbank' market  Main participants: Central Banks, commercial Banks (AD/s), corporations & private speculators  The free-floating currency system began in 1973, and was officially mandated in 1978  Online trading began in the mid to late 1990's

Structure of the Forex Market Trading Hours 24 hour market Sunday 5pm EST through Friday 4pm EST. Rollover at 5pm EST Trading begins in New Zealand, followed by Australia, Asia, the Middle East, Europe, and America Size Largest market in the world $ 3 trillion average daily turnover, equivalent to: 15 times the average daily turnover of global equity markets Nearly 50 times the average daily turnover of the NYSE The spot market accounts for about one-third of daily turnover

Structure of the Forex Market Major Markets

The US & UK account for more than 50% of turnover  Major markets: London, New York, Tokyo  Trading activity is heaviest when major markets overlap  Nearly two-thirds of NY activity occurs in the morning hours while European markets are open Trading  An estimated 95% of transactions are speculative  More than 40% of trades last less than two days  About 80% of trades last less than one week  Brokers research: 90% of traders lose money, 5% break even, 5% make money 

Around-the-clock FX trading Average Electronic Conversions Per Hour 25,000

20,000

15,000

10,000

5,000

0 1

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Greenwich Mean Time

10 AM Lunch Europe In Tokyo In Tokyo opening

Asia closing

Americas London open closing

Afternoon in America

6 pm In NY

Tokyo opens

FX Rates  

What is Exchange Rate ? Exchange Rate is a rate at which one currency can be exchanged into another currency. In other words it is value one currency in terms of other. say: US $ 1 = Rs.45.18 This rate is the conversion rate of every US $ 1 to Rs. 45.18

Methods of Quotation   

Method – I One Orange = Rs 2 One Apple = Rs 2.50

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Method – II Rs. 10 = 5 Oranges Rs. 10 = 4 Apples

Price under both the methods is the same though expressed differently

Method - I DIRECT(FC fixed) USD 1 = Rs 45.18 GBP 1 = Rs.85.99 EUR 1 = Rs 57.92

Method - II INDIRECT( HC fixed) Rs 100 = USD 2.2133 Rs 100 = GBP 1.1629 Rs 100 = EUR 1.7265

With Effect from 02.08.1993, all exchanges are quoted in Direct Method

Understanding Two Way Exchange Quotes

In Forex markets , there are two way quotes i.e. both buying and selling rates are given.  1 USD = INR 45.16/ 18  BUYING RATE $/RE = RE 45.16  SELLING RATE $/RE = RE 45.18

In the abovementioned quote, lowest is market buying rate and highest is market selling rate.

Understanding Two Way Exchange Quotes One of the features of the FX markets is that this is the nearest form of perfect markets existing today. One of the reasons why this is so is that prices are always Quoted as TWO WAY QUOTES U

C

B

H

U

S

F

Y

D

1

=

C

1 . 2 5 7 0C

I N

G

R

SA

H

H

F

1 . 2 5 7 0 / 7 3

F

1 . 2 5 7 3

ET EL L I N

G

R

A

T E

Understanding Exchange Rates Dollar/Swiss Francs -- USD/CHF  Note the order of the currencies  “USD” comes before the “CHF”

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The first currency($) - Base currency  Second currency (CHF) - Terms currency It is important to remember that Bid & Offer in trading always refers to the BASE CURRENCY. 

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Understanding Exchange Quotes   

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In the FX market, Time is of great importance. Therefore, there are short forms for everything. While quoting, the dealers use only the third & fourth decimals. USD/CHF 1.2540 / 45 USD/INR 45.1675 / 00 GBP/USD 1.8000 / 10 BIG FIGURE In a live dealing scenario dealers would quote only 40/45 , 75/figure , figure/10 and the market assumes that all players already know the BIG FIGURE

Calculating Cross Rates    

India is a market maker for Indian Rupee Dollar/ Rupee trading ( the first quotes) start in the Mumbai Market BUT WHAT ABOUT OTHER CURRENCIES ? WHERE DO RATES FOR CHF, GBP, EUR ETC COME FROM? HOW ARE THEY CALCULATED?

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A CHF/RUPEE RATE IS A CROSS OF DOLLAR/RUPEE & DOLLAR / CHF. DOLLAR / RUPEE = 45.35/36

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DOLLAR / CHF = 1.3440 / 45

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CHF / RUPEE = 33.73 / 75 In other words, 45.36 / 1.3440 = 33.75 AND 45.35 / 1.3445 = 33.73

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Calculating Cross Rates    

India is a market maker for Indian Rupee Dollar/ Rupee trading ( the first quotes) start in the Mumbai Market BUT WHAT ABOUT OTHER CURRENCIES ? WHERE DO RATES FOR CHF, GBP, EUR ETC COME FROM? HOW ARE THEY CALCULATED?

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A CHF/RUPEE RATE IS A CROSS OF DOLLAR/RUPEE & DOLLAR / CHF. DOLLAR / RUPEE = 45.16/18

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DOLLAR / CHF = 1.2570 / 73

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CHF / RUPEE = 35.92 / 94 In other words, 45.16 / 1.2570 = 35.92 AND 45.18/ 1..2573 = 35.94

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Forex market conventions    

Standard nomenclatures Concept of value date Dealing and settlement locations Standard ways of quoting  Direct

Quote  Indirect Quote  Exchange rate quote is always given as a number of units of the quoted currency per unit of the base currency eg. USD/INR

Forex market conventionscontd 

Example of a Standard Quotation USD/CHF Spot: 1.4550/1.4560  The left-side price is the bid i.e. the dealer will buy 1 USD and the “bid” rate for USD is CHF1.4550. His “offer” or “ask” rate for one USD is CHF 1.4560 i.e. he would be paid CHF 1.4560 for 1 USD sold. 



For most currencies quotations the base currency is the dollar. The major exceptions are EUR,GBP,AUD and NZD

Forex market conventionscontd Quotations in inter-bank are usually up to four decimal places and the last two digits are called pips or points.  Direct and Indirect methods of quoting  No fees charged  Transaction cost in the bid-offer spread  Message confirmations through SWIFT 

Types of transactions Ready or Cash –value today  Tomorrow or “tom”-value tomorrow  Spot transactions –two business days after trade date  Forward transactions- any value date beyond spot  Swap transaction – combination of spot and forward 

Types of Transaction: Value Date Concept Due to vastness of the market and origin of transactions and settlements may take place at different time zones, most of times deal dates and settlement date differs. Market uses different terminology which are used universally to avoid conflict. Type of TXN Date of Deal Value Date Cash/Ready 15.11.2008 15.11.2008 Wednesday

Wednesday

TOM

15.11.2008 Wednesday

16.11.2008 Thursday

Spot

15.11.2008 Wednesday

17.11.2008 Friday

Forward

15.11.2008 Wednesday

Any day after 17.11.2008

Types of Transaction: Value Date Concept 

Due to vastness of the market and origin of transactions and settlements may take place at different time zones, most of times deal dates and settlement date differs. Market uses different terminology which are used universally to avoid conflict

Type of TXN Cash/Ready TOM Spot

Forward

Date of Deal 17.11.08 Friday 17.11.08 Friday 17.11.08 Friday

Value Date 17.11.08 Friday 20.11.08 Monday 21.11.08 Tuesday

17.11.08 Friday

Any day after 21.11.08

Transactions in the Foreign Exchange Market 



Spot exchange rates: the day’s rate offered by a dealer/bank Spot trade involves the almost immediate purchase or sale of foreign exchange.  Typically,

cash settlement is made within 2 business days. The spot market is an overthe-counter (OTC) market where contracts are tailored for each customer

Forward Rates    



What is a Forward Rate ? Rate agreed for settlement on an agreed date in the future All rates are derived from Spot rates Forward rate is the spot rate adjusted for the premium / discount Forward Rate = Spot Rate + / - premium or discount

Transactions in the Foreign Exchange Market 



Forward Exchange Rates  Agreed in advance rates to buy/sell a currency on a future date. Usually quoted 30, 90, 120, 365 days in advance.  May be at par, discount, or premium.  Forward contracts can be used to hedge or cover exposure to foreign exchange risk Forward Market - Participants  Hedgers: traders that try to protect themselves from future unfavorable exchange rate movements.  Speculators: traders that expose themselves to currency risk in order to profit from exchange rate fluctuations.

Premium/Discount  



Forward price = Spot price plus or minus forward margin. Premium –forward value of currency is higher than spot rate. A currency with lower rate of interest is said to be at premium in the forwards. Forward margins added to spot rate. Discount – forward value of currency is lower than spot rate. A currency with higher rate of interest is said to be at discount. Forward margins deducted from spot rate

Transactions in the Foreign Exchange Market 

Swap Operation - Simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency - Spot currency swapped against forward.  When

are foreign exchange swaps needed?

• Need a currency for a while, so buy it now and sell it later. • If foreign currency receivable is earlier than payable and the company wants to use the foreign currency in between the two dates. • To effectively change the maturity dates of forward contracts.

Transactions in the Foreign Exchange Market 

Arbitrage - Currency arbitrage means buying a currency in one market (say New York) at a low price and reselling, moments later, in another market at a higher price.   

Buying low and selling high … given slightly different exchange rate quotes in one location vs another. Could result in equalizing the exchange rates in different markets. Possible because of the ease & speed of communication between commercial centres in the world.

Assume that the rate of exchange in London is £ 1 = $2 while in New York £ 1 = $2.10. One can purchase one pound sterling in London for two dollars and earn a profit of $0.10 by selling the pound sterling in New York for $2.10. This situation would lead to an increase in demand for sterling in London and consequently, an increase in the supply of sterling in New York. This could result in equalizing the exchange rates in different markets.

Derivative Instruments 



Derivatives instruments are management tools derived from underlying exposures (Assets) such as Currency, Commodities, Shares, Bonds or any other indices, used to reduce or neutralize the exposure on the underlying contracts. Derivatives could be Over the Counter (OTC) i.e. made to order or Exchange Traded Facilities which are standardized in terms of quantity, quality, start & ending dates.

Hedging 



Hedging - Covering of export risk. It provides a Mechanism to exporters and importers to guard themselves against losses arising from fluctuations in exchange rates. Instruments  Forwards  Futures  Options  Swaps

Hedging Instruments •

Forwards are custom-made contracts to buy or sell foreign exchange in the future at a presently specific price. Maturity and size of contracts can be determined individually to almost exactly hedge the desired position.

•

Publicly traded on many exchanges worldwide, a currency future is a contract that resembles a forward contract. However, unlike the forward contract, the currency future is for a standard amount on a standard delivery date.

Hedging Instruments •

. •

The currency option allows, but does not require, a firm to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified date. A call option grants the right to buy the foreign currency in question; a put option grants the right to sell the foreign currency. Swaps are another at versatile, exposures. extensive.

agreements to exchange one currency for specified dates and prices. They are allowing easy hedging of complex Documentation requirements may be

FUTURE CONTRACTS 

 

Like forward contracts, future contracts also represent a commitment to exchange a specified quantity of one currency for another, at a specified price and on a specified future date Differences: Forward contracts =>customised while Future contracts => standardised

What is an FX Option 

An FX option contract gives the buyer (or holder) the right, but not the obligation, to:  Buy Rupees, in the case of a Rupee call/ Dollar put option, against Dollars (or sell Rupees against Dollars in the case of a Rupee put/Dollar call option);  For a predetermined quantity of Rupees;  At a predetermined fixed price (the strike or exercise price);  On (if European style) or until (if American style) a fixed future date;  For a premium (option price) negotiated at the time of dealing.

How does an FX Option Differ from a Forward  

Consider an exporter who expects to receive $1MN in 3 months. The exporter can go in for  Forward contract or Option contract  Forward contract – performance is obligatory on the for buyer and seller.* • Option contract – performance is not obligatory for for option holder.  Suppose , exporter goes for option contract. He will agree to sell $1 mn after 3 months. On due date, depending upon $/RE rate, he will decide to exercise the option or not.

Foreign Exchange Exposures or Risks 

Foreign Exchange Exposure refers to the possibility that a firm will gain or lose due to changes in exchange rates - the degree to which, a company is affected by the exchange rate changes.  Translation

Exposure  Transaction Exposure  Economic Exposure

Foreign Exchange Exposures or Risks 





Translation Exposure sometimes called accounting exposure measures the effect of an exchange rate change on published financial statements of a firm. Transaction Exposure refers to the potential change in the value of outstanding obligations due to changes in the exchange rate between the inception of a contract and the settlement of the contract Economic Exposure also called operating exposure, competitive exposure, or revenue exposure, measures the impact of an exchange rate change on the net present value of expected future cash flows from a foreign investment project.

Analyzing Country Risk     

Importance: To identify the common factors used by MNC’s to measure a country’s political risk To identify the common factors used by MNC’s to measure a country’s financial risk To explain the techniques used to measure country risk & To explain how MNC’s use the assessment of country risk when making financial decisions

Political & Financial Risk Factors     

 

Consumer’s Attitude in the Host country Host Government Actions Fund Transfers Blockage Currency Inconvertibility War, Terrorist attack, labor strike, scandal within a country, country’s banking system, Trade restrictions Bureaucracy & Corruption Economic Growth Indicators – Interest rates, exchange rates, inflation & Demand for product

Types and Techniques of Country Risk Assessment   

  

Macro assessment & Micro assessment of Country Risk (political & financial factors) Checklist Approach – judgment on political & financial factors Delphi technique – collection of independent opinions on country risk without group discussion by the assessors (like employees or outside consultants) Quantitative analysts Inspection visits Combination of techniques

Measuring Country Risk 

     

Thru – Checklist approach – separate rating for political & financial risk –assigning values from 1 – 5 or weights Variation in methods of measuring country risk Using country risk rating for decision making Comparing risk ratings among countries Actual country risk ratings across countries Incorporating country risk in capital budgeting by adjusting the discount rate or estimated cash flows Country Risk affecting Financial Decisions – Cases – Gulf War, Asian Crisis, Terrorist attack on US and Terrorism in Afghanistan, Pakistan, Hindustan, Srilanka etc.

Reducing exposure to Host Government Takeovers Use a short-term horizon  Rely on unique supplies or technology  Hire local labor  Borrow local funds  Purchase insurance  Use project finance 

Corporate Strategy & Foreign Direct Investment – Objective & Motives   



To describe common motives for initiating direct foreign investment & Illustrate the benefits of international diversification Revenue Relative Motives –Attract new sources of demand, Enter profitable markets, Exploit monopolistic advantages, React to trade restrictions, Diversify internationally Cost Related Motives – Fully benefit from economies of scale, Use foreign factors of production, use foreign raw materials, use foreign technology, React to exchange rate movements

Benefits of FDI    

 

Comparing Benefits of FDI among countries Comparing benefits of FDI over Time International Diversification: Benefits Diversification Analysis of International projects – comparing Portfolios along the Frontier, Comparing Frontiers among MNCs Diversification among Countries, Decision subsequent to FDI Host Government views o FDI, Incentives to encourage FEDI, Barriers to FDI, Government Imposed conditions to Engage in FDI

Capital Budgeting in MNC/Foreign Subsidiary - Objectives To compare the capital budgeting analysis of an MNC’s subsidiary versus its parent;  To demonstrate how Multinational capital budgeting can be applied to determine whether an international project should be implemented &  Explain how the risk of international projects can be assessed 

Capital Budgeting in MNC/Foreign Subsidiary - Perspective Subsidiary versus Parent  Tax Differentials  Restricted Remittances, Excessive Remittances, Exchange Rate Movements  Summary of Factors like cash flows before or after tax, conversion of funds/remittances etc, Withholding tax etc. 

Input & Factors for MNC Capital Budgeting 



Initial investment, consumer demand, price, variable cost, fixed cost, project lifetime, salvage (liquidation) value, restrictions on fund transfers, tax laws, exchange rates, Required rate of return Factors – Exchange rate fluctuations, Inflation, financing arrangement blocked funds, uncertain salvage value, Impact of project on prevailing cash flows, Host government incentives, Real options

Adjusting Project Risk Assessments Risk Adjusted Discount Rate  Sensitivity Analysis – What if scenario?  Simulation – Generation of a probability distribution for NPV based on a range of possible values for one or more input variables with the help of a computer package. 

Capital Structure and Multinational Cost of Capital Objective To explain how corporate and country characteristics influence an MNC’s cost of capital  Explain why there are differences in the costs of capital among countries &  Explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure 