INTERNATIONALFINANCE

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PAWAN JHABAKP.G.D.Ed.M., M.Com. (Finance)

Ex. Vice Principal, Rustomjee Business School,Dahisar (West), Mumbai 68.

(As per the Revised Syllabus 2016-17 of Mumbai Universityfor T.Y. BMS, Semester – VI)

© AUTHORNo part of this publication shall be reproduced, stored in a retrieval system, or transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of theauthor and the publisher.

FIRST EDITION : 2017

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PREFACE

“Genius is the ability to reduce the complicated to the simple”… Albert Einstien

I earnestly hope that the book will make complicated but very enlightening subject ‘InternationalFinance’ simple to understand and Score high marks in exams.

The book is divided in Part 1 and Part 2.Since Numericals are scoring and students like numericals more it has been put 1st as Part

I!!Selected Theory has been then put as Part 2. Since weightage of theory is 50 Marks it merits

effort right from the beginning !!I am thankful to one and all who have contributed directly or indirectly to make New edition

possible.This book is user-friendly and different. As one goes through the book, one will feel the

difference, and this will help to master ‘IF’ in an enjoyable manner, with life-time utility.The book covers ‘University’ Prescribed Syllabus with Practical Dimension !!I recommend one reads book “The Alchemist” by Neil Arwin and “Zero Sum World” by

Gideon Rachman to understand the subject from practical dimension.Best Wishes!!Million Thanks.

PAWAN V. JHABAKM.Com., P.G.D.Ed.M).,

Mobile: 9324343830 scorejhabak@gmail.com

Visiting Faculty: Amity Business School Aditya Institute of Management Studies & Research Mumbai Educational Trust

Ex. Visiting Faculty: Lala Lajpatrai College Vivekanand Education Society Rajiv Gandhi Institute of Technology S.K Somaiya Narsee Monjee College Usha Pravin Gandhi. Bhavan’s College (Andheri) Rizvi College S.K. Somaiya Akbar Peerbhoy Bhurani College Poddar College etc

Ex. Vice Principal: Rustomjee Business School

INTERNATIONAL FINANCEModules at a Glance

Sl. No. Modules No.of Lectures

1 Fundamentals of International Finance 152 Foreign Exchange Markets, Exchange Rate Determination &

Currency Derivatives 153 World Financial Markets & Institutions & Risks 154 Foreign Exchange Risk, Appraisal & Tax Management 15

Total 60

SYLLABUS

Sl. No. Modules/Units

1. Fundamentals of International Finance

(a) Introduction to International Finance: Meaning/Importance of International Finance, Scope of International Finance, Globalization

of the World Economy, Goals of International Finance, The Emerging Challengesin International Finance

(b) Balance of Payment: Introduction to Balance of Payment, Accounting Principles in Balance of Payment,

Components of Balance of Payments, Balance of Payment Identity Indian Heritagein Business, Management, Production, Consumption.

(c) International Monetary Systems: Evolution of International Monetary System, Gold Standard System, Bretton Woods

System, Flexible Exchange Rate Regimes, Current Exchange Rate Arrangements,European Monetary System, Fixed & Flexible Exchange Rate System

(d) An introduction to Exchange Rates: Foreign Bank Note Market, Spot Foreign Exchange Market Exchange Rate Quotations

Direct & Indirect Rates Cross Currency Rates Spread & Spread %

Factors Affecting Exchange Rates

2. Foreign Exchange markets, Exchange Rate Determination and Currency Derivatives

(a) Foreign Exchange Markets

· Introduction to Foreign Exchange Markets, Structure of Foreign Exchange Markets,Types of Transactions & Settlement Date, Exchange Rate Quotations & Arbitrage,Forward Quotations (Annualized Forward Margin)

(b) International Parity Relationships and Foreign Exchange Rate:· Interest Rate Parity, Purchasing Power Parity & Fisher Parity, Forecasting Exchange

Rates (Efficient Market Approach, Fundamental Approach, Technical Approach,Performance of the Forecasters), Global Financial Markets & Interest Rates (Domestic& Offshore Markets, Money Market Instruments)

(c) Currency and Interest Rate Futures: Introduction to Currency Options (Option on Spot, Futures & Futures Style Options),

Futures Contracts, Markets and the Trading Process, Hedging & Speculation withInterest Rate Futures, Currency Options in India

3. World Financial Markets and Institutions and Risks

(a) Euro Currency Bond Markets: Introduction to Euro Currency Market, Origin of Euro Currency Market, Euro

Bond Market (Deposit, Loan, Notes Market), Types of Euro Bonds, Innovation inthe Euro Bond Markets, Competitive Advantages of Euro Banks, Control & Regulationof Euro Bond Market

(b) International Equity Markets and Investments:

Introduction to International Equity Market, International Equity Market Benchmarks,Risk & Return from Foreign Equity Investments, Equtiy Financing in the InternationalMarkets, Depository Receipts (ADR, GDR, IDR)

(c) International Foreign Exchange Markets:

Meaning of International Foreign Exchange Market, FERA v/s FEMA, Scope &Significance of Foreign Exchange Markets, Role of Forex Manager, FDI v/s FPI,Role of FEDAI in Foreign Exchange Market

(d) International Capital Budgeting: Meaning of Capital Budgeting, Capital Budgeting Decisions, Incremental Cash

Flows, Cash Flows at Subsidiary and Parent Company, Repatriation of Profits,Capital Budgeting Techniques — NPV

4. Foreign Exchange Risk, Appraisal and Tax Management

(a) Foreign Exchange Risk Management: Introduction to Foreign Exchange Risk Management, Types of Risk, Trade &

Exchange Risk, Portfolio Management in Foreign Assets, Arbitrage & Speculation(b) International Tax Environment:

Meaning of International Tax Environment, Objectives of Taxation, Types of Taxation,Benefits towards Parties doing Business Internationally, Tax Havens, Tax Liabilities

(c) International Project Appraisal: Meaning of Project Appraisal, Review of Net Present Value Approach (NPV),

Option Approach to Project Appraisal, Project Appraisal in the International Context,Practise of Investment Appraisal

Paper Pattern

Duration: 2.5 hours 75 Marks

N.B.: 5 questions of 15 marks each.All questions are compulsory.

Q.1. Attempt any two:

(a) Theory Intorduction to I.F. 7.5 Marks

(b) Theory BOP/IMS 7.5 Marks

(c) Numerical Exchange Rates 7.5 Marks

Q.2. Attempt any two:

(a) Numerical Foreign Exchange Market 7.5 Marks

(b) Theory International Parity Relationship 7.5 Marks

(c) Theory Currency & Interest Rate Futures 7.5 Marks

Q.3. Attempt any two:

(a) Theory Euro Currency Market 7.5 Marks

(b) Theory Equity Markets or Foreign Exchange Market 7.5 Marks

(c) Numerical Capital Budgeting 7.5 Marks

Q.4. Attempt any two:

(a) Theory Foreign Exchange Risk 7.5 Marks

(b) Theory International Tax Environment 7.5 Marks

(c) Numerical/Theory Project Appraisal 7.5 Marks

Q.5. (a) Numerical 5 Marks

(b) Case Study 10 Marks

Note: For updates on sums and theory send email 2 weeks before exam to scorejhabak@gmail.cm

CONTENTS

— Formula (i) – (ii)

Part - IPROBLEMS/NUMERICALS + SOLUTIONS

1. Direct and Indirect Rates 3 – 9

2. Cross Rate Calculations 10 – 16

3. Percentage Spread Calculations 17 – 24

4. Identify and Calculate Geographical Arbitrage 25 – 33

5. Identify and Calculate Triangular Arbitrage 34 – 48

6. Forward Rates Calculations (Formula Method) 49 – 59

7. Calculation of Swap Points 60 – 75

8. Forward Rates Calculations (Table/Schedules Method) 76 – 88

9. Annualised Forward Margin (AFM) 89 – 95

10. Covered Interest Arbitrage 96 – 113

11. Borrowing and Investment Decision 114 – 121

12. Miscellaneous Patterns 122 – 134

IF University Sum 135 – 144

Part - IITHEORY

Unit I - Fundamentals of International Finance

1a. Introduction to International Finance 147 – 151

1b. Balance of Payment 152 – 158

1c. International Monetary Systems 159 – 170

1d. An Introduction to Exchange Rates 171 – 178

Unit II - Foreign Exchange Markets, Exchange RateDetermination & Currency Derivatives

2a. Foreign Exchange Markets 179 – 187

2b. International Parity Relationships and Foreign Exchange Rate 188 – 193

2c. Currency and Interest Rate Futures 194 – 212

Unit III - World Financial Markets & Institutions & Risks

3a. Euro Currency Bond Markets 213 – 219

3b. International Equity Markets and Investments 220 – 231

3c. International Foreign Exchange Markets 232 – 238

3d. International Capital Budgeting 239 – 245

Unit IV - Foreign Exchange Risk Appraisal & Tax Management

4a. Foreign Exchange Risk Management 246 – 250

4b. International Tax Environment 251 – 258

4c. International Project Appraisal 259 – 262

IF — April 2016 (Revised Course) 263 – 265

Bibliography and Acknowledgement 266 – 000

ALL FORMULAS/NOTES

(1) Inverse Formula:

USD/GBPBid =1

/ askGBP USD

USD/GBPAsk =1

/ bidGBP USD

(2) % Spread = 100Spread

Mean rate

=100

2

Ask BidAsk Bid

= 200

Ask BidAsk Bid

(3) USD/GBPBid = Mean Rate – 12 Spread

USD/GBPAsk = Mean Rate + 12 Spread

(4) In 2 point/3 point arbitrageLet the capital be 1 Million BC

Arbitrage Gain =1

1

Pr incipal Indentified Bid ( Higher ) Pr incipal

Identified Ask ( Lower )

(5) F = 1

100 12

1100 12

Rv nS

Rb n

Note: In two way quotation in calculation of Bid take D.R. of V.C. and L.R. of B.C.Note: In two way quotation in calculation of Ask take L.R. of V.C. and D.R. of B.C.

(6) 3m fwd USD/GBP —Spot USD/GBP —

Difference ———————

(i)

= Forward Margin= Swap PointsNote: If difference is positive it represents premium on Base Currency. Premium

Swap points are written in increasing order.E.g. 78 – 117And vice versa.(7) AFM = Rv – Rb

(8) AFM =12 100F S

S n

Note: AFM is calculated on ASK rates

(9) 100 12

bR RF S nS

No arbitrage exists there.

(10) 100 12

v bR RF S nS

Then arbitrage existsBorrow in Variable Currency and invest in Base Currency.

(11) 100 12

v bR RF S nS

Then arbitrage existsBorrow in Base Currency and invest in Variable Currency.

(12) Amount Payable = 1100RTP

(13) When borrow in Variable Currency then divide by SpotAsk & multiply by FwdBid.(14) When borrow in Base Currency then multiply by SpotBid & devide by FwdAsk.(15) When two way quotations are given use Case 1 & Case 2 method to calculate

Arbitrage Gain.(16) Borrowing Decision

1100 12 Ask

Bid

INR amt LR n Fwd INR amtSpot

Note: Lowest interest option is recommended(17) Investment Decision

1100 12 Bid

Ask

INR amt DR n Fwd INR amtSpot

Note: Highest interest option is recommendation.(ii)

PART - II

THEORY

145

147

INTRODUCTION TOINTERNATIONAL FINANCE

UNIT I – FUNDAMENTALS OF INTERNATIONAL FINANCE

Structure:1.1 MEANING AND SCOPE OF INTERNATIONAL FINANCE

1.2 IMPORTANCE OF INTERNATIONAL FINANCE

1.3 GLOBALIZATION OF THE WORLD ECONOMY

1.4 GOALS OF INTERNATIONAL FINANCE

1.5 THE EMERGING CHALLENGES IN INTERNATIONAL FINANCE

1.6 REVIEW QUESTIONS

1.1 MEANING AND SCOPE OF INTERNATIONAL FINANCEThe study of international finance essentially involves the study of different mechanisms

by which money can be raised in international markets. The main areas through which monetaryresources are raised are:

(A) International Equity Market(B) International Debt Market(C) International Loan Syndication(D) International Trade CreditAll these mechanisms in different proportions involve two additional variables beyond

those applicable to raising resources domestically. These additional variables are:

1aCHAPTER

148 INTERNATIONAL FINANCE

(1) The rate of conversion between currencies called the exchange rate(2) The rates of interest applicable to the two currencies being exchangedThe study of International Finance therefore involves an understanding of International

Economics and the Mechanism of Foreign Exchange Arithmetic. The underlying need forresources arises out of international trade.

International Trade

The justification for international trade was first explained through the ‘Theory of AbsoluteAdvantage’ by Economist Adam Smith. This theory was subsequently modified and reformulatedas the ‘Theory of Comprative Advantage’ by Economist David Ricardo. In simple terms, whatthe theory explains is that each country has a relative advantage over the others in manufacturingcertain products or delivering certain services. This advantage is in terms of cost efficiency,arises out of technological, climatic, geographical, cultural, natural resource or educationalfactors.

International trade therefore helps to achieve the following:(1) Transfer of efficiency from one geographical area to another(2) Improvement in the standard of living of both communities(3) Provides for better utilization of resources at a universal levelMost countries have independent legal tenders, which imply that they need to be exchanged

for meeting international liabilities. This is the main reason for the existence of the foreignexchange market. Thus, the basis of the foreign exchange market is the fact that commumitiesand countries trade with each other.

Foreign Exchange Market

The need for a foreign exchange market therefore arises out of the fact that the powerof domestic legal tender, circulating in the form of currency notes, to redeem commerciallaibilities legally, is limited by national boundaries. Both the seller and the buyer want toreceive and make payment in their respective domestic currencies. The task of fulfilling thisrequirement is handled by international commercial banks.

When these transactions get executed through the intermediation of banks, one currencygets converted into another. This process is called ‘Foreign Exchange’.

1.2 IMPORTANCE OF INTERNATIONAL FINANCEInternational finance plays a critical role in international trade and inter-economy exchange

of goods and services. It is important for a number of reasons, the most notable ones arelisted here”

International finance is an important tool to find the exchange rates, compare inflationrates, get an idea about investing in international debt securities, ascertain theeconomic status of other countries and judge the foreign markets.

Exchange rates are very important in international finance, as they let us determinethe relative values of currencies. International finance helps in calculating theserates.

INTRODUCTION TO INTERNATIONAL FINANCE 149

Various economic factors help in making international investment decisions. Economicfactors of economies help in determining whether or not investors’ money is safewith foreign debt securities.

Utilising an IFRS is an important factor for many stages of international finance.Financial statements made by the countries that have adopted IFRS are similar. Ithelps many countries to follow similar reporting systems.

IFRS system, which is a part of international finance, also helps in saving moneyby following the rules of reporting on a single accounting standard.

International finance has grown in stature due to globalisation. It helps understandthe basics of all international organizations and keeps the balance intact amongthem.

An international finance system maintains peace among the nations. Without a solidfinance measure, all nations would work for their self-interest. International financehelps in keeping that issue at bay.

1.3 GLOBALIZATION OF THE WORLD ECONOMYWhat, Why and How Globalization is? A lot of work has been done in the past on

globalization but its effects on the economic development have not been discussed in detail.Globalization is not a new concept. In past, people used to travel to other places for gainingcontrol on others lands, for finding out the better living style, for finding out the new placesand earning profits by selling in different regions. These activities were carried out eventhousands of years before. But it is said that the earliest form of globalization was startedfrom Greek, Roman, Egyptian, and Babylonian Empires. In the regime of Mongols, the famousSilk Road connected the Central Asia and Europe (Wikipedia, 2011). Statistics indicates thatGlobalization is expanding very rapidly Worldwide. Data gathered from WTO shows thateconomy of the world is expanding since 1950. Till 2004, the volume of the merchandisetraded has expanded about 7.5 times (Farrell, 2007). According to one Author Globalizationrefers to the political, economical, social and technological links in different countries (Hamilton& Webster, 2009). Globalization is a contested concept that refers to shrinkage of time andspace (Steger, 2009). According to another definition “globalization is the diminution orelimination of state-enforced restrictions on exchanges across borders and the increasinglyintegrated and complex global system of production and exchange that has emerged as aresult (Palmer, 2002).” Apart from those mentioned above, many more definitions can befound in the literature. Economic development and its different aspects refer to the improvementsin quality of human life.

Cultural Changes: Through the development of Globalization, world is getting into anidentical culture that is understood by every nation, we may call it intermixing of the cultures.People of world, especially people of rich countries are getting less conscious about theirnational cultures and they have started emerging in world culture. Globalization has resultedin increasing the diversity and boosting telecom and tourism sector of the world (Nigam,2009).

Environmental Effects: On the one hand, globalization has resulted in making the manmore curious toward its planet in which he is living and its ecology, i.e., its environmentthrough the technological advancements. But, on the other hand, it is considered that with the

150 INTERNATIONAL FINANCE

growth of transport has resulted in destruction of ozone layer and many species on the earth.For the economic development, every country has to pass from the dirty stage of industrializationwhich results in the extraction of poisonous material and harmful wastes that are dangerousfor the human’s health. But it is considered that these things are necessary to come alongwith the developments in living standards of humans (Nigam, 2009). But in spite all theseadverse facts, Globalisation has become an unavoidable necessity for Economic Development.

1.4 GOALS OF INTERNATIONAL FINANCEInternational finance research deals with macroeconomics; that is, it is concerned with

economies as a whole instead of individual markets. Financial institutions and companies thatconduct international finance research include the World Bank, the International FinanceCorporation (IFC), the International Monetary Fund (IMF) and the National Bureau of EconomicResearch (NBER). There is an international finance division at the U.S. Federal Reserve thatconducts analysis of policies that are relevant to U.S. capital flow, external trade and developmentof markets in countries around the world.

International or foreign trading is arguably the most important factor in the prosperityand growth of economies that participate in the exchange. The growing popularity and rateof globalization has magnified the importance of international finance. Another aspect toconsider, in terms of international finance, is that the United States has shifted from beingthe largest international creditor (lending money to foreign nations) and has since become theworld’s largest international debtor; the United States is taking money and funding fromorganizations and countries around the world. These aspects are key elements of internationalfinance.

Some of the Goals of International finance are:

Access to capital markets across the world enables a country to borrow duringtough times and lend during good times.

It provides domestic investment and growth through capital import. Worldwide cash flows can exert a corrective force against bad government policies. It prevents excessive domestic regulation through global financial institutions. International finance leads to healthy competition and, hence a more effective banking

system. It provides information on the vital areas of investments and leads to effective

capital allocation.International Finance promotes the integration of economics, facilitating the easy flow

of capital. The free transfer of funds would eventually result in more equality among countriesthat are a part of the global financial system.

1.5 THE EMERGING CHALLENGES IN INTERNATIONAL FINANCEThe decade of 1990s can be characterised as the “Globalisation Decade”. Around the

world, the process of dismantling the barriers to international trade and capital flows whichhad begun in early 1980s accelerated in the 1990s and reached its culmination during theclosing years of the last decade of the century. The globalisation process has acceleratedduring the starting years of the 21st century.

INTRODUCTION TO INTERNATIONAL FINANCE 151

Even developing countries like India, which for a long time, followed an inward-lookingdevelopment strategy concentrating on import substitution have, in recent years, recognisedthe vital necessity of participating vigorously in international exchange of goods, servicesand capital. The 1980s witnessed a significant shift in policy towards a more open economy,considerable liberalisation on imports and a concerted effort to boost exports. Starting in1991, the decade of 1990s ushered in further policy initiatives aimed at integrating the Indianeconomy with the international economy. The policy stance in the new millennium alsostresses more openness and networking with the global economy.

Define:

(a) NOSTRO accounts: Demand deposit accounts, denominated in foreign currenciesmaintained by domestic banks with banks overseas are called NOSTRO accounts. Nostromeans ‘our account with you’.

(b ) VOSTRO accounts: Demand deposit accounts denominated in domestic currencymaintained by overseas banks with domestic banks are called VOSTRO accounts. Vosrtomeans ‘your account with us’.

(c) LORO accounts: The term LORO is used when the NOSTRO/VOSTRO account isreferred to, by a bank other than the account maintaining bank and the bank with which theaccount is maintained. In other words, it is used when referring to third party accounts.LORO Account, ‘their account with you’.

(d) FIAT Currencies: FIAT currencies are paper currency notes issued by the centralMonetary Authority of the respective countries, incorporating a promise to redeem thosenotes at face value.

(e) Correspondent BanksThe bank with whom such a nostro or vostro a/c relationship is established is called

correspondent bank. This bank essentially acts as an agent of the domestic bank (principal)and undertakes various functions as follows:

Maintaining the foreign currency a/c and receiving and making payments on behalfof the counterparty (Principal) bank.

Providing temporary overdrafts as and when necessary. Providing credit reports on companies located in the country of the correspondent

bank.

1.6 Review Questions

Q. 1. Short Notes:(a) Importance of International Finance.(b) Goals of International Finance.

Q. 2. Explain Globalization & Scope of International Finance.Q. 3. Explain Emerging challenges in International Finance.

r r r