Exchange Rate Quotations

Structure of Foreign Exchange MarketExchange Rate QuotationTypes of Transaction and Settlement Dates

Intl.fin.1INTERNATIONAL FINANCIAL MANAGEMENTPART IIExchange Rate QuotationsIntl.fin.2Existence of a number of currencies gives rise to transactions in these currencies for settlement of international transactions.Two parties may exchange their respective domestic currencies in settlement of export import transaction.Or both parties may agree to settle the transaction in a third country currency.In the absence of an organized market It would be difficult to find buyers and sellers of currencies to find each other.This has given rise to the development of a foreign exchange market.

Factors That Influence Exchange RatesIntl.fin.3The following equation summarizes the factors that influence the exchange rates (the spot rate of a currency):e=(INF, INT, INC, GC, EXP), where e = change in the spot rateINF = change in the inflation rates between two countriesINT = change in the interest rates between two countriesINC = change in the differential in the income levels of two countriesGC = change in the government controls and EXP = change in expectations of future exchange rates

>> Factors That Influence Exchange RatesIntl.fin.41. Changes in the relative inflation ratesChanges in inflation rates can affect the international trade activitythat in turn affects the demand and supply of a currencythat in turn affects the exchange rates.Equilibrium rate: Quantity suppliedRate

SDeS1D1>> Factors That Influence Exchange RatesIntl.fin.52. Changes in in relative interest rates (concept of real interest rates)Changes in relative interest rates can affect investment in foreign securitiesThat affects the demand and supply of currenciesWhich in turn can affect the exchange rates3. Relative income levelsIncome can affect the amount of imports demandedChanges in demand can affect the exchange rates>> Factors That Influence Exchange RatesIntl.fin.64. Government controls influence the exchange rates in many ways including imposition of:Foreign exchange barriersTrade barriersMarket interventions etc.Foreign Exchange MarketIntl.fin.7No physical marketIt is a virtual market consisting of a network of banks, brokers and dealers across various financial centers around the world.Linked with each other by telephone, telefax, computer and other electronic network like SWIFT system etc.Information on the quotes of major international banks, money markets, interest rates etc. are continuously fed to the dealers by service providers like Reuters, Telerate Systems, Bloom Berg etc.>>>>Foreign Exchange MarketIntl.fin.8Informal code of moral conduct a forex dealers word is their bond! Transactions done on telephone are followed by mail confirmations.It assists international trade and investment by enabling currency conversion. It also supports direct speculation in the value of currencies.

Uniqueness of Forex MarketIntl.fin.9Huge trading volumes leading to high liquidity (Average daily turnover is in excess of US$4 trillion)Wide geographical dispersionRound the clock operation, except weekendsThe variety of factors that affect exchange ratesRazor-thin margins of profitUse of leverage to enhance profitBecause of these factors, forex market is referred to as the market closest to the ideal of perfect competition.

Structure of Foreign Exchange MarketIntl.fin.1185% of the transactions are speculative and only 15% are trade-related or commercial transactions (According to the BIS, the average forex trading volume in 2004 was $1.9 trillion per day nearly 20 times the daily turnover of N.Y. Stock Exchange!) Theoretically, it is a zero-sum game. Presence of hedgers and interventions by central banks result in speculative gains or losses.Main players: Large commercial banks (Interbank Market) (40% of the turnover)Large MNCsHedge Funds, Pension Funds, Insurance Companies, Mutual Funds etc.Forex brokersCentral Banks>>

Structure of Foreign Exchange MarketIntl.fin.12Large commercial banks deal in forex on their own account as well as on behalf of their customers.They act as market makers.There are numerous market makers in the market and all of them would be giving different quotes for a pair of currencies.The market-making activities of commercial banks along with speculation makes the market extremely liquid and volatile. Main trading centers: New York, London, Tokyo, Hong Kong, Singapore. >>

Structure of Foreign Exchange MarketIntl.fin.13Brokers do not actually buy or sell any currency.They are a link and match-makers between different players in the market.Brokers help the prospective buyer or seller to keep their identities secret till the deal is struck.Brokers also help the players to get a feel of the market (direction of quotes)Large corporations also bet on the markets to make exchange profits.The inter-bank market is called the Wholesale Market whereas the market in which the banks deal with their customers is called the Retail Market. >>Major Participant Groups & Their MotivesIntl.fin.14Non-banking entities simply exchange currencies to honour their obligations or to get the desired currency.Traders use the forex market for hedging their exposures o/a changes in the exchange rate.Banks operate on behalf of their customers and also engage themselves in proprietary trading.Arbitrageurs change currencies to take advantage of varying rates in different markets.Speculators buy and sell currencies for the sake of profit when they expect movement in the exchange rate in a particular direction. A major structural change Introduction of Electronic Trading System (ETS)Intl.fin.15In April 1992, Reuters introduced a new service that added automatic execution to the process.Traders enter buy and sell orders directly into their terminals on an anonymous basis and these prices are visible to all market participants.Another trader, anywhere in the world, can execute the trade simply by hitting two buttons.ETS has reduced the cost of trading by eliminating the brokers and the number of transactions.

Financial Instruments In Forex MarketIntl.fin.16Spot has the shortest time frame, involves cash rather than a contract and interest not included in the agreed upon transaction. Forward rate is fixed on the day of the transaction itself for a future transaction but money does not change hands until an agreed future date.Swap currency swap & interest rate swapFuture standardized forward contracts traded on exchange.Options an exchange traded derivative where the option holder has the right to buy/sell currency but no obligation to do so. Whereas the option writer has the obligation to stick to the contract.Speculation speculators have a stabilizing influence on the market providing market for hedgers and transferring risk from those who dont wish to bear it to those who do Milton Friedman.

Structure of Foreign Exchange MarketIntl.fin.17Being a virtual market, it is a round-the-clock market.

London, New York and Tokyo markets are the biggestintl.financing18

Hong Kong Tokyo & Sydney Bahrain Singapore Frankfurt London New York ChicagoSan FranciscoGMT 2300 2200 2100 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 0900 0800 0700 0600 0500 0400 0300 0200 0100 -10 -09 -08 -07 -06 -05 -04 -03 -02 -01 -00 +01 +02 +03 +04 +05 +06 +07 +08 +09 +10 +12THE WORLD OF FOREIGN EXCHANGE DEALINGTokyoHong KongSingaporeBahrainFrankfurtLondonNew YorkChicagoSan Francisco Foreign Exchange Dealing Times: GMTSydneyAttributes of Banks That Provide Foreign ExchangeIntl.fin.19Competitiveness of quote: A saving of 1 cent per unit on an order of one million units of currency is worth $10,000Special relationship with the bank: The bank may offer cash management services or may be willing to make special efforts to obtain hard-to-find currencies for the customer.Speed of execution: Banks vary in efficiency with which they handle an order. A corporate needing the currency will prefer a bank that handles the paper work properly and puts through the transaction speedily. >>

>> Attributes of Banks That Provide Foreign ExchangeIntl.fin.20Advice about currency market conditions: Some banks may provide assessment of foreign economies and relevant activities in the international financial environment that relate to corporates.Forecasting advice: some banks may provide forecasts of exchange rates to the corporates.In view of the above advantages a corporate needing a foreign currency should not automatically choose a bank that will sell a currency at the lowest price; It pays to develop a close relationship with a major bank in case they need a favour from a bank.

Settlement of TradesIntl.fin.21Settlement of trades take place by transfer of money to the Nostro Accounts of the respective currencies held with a correspondent bank.Nostro, Vostro and Loro accounts.Clearing House Inter-bank Payment Systems: CHIPS & CHAPSOver Bought / Over Sold positionsCompetition between the market makers ensures that the divergence in quotes are not wide.Indian Foreign Exchange MarketIntl.fin.22Three-tired market.Tier I : Transactions between ADs and RBITier II : Inter-bank transactionsTier III : Retail segment transactions between ADs and Money Changers and customers.Market is regulated by the provisions of FEMA, 1999RBI is the regulator under the powers vested by FEMA.Players:Authorized Dealers (Categories A, B & C) and Money Changers >>Indian Foreign Exchange MarketIntl.fin.23In the first tier, RBI buys and sells foreign exchange from/to ADs.The second tier is the inter-bank market where ADs transact business among themselves. Since the amounts transacted are large, they form the wholesale market.Transactions in the third tier are generally small and deal with exporters, importers and individuals. It is called retail market.Most of the transactions take place in hard convertible currencies like US dollar, Pound Sterling, Euro and Japanese Yen.

Clearing ProcessIntl.fin.24A majority of forex transactions in India involves dollar as one leg;A multilateral netting mechanism has been created through the CCIL (Clearing Corporation of India Ltd.) for settlement of all dollar denominated transactions.As a central counterparty CCIL guarantees trade settlement.ADs pass the dollar-related transactions through CCIL for netting and settlement.CCIL in turn settles the dollar leg through its correspondent in the USA.The rupee leg is settled through the member banks account with RBI.Advantage: Substantial cost and time benefit for the ADs.Transactions in currencies other than dollar are settled directly by ADs through their respective Nostro bank accounts.Exchange Rate QuotationsIntl.fin.25Currencies are traded in pairs like xxx/yyy. Currency xxx is the base currency and yyy is the counter currency (or quote currency). E.g., USD/JPY, USD/CAD, USD/INR etc Remember: The value of the base currency is always 1 The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). For these pairs, where USD is not the base currency, a rising quote means the US dollar is weakening and buys less of the other currency than before. Direct Quote: Exchange Rate is expressed in terms of number of units of domestic currency per unit of foreign currency.E.g., 1USD = INR55.42Indirect Quote: Domestic currency fixed and foreign currency variable.E.g., Rs.100/$Market quotes: DM/$ : 1.6688 / 93Inter-bank quote: DM / $ : 88 / 93A few currencies are quoted in 100s rather than 1s or 2s. E.g., Japanese Yen ($/100Y: 0.9150/52)Direct & Indirect QuotesIntl.fin.26Example:If direct quote is Rs.45/US$, how to present it in indirect quote?US$1/Rs.45 = US$0.0222/Re.If indirect quote is US$0.025/Re, how can this exchange rate be shown under direct quote?Re.1/US$0.025 = Rs.40/US$Inverse QuotesIntl.fin.27For every quote A/B there is an inverse quote B/AE.g., Euro / $ : 1.6688 / 93 is a quotation in Frankfurt.The quote on the left side is called the Bid (purchase) rate and that on the right is called the Ask (sale) rate.Bid always precedes the ask rate.Bid is the rate at which the bank is prepared to buy dollars (also means the rate at which it is ready to sell Euro) and Ask is the rate at which it is prepared to sell dollars (also means the rate at which it is prepared to buy Euro).Hence the Euro / $ bid rate would correspond to $ / Euro ask rate.

Inverse QuotesIntl.fin.28For the above example,The implied ($/Euro)bid = 1 / (Euro/$)askThe implied ($/Euro)ask = 1 / (Euro/$)bidSo the implied inverse rate is:$ / Euro : 0.5990 / 0.5992The above equations can be generalized as:Implied (B/A) quote:1/(A/B)ask Divided by 1/(A/B)bidInter-Bank and Merchant QuoteIntl.fin.29In an inter-bank transaction, The bank requesting the quote is the customer and The bank giving the quote is the market maker.Example of a market quote:Euro/$ : 1.6688 / 1.6693It is the market practice to quote the same rate as Euro/$ : 1.6688/93The rate on the left side is the bid (buying) rate and that on the right side is the ask (selling) rate. A few currencies like Japanese Yen are quoted in units of 100 ($/100Y=0.9150/52)The quote after the decimal points is called basis points.According to FEDAI Regulations, all rates have to be quoted to four decimal points, with the last two being multiples of 5 (this rule is ignored for the sake of simplicity and learning)Inter-Bank and Merchant QuoteIntl.fin.30The spread between bid and ask prices is influenced by:Spread = (Order costs + Inventory costs Competition Volume + Currency risk)Order costs are costs of processing orders, clearing costs etc. Inventory costs are costs of maintaining inventory of a particular currency. Holding an inventory involves an opportunity cost.Competition: Higher the competition, the lower the spread.Volume: Higher the volume, lower the spread.Currency risk: Higher the volatility of the currency, higher the spread as the intermediaries dealing in these currencies could incur large losses due to abrupt change in the values of these currencies.Rate Spreads in Forex QuotesIntl.fin.31Example: Consider the following bid-ask prices: Rs.40 40.50/ US$. Find the bid-ask spread.Spread = 40.50 40.00 = 00.50p% spread = (0.50 / 40.50) x 100 = 1.23%Find out the bid rate if ask rate is Rs40.50/US$ and the bid-ask spread is 1.23%.(40.50 x)/40.50 = 0.0123 or40.50 x = 0.0123 x 40.50 or40.50 8*0.50 = x or x = Rs40.00

Cross Rates (Synthetic Rates)Intl.fin.32Cross Rates (also called Synthetic Rate):Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (generally the USD)Suppose we want to find out the cross rates between SFR and CND with the following market quotation: SFR/USD: 5.5971/78 and USD/CND: 0.7555/62Synthetic (Sfr/Can$)bid rate = (Sfr/$)bid x ($/Can$)bid = 5.5971 x 0.7555 = 4.2286Cross Rates (Synthetic Rates)Intl.fin.33Synthetic (Sfr/Can$) ask rate = (Sfr/$)ask x ($/Can$) aski.e., 5.5978 x .7562 = 4.2330Therefore, the synthetic quote of Sfr/Can$ will be: Sfr/Can$ = 4.2286 / 4.2330The rates can be generalized as:Synthetic (A/C)bid = (A/B)bid x (B/C)bid and Synthetic (A/C)ask = (A/B)ask x (B/C) ask, where A, B & C are three currencies.

Cross Rates (Synthetic Rates)Intl.fin.34Suppose Currency A is Swiss Francs, Currency B is Canadian Dollars and Currency C is US Dollars, then a chain formula for cross rate between Sfr and Can$ would be:How many Sfr = 1Can$, if 1Can$ = 0.7555US$ and if 1US$ = 5.5971Sfr The numbers on the right hand side will form the numerator and those on the left will form the denominator. On simplifying, (Sfr/Can$)bid = 0.7555 x 5.5971 = 4.2286 (Sfr/Can$)ask = 5.5978 x 0.7562 = 4.2330

Forward RatesIntl.fin.35A forward rate in a Forward Contract is an agreement between a commercial bank and its customer to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future.The most common forward contracts are for 30, 60, 90, 180 and 360 days. However, contracts for periods in between (Broken period contracts) are also available (discussed elsewhere).The difference between the forward rate (FR) and the spot rate (SR) at a given time is measured by the premium (Pm) or discount (- ): FR = SR(1 + Pm)Examples of Buying & Selling RatesIntl.fin.36Mr. X presents a foreign draft for US$5,000 for credit to his account. Mr. X wants a foreign draft for US$200 to subscribe to a foreign magazine.ABC Ltd. has lodged an export bill for US$50,000 which is realized and credited to the Nostro account of the A.D.Mr. Dutta is visiting his children in USA. He requests for a Vishwa Yatra Card for US$3,000.Mr. Mishra, an Indian citizen working in US has remitted US$10,000 to an AD for opening a foreign currency term deposit account.Different Types of Buying RatesIntl.fin.37TT Buying RatePayment of foreign draft issued by a correspondent bank.Realization of foreign cheques / bills sent on a collection basis.Cancellation of outward remittances.Payment of FCNR DepositCancellation of Forward Sale ContractComputed as: Interbank Spot Buying Rate Exchange Margin.

Different Types of Selling RatesIntl.fin.38TT Selling RateIssue of drafts/TTs and all clean instruments for remittance outside India.Cancellation of forward purchase contractsSpot TT Selling Rate = Interbank Spot Selling Rate + Exchange Margin.Bills Selling RatePayment of import billsAdvance payment for importsSpot Bills Selling Rate = Interbank Spot Selling Rate + Exchange Margin.Travellers cheques (TC) selling rate (TT Selling + 0.5% towards handling charges)Foreign currency notes selling rate (TC selling + 0.5%)

Different Types of Buying RatesIntl.fin.39TC Buying RateBills Buying RatePurchase of export billsPurchase of travelers cheques and currency notesFC Buying Rate

Notional RatesIntl.fin.40An assumed rate which is used for notionally converting foreign currency deposits into Rupees is called Notional Rate.Banks are required to report rupee value of all foreign currency deposits and loans as on 31st March at the prevailing notional rate only.All banks are fixing the notional rate in line with the weekly average of daily rates for different currencies advised by FEDAI on every Friday.Nominal, Real and Effective exchange ratesIntl.fin.41The exchange rates quoted by the market are nominal exchange rates.Real exchange rate is price-adjusted nominal exchange rate.The relation between nominal and real exchange rate can be written as:er = eP/P* , where P and P* are domestic and foreign price indices.Suppose the WPI in India and USA rises from 100 in 1998 to 120 and 110 respectively in 2001and if the nominal exchange rate between the two currencies between the two dates remain at Rs40/$, the real exchange rate will move to: 40 x 120/110 = Rs43.64/$In a floating rate system the nominal rate moves automatically with the change in the price level, but it does not happen so in a fixed exchange system because of the administered rate. As a result there will be a gap between the two.

Effective Exchange Rate (EER)Intl.fin.42EER is the measure of the average value of a currency relative to two or more other currencies , normally shown in the form of an index.It is possible that Indian Rupee depreciates against US dollar but appreciates against Japanese Yen.It is also possible that Rupee depreciates vis--vis different currencies at different rates.Therefore it is essential to develop an index to measure how rupee fares, on an average, in the foreign exchange market.Such an index is called an effective exchange rate.More on EERIntl.fin.43Process of construction of an EER index:Step 1: Select the basket for the currency (only those currencies are included that matter significantly in the countrys trade)Step 2: Find out the weight of different currencies in the basket in the following way:Assuming that India has trade links with only USA and Japan Indian exports to them are $6000 and $4000 and Imports from them are $7000 and $3000 respectively, Then, the weights for these two countries will be:USA=(6000 + 7000) [(6000 + 7000) + (4000 + 3000)] = 0.65. Japan=(4000 + 3000) [(4000 + 3000) + (6000 + 7000)] = 0.35More on EERIntl.fin.44Step 3: Find out the exchange rate index as follows:Suppose in 1998, the exchange rate was Rs40/$ and Rs50/Yen100;In 2001the exchange rate changed to Rs44/$ and Rs60/Yen100;If 1998 is the base year the exchange rate index in 2001 will be 110 (100 + 10% increase) for US$ and 120 (100 + 20% increase) for Yen.EER 1998 = [(0.65 x 100)+ (0.35 x 100)] = 100EER 2001 = [(0.65 x 110) + (0.35 x 120) = 113.5This means that rupee depreciated on an average by 13.5% during the period 1998 2001.Intl.fin.45Problems in foreign exchangeProblems in foreign exchangeIntl.fin.461. If direct quote is `45/US$, show how this exchange rate can be presented under the indirect quote?Solution: US$1 / `45 = US$ 0.0222 / `2. If indirect quote is US$ 0.025 / `, how can this exchange rate be shown under direct quote?Solution: `1/US$0.025 = `40 / US $3. Consider the following bid ask prices: `40 40.50 / US$. Find the bidask spread in percentage terms.Solution: Spread = [(Ask price Bid price) Ask price] x 100= [(40.50 40.00) / 40.50] * 100 = 0.0123 or 1.23%

Problems in foreign exchangeIntl.fin.474. Find out the bid rate if ask rate is `40.50 / US$ and the bid-ask spread is 1.23%.Solution: [(40.50 x) 40.50 = 0.0123 or40.50 x = 40.50*0.0123 = 40.50 0.50 = x or x = `40.005. Find out the forward rate differential if spot rate of US $ is `45.00 and one month forward rate is `45.80.Solution: Forward premium (discount) = [(n-day forward rate spot rate) / spot rate] * (360 / n)(360/30)*{(45.80 45.00) / 45.00} * 100 = 21.33%

Problems in foreign exchangeIntl.fin.486. Find the one month forward rate of US dollar if spot rate is `45.00 and the forward premium is 12%.Solution: (360 / 30){(x 45.00) / 45.00} = 0.12Or (x 45) = 0.12 x 45 x 30 / 360Or x = 45 + 0.45 Or x = `45.457. Suppose a newspaper quotes `35.0035.20/US$ and at the same time it quotes Canadian$0.76 0.78/US$, find out the rates between Rupees and Canadian dollars. >>

Problems in foreign exchangeIntl.fin.49Solution: Buying Rate: `35.00/US$1 X US$1/C$0.78 = `44.87/C$Selling Rate: `35.20/US$1 X US$1/C$0.76 = `46.32/C$Or combining the two, ` / C$ rates are: `44.87 46.32 / C$8. Suppose one month forward US$/` rate is `34.50 34.80 and US$/C$ is C$0.79 0.83, find out the forward rate of C$/`.

Problems in foreign exchangeIntl.fin.50Solution: `34.80 / C$0.79 = `44.05/C$ 34.50/C$0.83 = `41.57Combining the two, we get `41.57 44.05 / C$9.Find `/ exchange rate if the two exchange rates are: `43.93 43.95 and 0.83 0.84 / US$.Solution:Bid rate: `43.93 / 0.84 = `52.30Ask rate: `43.95 / 0.83 = `52.95Combining the two we get: ``52.30 52.95 /

Problems in foreign exchangeIntl.fin.5110. The following are the middle rates reported by Reuters for Canadian dollars on a particular day. Fill up the blanks with suitable cross rates:

Solution:

Country / CurrencyUSDEURGBPJPYCanada1.2341Euro Area0.8247-Great Britain0.5488-Japan108.83-Country / CurrencyUSDEURGBPJPYCanada1.23411.49652.24850.0113Euro Area0.8247-1.50260.0076Great Britain0.54880.6655-0.005Japan108.83131.96198.28-Problems in foreign exchangeIntl.fin.5211. Consider the following data:Spot Pound = $1.9510/203-month forward: $1.9257/703-month forward premium is = 2.53/2.50 cents (Spot forward)Calculate the rate of dollar premium against sterling (Sterling discount against the dollar)Answer: For seller of sterling:0.0253/1.9510 x 4 x 100 = 5.19% p.a.b. For buyer of sterling:0.0250/1.9520 x 4 x 100 = 5.12% p.a.c. For mid-price quote:0.02515*/1.9515^ x 4 = 5.16% p.a. [ *(0.0253 + 0.0250)/2, ^(1.9520 + 1.9510)/2]

Problems in foreign exchangeIntl.fin.5312. A foreign exchange dealer quoted the following rates for Pounds Sterling on Friday, November 30, 1995.Spot$1.4710/81030-day forward65/4490-day forward145/123180-day forward290/222Determine the outright quotations for the Pound Sterling.Was Pound Sterling selling at a forward premium or a forward discount on that date? Calculate the forward premium (or discount) on the 90-day forward contract. Use ask rate to answer the question.How many US dollars would it cost you to buy 1,000,000 on November 30 1995?If you expect to receive 1,000,000 in 180 days from the quotation date, how many US dollars would you expect to realise by selling them forward?Assuming that the yield on a 6-month CD of major banks in the US is 9%, what should be the yield on a comparable CD in UK to insure interest parity between the two countries? SolutionIntl.fin.54Forward discount = (forward rate spot rate)/spot rate x 12/nx100 = (1.4687 1.4810)/1.4810 x 12/3 x 100 = - 3.32%1,000,000 x 1.4810 = $1,481,0001,000,000 x 1.4220 = $1,442,000Forward discount=(1.4588 1.4810)/1.4810 x 12/6 x100 = -3% Therefore the yield on a UK CD should be 12% (9% + 3%)

SpotI Month3 Months6 Months$1.4710 1.4810$1.4710 1.4810- 0.0065- 0.0044$1.4710 1.4810- 0.0145 0.0123$1.4710 1.4810- 0.0290- 0.0222Outright quotes$1.4645 1.4766$1.4765-1.4687$1.4420-1.4588Problems in foreign exchangeIntl.fin.5513. You have called a foreign exchange dealer and asked for Euro-dollar quotation for spot, 1-month, 3-month and 6-month. The trader responded with the following quotes: $0.2479/81, 3/5, 8/7 and 13/10 respectively.What does this mean?If you wish to buy spot Euros how much would you pay in dollars?If you wished to buy dollars how much would you pay in Euro?

Problems in foreign exchangeIntl.fin.56Answer:

We can buy spot euros at the banks spot selling rate of $0.2471 per Euro./$ Bid rate = $/ Ask rate. We can buy spot dollars at 1 0.2479 = 4.0339

1-month3-month6-monthSpot /$ rate0.2479 0.24810.2479 0.24810.2479 0.2481Forward rate0.0003 0.0005 0.0008 0.00070.0013 0.0017Outright quote0.2482 0.24860.2471 - 0.24740.2466 0.2464Intl.fin.57Exchange Rate ForecastingTo explain how firms can benefit from forecasting exchange rates;To describe the common techniques used for forecasting; andTo explain how forecasting performance can be evaluated.Why Firms Forecast Exchange Rates?Intl.fin.58Forecasting exchange rates is a very difficult task, and it is for this reason that many companies and investors simply hedge their currency risk.MNCs need exchange rate forecasts for their:hedging decisions,short-term financing decisions,short-term investment decisions,capital budgeting decisions,earnings assessments, andlong-term financing decisions.Why?Corporate Motives for ForecastingExchange RatesIntl.fin.59Decide whether to hedge foreign currency cash flowsDecide whether to invest in foreign projectsDecide whether foreign subsidiaries should remit earningsDecide whether to obtain financing in foreign currenciesIn short, to minimize risks and maximize returns

Forecasting TechniquesIntl.fin.60The numerous methods available for forecasting exchange rates can be categorized into four general groups:Technical,Fundamental,Market-based, andMixed.None of the above methods is superior to others. This speaks to the difficulty of generating a quality forecast.Technical ForecastingIntl.fin.61Technical forecasting involves the use of historical data to predict future values E.g. time series models.Speculators may find the models useful for predicting day-to-day movements.However, since the models typically focus on the near future and rarely provide point or range estimates, they are of limited use to MNCs.Fundamental ForecastingIntl.fin.62In general, fundamental forecasting is limited by:the uncertain timing of the impact of the factors,the need to forecast factors that have an immediate impact on exchange rates,the omission of factors that are not easily quantifiable, andchanges in the sensitivity of currency movements to each factor over time.Market-Based ForecastingIntl.fin.63Market-based forecasting uses market indicators to develop forecasts.The current spot/forward rates are often used, since speculators will ensure that the current rates reflect the market expectation of the future exchange rate.For long-term forecasting, the interest rates on risk-free instruments can be used under conditions of IRP.Mixed ForecastingIntl.fin.64Mixed forecasting refers to the use of a combination of forecasting techniques.The actual forecast is a weighted average of the various forecasts developed.Comparison of Forecasting MethodsIntl.fin.65The different forecasting methods can be evaluated:graphically by visually comparing the deviations from the perfect forecast line, orStatisticallyby computing the forecast errors for all periods.Purchasing Power Parity (PPP)Intl.fin.66(PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks.It is based on the theoretical Law of One Price, which states that identical goods in different countries should have identical prices.The exchange rate may however change to offset price changes due to inflation.Suppose prices in the U.S. are expected to increase by 4% over the next year while prices in Canada are expected to rise by only 2% and the inflation differential between the two countries is 2%, >>>>Purchasing Power Parity (PPP)Intl.fin.67It means prices in the U.S. are expected to rise faster relative to prices in Canada.In this situation, the purchasing power parity approach would forecast that the U.S. dollar would have to depreciate by approximately 2% to keep prices between both countries relatively equal.If the current exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP would forecast an exchange rate of US$91.8 Cents/1C$, meaning it would now take 91.8 cents U.S. to buy one Canadian dollar.

Big Mac IndexIntl.fin.68One of the most well-known applications of the PPP method is illustrated by the Big Mac Index, compiled and published by The Economist. This light-hearted index attempts to measure whether a currency is undervalued or overvalued based on the price of Big Macs in various countries. Since Big Macs are nearly universal in all the countries they are sold, a comparison of their prices serves as the basis for the index.Big Mac Index (BMI)Intl.fin.69The concept behind the BMI is that prices will eventually equalize over time. While this simple formula may serve as a theoretical guide to determine under and overvalued currencies, practicality says many limitations exist in the short and long term for measuring evaluations and achieving successful trades.

Relative Economic Strength ApproachIntl.fin.70The relative economic strength approach looks at the strength of economic growth in different countries in order to forecast the direction of exchange rates. The idea being that a strong economic environment and potentially high growth is more likely to attract investments from foreign investors.In order to purchase investments in the desired country, an investor would have to purchase the country's currency - creating increased demand that should cause the currency to appreciate. >>>>Relative Economic Strength ApproachIntl.fin.71Another factor that can draw investors to a certain country is interest rates. High interest rates will attract investors looking for the highest yield on their investments, causing demand for the currency to increase, which again would result in an appreciation of the currency. >>Relative Economic Strength ApproachIntl.fin.72Unlike the PPP approach, the relative economic strength approach doesn't forecast what the exchange rate should be. Rather, this approach gives the investor a general sense of whether a currency is going to appreciate or depreciate and an overall feel for the strength of the movement.This approach is typically used in combination with other forecasting methods to develop a more complete forecast.Econometric ModelsIntl.fin.73The factors used in econometric models are normally based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate.If interest rate differential between the U.S. and Canada (INT), the difference in GDP growth rates (GDP), and income growth rate (IGR) differences between the two countries are found to be the most important factors in forecasting the exchange rates, the econometric model could be: USD/CAD (1-year) = z + a(INT) + b(GDP) + c(IGR) >> Econometric ModelsIntl.fin.74The coefficients a, b and c in the formula will determine how much a certain factor affects the exchange rate and direction of the effect (whether it is positive or negative). This method is probably the most complex and time-consuming approach of all. However, once the model is built, new data can be easily acquired and plugged into the model to generate quick forecasts. Time Series ModelIntl.fin.75One of the more popular time series approaches is called the autoregressive moving average (ARMA) process.The rationale for using this method is based on the idea that past behavior and price patterns can be used to predict future price behavior and patterns.The data you need to use this approach is simply a time series of data that can then be entered into a computer program to estimate the parameters and essentially create a model for you.Bottom Line Approach (BLA)Intl.fin.76Since bottom line is most valuable for a business a finance manager would see which parameter affects the bottom line most.The result from this method is limited by focusing only on one parameter i.e., profit.A combination of different factors will lead to better forecasting of exchange rates.Intl.fin.77Managing Foreign Exchange ReservesMotives for holding foreign exchange reservesIntl.fin.78Can be classified under:TransactionSpeculative and PrecautionaryTransaction motive arise because of international trade handled by banks.Speculative motive arise because of individuals or corporates engaging themselves in speculation for profit.Central bank reserves however arise as a precaution against unpredictable flows. >>

Objectives of maintaining reservesIntl.fin.79Maintaining confidence in monetary and exchange rate policies.Enhancing capacity to intervene in the foreign exchange markets.Limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crises including national disasters or emergencies.Providing confidence to the markets and Adding to the comfort of the market participants by demonstrating the backing of domestic currency by external assets.Implications of reserve accumulationIntl.fin.80Portfolio inflows are temporaryWhereas current account surpluses tend to endure and have positive effect on the exchange rate.Persistent current account surpluses are identified with appreciation of long-term equilibrium exchange rate.Resisting current account surpluses may cause larger capital flows with potential appreciation pressure.In many emerging market economies there is a wide gap between forex reserves and the currency in circulation.The central bank can finance this gap by issuing domestic monetary liabilities.If the increased reserves put downward pressure on short- term interest rates, bank credit would tend to expand and inflationary pressure will mount.Central banks would try to control the inflationary pressure by selling govt. security (Sterilized intervention)Build up of reserves may sometimes be inimical for economic growth.

Fiscal cost of interventionIntl.fin.81Large currency appreciation against anchor currency(ies) may result in considerable valuation losses.It is however debatable how far valuation losses might matter for the sustainability of intervention policy.Intervention to prevent a rise in exchange rate can accentuate macroeconomic and financial imbalances.Increased bank lending resulting from partial or ineffective sterilization could finance excessive investment in certain sectors like property markets or equity market with adverse effects.QuestionsIntl.fin.82Discuss the motives for holding foreign exchange reserves. Is foreign exchange reserves buildup inimical to growth?What are the challenges posed by the surge in capital flows to the conduct of monetary and exchange rate policy?Critically examine the renewed interest in recent times in foreign exchange reserves in the context of increasing globalization, acceleration of capital flows and integration of financial markets.Explain why it would be virtually impossible to set an exchange rate between Indian Rupee and U.S. dollar and to maintain a fixed rate of exchange.>> QuestionsIntl.fin.83Assume that the Federal Reserve believes that dollar should be weakened against Chinese Yuan. Explain how the Fed can use direct and indirect intervention to weaken the dollar value with respect to yuan. Assume that future inflation in the U.S. is expected to be low regardless of Feds actions.Explain briefly why the Federal Reserve may attempt to weaken the dollar?How can a central bank use indirect intervention to change the value of a currency?What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal?

>> QuestionsIntl.fin.84How can a central bank use direct intervention to change the value of a currency? Explain why a central bank may desire to smooth exchange rate movements of its currency?Compare and contrast the fixed, floating and managed float exchange rate systems. What are some advantages and disadvantages of a freely floating exchange rate system versus a fixed exchange rate system?Types of TransactionsIntl.fin.85Transactions can be classified based on the time between entering into a transaction and its settlement.Ready or Cash transaction: Settled the same day or value today transaction.TOM transaction: Settled the next daySpot transaction: Settled 2 business days from the date of the contract.Forward transaction: Parties to the transaction agree to buy or sell a currency or commodity at a predetermined future date at a particular price decided on the date of transaction.Intl.fin.86Value DatesIntl.fin.87The settlement date of a forex transaction is called its value date.A Spot transaction is settled 2nd business day from the date of transaction.Neither day should be a holiday either in any of the settlement locations or in the dealing location of the market making bank.The settlement date for a forward contract depends on:The settlement date for the spot transaction entered on the same date as the forward contract andthe maturity of the forward contract in months.Value DatesIntl.fin.88For example,If a 3 months (or 90 days) is entered into on July 20, the spot value date is July 23 (assuming that July 21 is a holiday).The settlement date for the forward contract will be Oct 23 (by adding 3 calendar months).If it is a holiday that day, then the settlement is shifted to the next day.Suppose the spot settlement date is the last day of the month, then the settlement date of the forward contract will be the last day of the relevant month irrespective of the number of days in the two months.

Value DatesIntl.fin.89Example: If one month forward contract is entered to on Jan 29, then the spot settlement will be Jan 31 and forward settlement will be on Feb 28 or 29.If the forward settlement date of a contract is say Oct 31, and if it happens to be a holiday, then the settlement cannot be done on Nov 1. In such a case the settlement will be shifted to the previous day i.e., Oct 30.Forward Quotes Premium & DiscountIntl.fin.90A currency is said to be at premium it its forward rate is higher than its current spot rate.Conversely, a currency is at a discount, if the forward rate is lower than the current spot rate.Example 1: INR/USD : 45.42/44 and 3m INR/USD : 46.62/70USD/GBP : 1.6721/26 and 3m USD/GBP : 1.6481/92The spread between the bid and the ask rates increases as one goes into the future.Forward Quotes Premium & DiscountIntl.fin.91The difference between the spot rates and forward rates can be expressed in terms of swap points.In the rupee-dollar example, the swap points are 120/126 (46.62 45.42 and 46.70 45.44).In the dollar-pound example, the 3-month swap points are 240/234 (1.6721-1.6449 and 1.6726-1.6492).Rules:When swap points are low/high, currency B is at a premium and A is at discount:Premium: Add swap points to spot rate to get the outright forward rate orDeduct swap points from the outright forward rate to get the spot rate.

Forward Quotes Premium & DiscountIntl.fin.92Forward rates can be expressed in two ways. Commercial customers are usually quoted the actual price (outright rate). In the interbank market, however, dealers quote forward rate only as a premium or discount on the spot rate.Example: Spot sale JPN/USD Feb.6 1990: $0.006879 (A)90 days forward Yen : $0.006902 (B)Swap rate for 90 days Yen: 23 points (B A)Alternatively, the premium or discount can be expressed as annualized percentage as follows:

Forward Quotes Premium & DiscountIntl.fin.93Forward premium/discount = (Fwd. Rate Spot Rate)/Spot Rate x 12 (or 360)/forward months (or number of days)Thus, the annualized premium in the above example is: (0.006902 0.006879)/0.006879 x 12/3 = 0.0134 or 1.34%Out of two margins given for a month, the first one relates to the buying rate and the second rate to the selling rateIf the forward margins for a month are in ascending order it indicates premium and if it is in the descending order it is at a discount.

Forward Quotes Premium & DiscountIntl.fin.94If the forward rate is in premium the forward rate is found out by adding the margin to the spot rate and deduct it for discount.Example: The following quotes are received for spot, one month, 3 months and 6 months SFR and GBP:

>>Spot1 month3 months6 months/$2.00153019-1726-2242-35SFr/$0.6963684-69-1425-38Intl.fin.95The outright rates are:

Swiss Francs are selling at a premium against the dollar and Pound is selling at a discount.The wider percentage of the spread between the bid and the offer of SFr compared to /$ is due to broader market in Pounds.The widening spreads by maturity for both the currencies is caused by the greater uncertainty surrounding the future exchange rates.Pound SterlingSwiss FrancsMaturityBidAskSpread (%)BidAskSpread (%)Spot$2.0015$2.00300.075$0.6963$0.69690.086%1 Month1.99962.00130.0950.69720.69820.1433 Months1.99892.00080.0950.69720.69820.1436 Months1.99731.99950.1100.69880.70060.257Forward Quotes Premium & DiscountIntl.fin.96When the swap points are high/low, currency B is at a discount and currency A is at premium.Deduct the swap points from the spot rate to arrive at the outright forward price or Add them to the outright forward rates to get the spot rate.The bid side swap points are to be added to or subtracted from the spot bid rate (depending on the currency is at a premium or discount) to arrive at the forward bid rate. The ask-side swap points are added to or subtracted from the spot ask rate to get the forward ask rate.

Forward Quotes Premium & DiscountIntl.fin.97Rolling over a forward contract: When the maturity of a forward contract is extended by cancelling the existing contract and entering into a new contract for the extended duration, it is called rolling over a forward contract.In India rolling over forward contracts for over one year is not permitted.A party with an exposure longer than one year can initially hedge for the maximum maturity available and roll over at maturity for further periods.Broken date Forward ContractsIntl.fin.98A broken date forward contract is a contract which is not a whole month or for which a quote is not readily available.The rate for a broken period contract is calculated by interpolating between the available quotes for the preceding and the succeeding maturities. Example: What will be the forward rate for 1month and 10 days (broken date contract) if$/`Spot :40.00 40.101month fwd.:40.50 40.703month fwd.:40.80 41.10>>

Broken date Forward ContractsIntl.fin.99Solution:

For 1month and 10 days, swap points are:

Buying Rate: 50 + (80-50) x 10/60 = 55 Selling Rate: 70 + (11070) x 10/60=77

The forward rate for 1 month and 10 days will therefore be `40.55 40.77/$

Broken date Forward ContractsIntl.fin.100A customer wants a quote from the bank for purchasing dollars from the bank on Sept. 29. Dollar is at a premium and the swap points are 29/35 between Aug and Oct maturity. On the ask side, the premium is 35 points which is spread over 61(30+31) days. The required maturity is 29 days away from Aug maturity. Hence the premium charged by the bank over and above the Aug rate will be 35x29/61=17 points. The rate charged will be 5.5885 + 0.0017 = Sfr5.5902/$ Similarly, the buy and sell rates can be calculated for any intervening rates between two given maturities.>>Option ForwardsIntl.fin.101Customer of a bank has the option to ask for settlement of the contract anytime during a particular period called the option period.Giving quotes for this kind of contract is not as straight forward as a quote for an outright forward contract because while the exchange rate is fixed the timing of the exchange is not fixed.If the exchange takes place at an unfavorable time the bank would incur a loss. To avoid a loss, banks adopt the following rules:Option ForwardsIntl.fin.102When the bank is buying a currency:Will add the minimum premium possible (when it is at a premium) to the spot rate andWill deduct the maximum discount from the spot rate (when it is at a discount).The bank quotes a rate applicable to the beginning of the option period when the currency is at a premium and that applicable to the end of the option period when it is at a discount.Option ForwardsIntl.fin.103When the bank is selling a currency:Will add the maximum premium possible (when it is at a premium) to the spot rate Will deduct the minimum discount possible (when it is at a discount) from the spot rate.This would result in the bank quoting the rate applicable to the end of the option period when the currency is at a premium and to the beginning of the option period when it is at a discount.Example1: Euro/Sfr rate: Spot: 1.2245/49, 3m fwd.: 10/15, 4m fwd.: 15/25, Option 4 months

Option ForwardsIntl.fin.104Sfr is at a premiumIf the bank is selling Sfr, it will load the maximum premium to the spot rate (on the implicit assumption that the customer will demand delivery when the currency is most expensive). So it will quote a rate Euro 1.2274/Sfr (1.2249 + 0.0025)If the contract is to buy SFr, the bank would assume that the customer would choose to exercise his option when SFr is at its cheapest i.e., at the beginning of the fourth month. So it will load a minimum premium to the spot rate and quote Euro1.2255/SFr (1.2245 + 0.0010)Option ForwardsIntl.fin.105Example 2. Currency is at a premium at the beginning of the option period and at a discount during the option period.SFr/Aus$ : 3.4925/301month : 3.4935/452months : 3.4930/42Customer Option to buy Aus$ any time during the second month, the bank would quote the rate of SFr3.4945/Aus$ and if the option were to sell Aus$, the quotation would be SFr3.4930/Aus$.i. Conditions that will result in international arbitrage.ii. The concept of interest rate parity and how it prevents arbitrage opportunitiesIntl.fin.106CURRENCY ARBITRAGE & INTEREST RATE PARITYInternational ArbitrageIntl.fin.107Definition: Capitalizing on a discrepancy in the quoted prices by making a risk-less profit.Three forms:Locational arbitrageTriangular arbitrageCovered interest arbitrage1. Locational arbitrage:Example: Two coin shops A & B are in the business of buying and selling coins. Shop A is prepared to sell a particular coin at Rs.120 and shop B is prepared to buy the same coin for Rs.130.A coin collector can buy the coin at Rs.120 from shop A and sell the same to shop B for Rs.130 and thus earn a risk-free profit of Rs.10 in the transaction.Prices in the shops may vary because of their different locations. Demand conditions also vary if the two shops are not aware of each others prices. These factors give rise for arbitrage opportunities. Gains from locational arbitrage would depend on the amount of money that the arbitrager uses and the size of discrepancy.Triangular Currency ArbitrageIntl.fin.108Exchange dealers are continually alert to the possibility of taking advantage through triangular currency arbitrage.These transactions involve buying a currency in one market and simultaneously selling it in another market, to take advantage of exchange inconsistencies in different money centers.Suppose the Pound Sterling is bid at $1.5422 in New York and Euro is offered at $0.9251 in Frankfurt; At the same time London banks are offering Pound Sterling at 1.6650. Triangular Currency ArbitrageIntl.fin.109New York quote: /$ Bid - $1.5422/poundFrankfurt quote: /$ Ask - $0.9251/EuroLondon quote: / Bid - 1.6650/poundIf $1.5422 = 1 and If 1 = 1.6650 How many Euros = 1$i.e. (1.5422/1) x (1/1.6650) = 0.9262 or 1 = $1.0796Since euro is available in Frankfurt at a cheaper rate of $0.9251 (as against a cross rate of $1.0796) there is an arbitrage opportunity.Currency ArbitrageIntl.fin.110Let us assume that the trader begins in New York with $1 million.Acquire 1,080,964.22 (1,000,000/0.9251) in Frankfurt,Sell these euros for 649,277.76 (1,080,964.22/1.6650) in London and Resell the Pounds in New York for $1,001,239.05 (649,227.76 x 1.5422), making a profit of $1,239.05.This sequence of transactions is known as triangular currency arbitrage. >>Currency ArbitrageIntl.fin.111In the preceding example, the arbitrage transactions would tend the euro to appreciate vis--vis the dollar in Frankfurt and to depreciate against Pound Sterling in London.At the same time, sterling would tend to fall in New York against the dollar.Acting simultaneously, these currency changes will quickly eliminate profits from this set of transactions, thereby enforcing the no-arbitrage condition.Otherwise, a money machine would exist, opening the prospects of unlimited risk-free profits.Currency Arbitrage - ExerciseIntl.fin.112Your forex trader has given the following cross currency quotes. The quotes are expressed as one unit of currency on the left side per unit of currency shown at the top row.

Do any triangular arbitrage opportunities exist among these currencies? (Assume that any deviations from the theoretical cross rates of 5 points or less are due to transaction costs).How much profit could be made from a $5 million transaction associated with each arbitrage opportunity?

CurrencySFrDKrPound Stg.Japanese YenUS $SFrDKrGBPJPN-3.3818-250.41227-3578.381-4960.29570-76-0.12381-9023.178-2512.4256-678.2031-41-190.121-3900.1276-780.4315-190.00526-29-1.5780-865.3021-330.6502-10123.569-707QuestionsIntl.fin.113Discuss the forex market structure in India.What risks confront the forex dealers and how do they cope with those risks?Suppose a currency increases in volatility, what is likely to happen to its bid ask spread? Why?Who are the principal users of the forward market?How does a company pay for the foreign exchange services of a commercial bank?The $/ exchange rate is 1=$0.95 and /SFr rate is SFr1 = 0.71, what is the SFr/$ exchange rate? >>QuestionsIntl.fin.114An investor wishes to buy euros spot @ $0.9080 and sell euros forward for 180 days @ 0.9146, what is the swap rate on euros and what is the forward premium or discount on 180 days euros?Suppose Credit Suisse quotes spot and 90 days forward rates on the Swiss Franc of $0.7957 60, 8 13,What are the outright 90 day forward rates that Credit Suisse is quoting?What is the forward discount or premium associated with buying 90-day Swiss Francs?Compute the percentage bid-ask spreads on spot and forward Swiss Francs.QuestionsIntl.fin.115As a foreign exchange dealer at Sumitomo Bank you have a customer who would like spot and 30-day forward Yen quotes on Australian Dollars. Current market rates are:Spot30-day101.37-85/US$11513A$1.2924 44/US$1 2026What bid and ask Yen cross rates would you quote on spot Australian dollars?What outright Yen cross rates would you quote on 30-day forward Australian dollars?What is the forward premium or discount on buying 30-day Australian dollars against yen delivery?OriginInstrumentsPlayersDecision Intl.fin.116Part II Unit 6 - International Financial Markets & InstrumentsCausesGovernments intervention for controlling their exchange ratesConsequences of intervention effortsIntl.fin.117THE ASIAN CRISIS OF THE 90sCrisis in ThailandIntl.fin.118Worlds fastest growing economy till 1997Grew faster than any other country over 1985 94Thai consumers spent freely and saved lessResult upward pressure on local interest rates and prices of real estate and productsThai Baht was linked to U.S. dollar till July 1995 and therefore attracted foreign investments because of high interest rates.More funds available to Thai banks were lent to the real estate sector based on the previous success of the developers>>Crisis in Thailand Intl.fin.119Thailand was a house of cards waiting to collapseLarge inflow of funds led to lower interest ratesThai government borrowed heavily to improve countrys infrastructure at high rates of interest.In 1997 foreign investors recognized Thailands potential weakness and started withdrawing their investmentsBaht started depreciating against all major currenciesOn July 2 1997 baht was delinked from dollar and Thailands central bank started intervening in the market

>> Crisis in ThailandIntl.fin.120The market intervention didnt helpIn July 1997 baht plummetedThe defaulted bank loans were over $30 billionOn August 5 1997 IMF and other countries agreed to provide a $16 billion rescue packageIn return Thailand agreed to reduce its budget deficit, prevent inflation from rising above 9% and increase taxesMany banks folded upThe crisis spread throughout Southeast AsiaEffects On Other CurrenciesIntl.fin.121In July August 1997 the malaise spread to Malaysia, Singapore, Philippines, Taiwan and Indonesia Their currency values depreciated fastEfforts by central banks to intervene and stabilize their currencies failedThe Southeast Asian Countries gave up their fight to contain depreciation of their currencies Many restrictions on forwards and futures market speculation did not bear fruitInvestors had no confidence in the markets and that resulted in flight of capitalThe currencies were allowed to float>> Effects On Other CurrenciesIntl.fin.122Due to integration of Southeast Asian economies the excessive cross-border lending by local banks turned badFinally, what began as the Thailand crisis became the Asian CrisisThe Asian Crisis had impact on many other countries across the globe - Hong Kong, Russia, South Korea, Japan, China, India, Latin American countries as well as Europe and United StatesLessons learnt: The Asian Crisis demonstrated the degree to which currencies could depreciate in response to lack of confidence by investors and the inability of central banks to stabilize their local currencies in such a crisis. How Exchange Rates Changed Intl.fin.123

-41%S.Korea-41%Taiwan-20%-37%-37%-84%Singapore- 15%- 0%Hong Kong 0%- 38%Ruble depreciated - IMF package of $22.6 billion Chaebols collapsed,Currency depreciatedIMF rescue package of $55 billionHow Interest Rates Changed between June 1997(.) and June 1998 Intl.fin.124

S.Korea(14)/17%Taiwan(5)/7%Philippines(11)/14%(7)/11%%Indonesia(16)/47%%Singapore(3)/7%(7)/8%Hong Kong (6)/10%(7)/12%(11)/24%Sources of International LiquidityIntl.fin.125Monetary gold held by the authorities as a financial assetSDRs (Value of SDR determined daily by the IMF on the basis of a basket of currencies, with each currency assigned a weight)Reserve position in the fund (difference between each members quota plus other claims on the fund less the Funds holdings of that members currency).Foreign exchange comprising monetary authorities claim on non-residents in the form of bank deposits, Treasury Bills, Short and long-term government securities, without regard as to whether the claim is denominated in the currency of the debtors or creditors.International Financial Markets & InstrumentsIntl.fin.126Origin of International Financial MarketsIntl.fin.127Demand for high quality dollar denominated bonds who wished to hold their assets outside their own countries.Concerns of these investors:Avoiding registration of ownership of investments and taxes in their home countries andProtecting themselves against falling values of domestic currencies.Euro bonds were designed to address these concerns.Major changes have taken place in the international markets since 1970s:Removal of exchange controls in countries like U.K., France and JapanApplication of technology to financial services etc.International Financial Markets & InstrumentsIntl.fin.128The integration of financial markets across countries has opened up the international markets.The financial intermediaries have developed a large variety of financial instruments to suit the needs of international investors for both equity and debt investments.Instruments in the bond market:Foreign Bonds: Yankee Bonds, Samurai Bonds, Bulldog Bonds, Euro Bonds: Euro dollar, Euro Yen and Euro Pound BondsInstruments in the Equity Market: ADR / GDR

International Financial Markets & InstrumentsIntl.fin.129Foreign Bonds: Bonds floated in domestic market denominated in domestic currency by non-resident entities.Euro Bonds: Bonds issued and sold outside the home country of the currency.Syndicated Euro Credits are available in euro markets by way of Club loans and Syndicated loans. Club loans are private arrangement between lending banks and a borrower.Syndicated Euro Credit is a full-fledged public arrangement for organizing a loan transaction.Wide network of participation by banksLoan maturity of 3 to 7 years.History of International Financial Markets & InstrumentsIntl.fin.130Until the end of 1970s there were restrictions on cross-border equity investments.Investors too preferred domestic equity markets because of perceived risks in foreign currency exposures.Early 80s witnessed liberation of many domestic economies and globalization. Issuers from developing countries were able to access international equity markets through issue of Depository Receipts GDRs, ADRs and IDRsAmerican Depository Receipts (ADRs)Intl.fin.131In April 1990 SEC allowed non-US companies to rise capital in the US market without having to register the securities with SEC or without having to change the financial statements according to US GAAP requirements.QIBs are permitted to invest in ADRsIt represents non-US companys publicly traded equity.Well-known intermediaries: Goldmann Sachs & Co., Merrill Lynch Intl. Ltd., J P Morgan etc.International Financial Markets & InstrumentsIntl.fin.132A Depository Receipt is a negotiable certificate issued by a depository bank which represents the beneficial interest in shares issued by the company.These shares are deposited with a local custodian appointed by the depository that issues the receipts against the deposit of shares.In countries with capital account convertibility, DRs and domestic equity shares are mutually convertible.Until the DRs are converted into equity shares, the holder will not have any voting rights and also there is no foreign exchange risk for the company.The company will be listed at the prescribed stock exchanges providing liquidity for the instrument.International Financial Markets & InstrumentsIntl.fin.133Borrowers / Issuers: Mostly, corporates, banks, FIs, govt. and quasi-govt. bodies who need forex funds.Corporates borrow foreign currencies for expansion of their operations abroad or because of dull and saturated domestic markets.Govts. Borrow for adjusting their BOP mismatches, for keeping sufficient inventory of currency reserves.FIs like IMF, World Bank, ADB etc. borrow long term funds for financing diversified financing. International Financial Markets & InstrumentsIntl.fin.134Lenders / Investors: Euro loans: The lenders are mostly international banks.For GDRs, the investors are mostly institutions and high net worth individuals.For ADRs, it is the institutional investors or HNIs through the Qualified Institutional Buyers.Intermediaries: Lead Managers, Co-lead Managers, Underwriters, Lawyers and Auditors, Stock Exchanges, Depository Banks and Custodians.Functions of IntermediariesIntl.fin.135Lead and Co-lead Managers: Undertaking due diligencePreparing the offer memorandumMarketing the issues, including the road showsSometimes there could be more than one lead manager to ensure successful launch.One of the lead manager will run the books (sending out invitations, allotting Bonds / DRs etc.) for the issue.Underwriters: Taking on the risk of under subscription and thus giving support to the issue.Functions of IntermediariesIntl.fin.136Agents & Trustees: The issuer of the Bonds should appoint paying agents in different financial centers for payment of interest and principal due to investors. These paying agents will be banks.Lawyers and auditors:Lawyers will draw up the legal documentation and The auditors will provide comfort letters to the lead managers on the financial health of the issuer.Listing Agents and Stock Exchanges: Listing Agents facilitate documentation and listing of the issue andStock Exchanges will review the application and provide comments on the issue prior to accepting the securities for listing.Functions of IntermediariesIntl.fin.137Depository Bank: Responsible for issuing DRs, facilitating exchange of DRs into underlying shares when presented for redemption.Custodian: The custodian holds the shares underlying the shares on behalf of the depository.Printers: Responsible for printing and delivery of the offer memorandum as well as the DRs / Bond certificates.

The Decision CriteriaIntl.fin.138Competitive costCurrency requirementPricing:Pricing of an international issue should consider the interest rates and market value of the stock in the domestic market, the exchange rate movements, hedging the risk, level of premium etc.Depth of the market in which the issue is being offered.International positioning: Long term perspective of the company.Regulatory aspects: Various approvals required from different authorities.Disclosure requirements.Investment climate International liquidity, country risk.Indicative Time Schedule for GDR/ADR IssueIntl.fin.139StageAdmn. Work involvedTime in weeksa. Initial decision

Meeting between issuer and lead manager planning the issue.Issue structure finalized in conformity with the domestic regulatory environment.Draft documentationDue diligence processBoard meeting and share holders approvalFixing various parties to the issue. 1 and 2Indicative Time Schedule for GDR/ADR IssueIntl.fin.140StageAdmin. Work involvedTime in weeksb. Approvals and drafts finalization

c. Pre-launch formalities

d. Launch of issuesOfficial approvals steps initiatedComfort and consent letters finalized with auditorsLegal opinion formats drafted and finalizedApprovals obtained

Road show preparations and presentationsPathfinder prospectus finalizedListing preparations in final stages

Road shows organizedDocumentation circulated among syndicateInvestors contracted3 and 4

7 and 8Indicative Time Schedule for GDR/ADR IssueIntl.fin.141StageAdmn. Work involvedTime in weekse. Pricing and closing

GDR Issue: Fees & ExpensesFinal terms fixedAllocation of securities to investorsFinal prospectus to be kept readyFinal listing documents lodged with stock exchangeSubscription agreement signedDelivery of global certificateClosing documents signedPayments to issuerTombstone advertisement

Underwriting fee (%) : 0.60 1.00Management fee (%) : 0.60 1.00Selling commission (%) :1.80 3.00 Total fees 3.00 5.00 ========= Debt markets and instrumentsIntl.fin.142INTERNATIONAL DEBT MARKETSInternational Debt Markets & InstrumentsIntl.fin.143International Debt Market (IDM)Intl.fin.144The International Debt Market offers a borrower:A variety of different maturities,Repayment structures and Currencies of denomination.Three original factors in the evolution of the Eurobond market are still of importance:Absence of regulatory interference, Less stringent disclosure practices and Favourable tax treatment.Debt Instruments Euro Bonds (EBs)Intl.fin.145EBs are bonds that are sold in countries other than the country of the currency denominating the bonds.Issuing EBs became easier with no exchange controls and no govt. restrictions on transfer of funds in international markets.All EBs, through their features, can appeal to any class of issuers or investors. The unique characteristics that make them flexible are:No withholding taxes of any kind on interest paymentsBonds are in bearer form with interest coupons attachedListed on one or more stock exchanges (Usually on the Luxembourg Stock Exchange) but issues are traded on OTC market. Debt Instruments Euro BondsIntl.fin.146Fixed Rate / Straight Debt Bonds: Fixed interest bearing securities redeemable at face value.These are unsecured bondsBonds issued in the Euro-market are called Euro Bonds.Interest on the bonds are benchmarked to LIBORRedemption of Straights is done by bullet paymentNo tax deduction at source on the income from these bonds.Can also be issued as Zero Coupon Bonds

Debt Instruments Floating Rate Notes (FRNs)Intl.fin.147FRNs are Bonds with maturity of 5 7 years.Conventionally the Bonds are called the Notes and the margin will be above 6 months LIBOR for euro dollar deposits.Procedure for issue: The mandated bank forms a syndicate groupThe lead bank is responsible for credit appraisal, preparing a prospectus, documentation etc.Pricing is generally done by the book-building routeBought-out deal: Pre-priced issue is presented to the market Debt Instruments Euro BondsIntl.fin.148Listing:Euro Bonds are generally listed in London / Luxembourg stock exchanges.Bond issue procedures generally end with tombstone advertisements.Clearing arrangements: Euro Bonds are generally handed over to either Euroclear system (Brussels) or Cedel (Luxembourg).Euroclear and Cedel follow two distinct practices viz. fungible (Details regarding the identity of the owners and location of individual securities are not provided) and non-fungible accounts for concluding transactions between parties.Euroclear handles trades on fungible basis, whereas Cedel permits both procedures.

Debt Instruments Foreign BondsIntl.fin.149Bonds issued by foreign entities for raising medium to long term financing.Yankee Bonds:US Dollar denominated bond issues by foreign borrowers in the U.S bond markets.SEC regulates these issues and requires:Complete disclosure documents in more detail than what is available in the prospectus.To adopt U.S accounting practices andU.S credit rating agencies will have to provide rating for these bonds.Debt Instruments Foreign BondsIntl.fin.150Samurai Bonds: Bonds issued by non-Japanese borrowers in the domestic Japanese markets.Maturities: 3 20 yearsAs this is issued for public, arrangements for underwriting and selling have to be made and involves large documentation.However, documentation and formalities are friendly and hospital.Expensive in terms of issuing costDebt Instruments Foreign BondsIntl.fin.151Bulldog Bonds: Sterling denominated foreign bonds raised in UK domestic market.Maturities: 5 to 25 years.Generally redeemed on bullet basisWill have to be listed on London Stock Exchange.Euro Notes:Euro Notes (EN) are different from syndicated bank credits and euro bonds in its structure and maturity periods.Pricing could be sub-LIBOR or a few basis points above LIBOR.Documentation formalities are minimal.Euro Notes possess flexibility and can be tailored to suit the specific requirements of different borrowers.

Debt Instruments Euro NotesIntl.fin.152Euro Commercial Paper:Short-term unsecured promissory notes that repay a fixed amount on a certain future date.Maturity: 3 months, 6 months and 1 year paper.Even though the maturities are small, the overall funding programme could be for medium to long term.Procedure: Select a dealer and an issuing and paying agent.No mandatory rating. However, borrowers seek rating for successful launching of CP programmes.Documentation: Simple An Information Memorandum, Dealer Agreement, Issuing and Paying Agency Agreement and the actual notes.No separate disclosure requirements.A variation of the ECP is the Asset-backed CP that is backed by financial assets such as mortgages or credit card receivables.Debt Instruments Euro NotesIntl.fin.153Note Issuance Facilities (NIFs): A medium-term legally binding commitment under which a borrower can issue short-term paper of up to one year.Currency: Mostly US $Margin: A spread over LIBOR or built into the NIF pricing itself.Underwriting: Yes, by banks. Could be a revolving underwriting facilityNIFs can be reissued periodically.Investors: Mostly commercial banks, insurance companies, provident funds etc.Medium-term Notes (MTNs):Sequentially issued fixed interest securitiesMaturity: Over one year, up to the desired level of maturity

Euro Credit SyndicationIntl.fin.154Syndicated Euro Credits are in existence since the late 60s.Period: 7 to 15 yearsRoI: Floating rate linked to 3 or 6 months LIBOR.Currency: Denominated generally in US$, JPY, Euro, SFR.Amortization: Half-yearly installments with 2 3 years grace period.Simplest way of raising foreign currency resources.Documentation: Information Memorandum and loan agreement from the lead manager.Underwriting: Yes, by a management group assembled by the lead bank, including itself.Comparative Analysis of Global Financial Markets.xlsx plus Comparative Analysis of Financial Instruments.xlsx

Glossary of Market TermsIntl.fin.155American Depository Receipt (ADR): A certificate of ownership issued by a U.S. bank as a convenience to investors in lieu of the underlying foreign corporate shares it holds in custody.Arbitrage: Locking in a riskless profit from price disequilibria or distortions in different marketsArms length price: Price at which a willing buyer and willing unrelated seller would freely agree to transact Basis Point: The last decimal in the quotation of an exchange rate and 0.01% when referring to interest rates or yields.Bid Rate: The price at which a market maker is prepared to buy a currency or borrow money.CHIPS (Clearing House Inter-bank Payment System): Inter-bank payment and settlement system in New York. Records all payments and receipts and gives the net position at the end of the day. The system has enabled member banks to substitute electronic payment in place of paper cheques.CHAPS (Clearing House Automated Payment System): Exists in London. Counterpart of CHIPS.CHATS (Clearing House Automated Transfer System): Operational in Hong Kong for automated inter-bank transactions.Glossary of Market TermsIntl.fin.156Eurocurrency: A deposit or a borrowing domiciled outside the home country of the currency.EDI (Electronic Date Interchange): Transfer of data between computers (Airline Reservation, SWIFT, Customs Clearance of exports / imports)Fixed date forwards: Standard maturity (or value) dates for contracts like one, three or six months.Forward Margin: Difference between spot and forward rates, also known as swap price or points.Fed Wire: A computer network that connects about 7000 banks around USA to the Federal Reserve Bank. Follows gross settlement system, unlike CHIPS. Used for payment and settlement of large value transactions.

Glossary of Market TermsIntl.fin.157Forward Rate: Price of a currency for value date beyond the spot date. If more expensive, the currency is at a premium, if cheaper, then at a discount.Market Making: Quoting rates for both buying and selling a currency.Middle Rate: Mean of Bid and Offered rates.Nostro Account: A banks account with a correspondent bank / branch abroad, in the home currency of that country.

Glossary of Market TermsIntl.fin.158Offer Rate: The price at which a market maker is prepared to sell (a currency) or lend (money).Option Forwards: One of the two parties to a forward contract has the option of choosing the delivery date within a specified period.Position: The net commitment in a currency. It is square if sales equal purchases, long, if purchases are more than sales and short if sales exceed purchases.Rollover: Similar to badla in the share market. Extending or postponing delivery.Reuter System: A computer based data bank that provides real-time data on forex rates of various markets all over the world.Spread: Price difference between bid and offer rates.Glossary of Market TermsIntl.fin.159Swap: Simultaneous sale and purchase of identical amounts of one currency against another, for different maturities. A swap could be spot (purchase or sale) against forward (sale or purchase), or forward against forward.Swap price or points: The difference in prices of the two (or points) legs of a swap.Straight Through Processing (STP): complete end-to-end automated processing of transactions from inception to settlement without any manual intervention.Telerate: It is another company like Reuters that provides information on global financial markets.Value Date: The date of exchange of currencies. Also referred to as delivery date or maturity date.Vostro Account: A local currency account of a foreign bank / branch.Intl.fin.160External Commercial Borrowings (ECBs)Meaning of ECBsECB refers to commercial loans in the form of:Bank loans, Buyers credit,Suppliers credit, Securitized instruments (e.g. floating rate notes and fixed rate bonds, non-convertible, optionally convertible or partially convertible preference shares)Availed of from non-resident lenders with a minimum average maturity of 3 years.Routes to ECBsECB can be accessed under two routes:(i) Automatic Route and(ii) Approval RouteAutomatic Route (AR):What is Automatic Route?Who can borrow under the AR?(a) Corporates, including those in the hotel, hospital, software sectors (registered under the Companies Act, 1956) and Infrastructure Finance Companies (IFCs) except financial intermediaries, such as banks, financial institutions (FIs), Housing Finance Companies (HFCs) and Non-Banking Financial Companies (NBFCs) are eligible to raise ECB.

Who can borrow under the AR? .. Contd.

(b) Units in Special Economic Zones (SEZ)(c) Non-Government Organizations (NGOs) engaged in micro finance activities (d) Micro Finance Institutions (MFIs) engaged in micro finance activities>>Who can be the lenders for ECBs under the AR?(a) International banks, (b) International capital markets, (c) Multilateral financial institutions (such as IFC, ADB, CDC, etc.) / regional financial institutions and Government owned development financial institutions, (d) Export credit agencies, (e) Suppliers of equipment, (f) foreign collaborators and (g) foreign equity holdersAmount & Maturity of ECB Under ARA corporate other than those in the hotel, hospital and software sectors: USD 750 million or its equivalent during a financial year.Corporates in the services sector viz. hotels, hospitals and software sector : Up to USD 200 million or its equivalent in a financial year for meeting foreign currency and/ or Rupee capital expenditure for permissible end-uses. The proceeds of the ECBs should not be used for acquisition of land.ECB up to USD 20 million or its equivalent in a financial year with minimum average maturity of three years.C:\Users\SESHU\Documents\Average Maturity Period on ECBs.xlsx

Amount & Maturity of ECB Under ARECB above USD 20 million or equivalent and up to USD 750 million or its equivalent with a minimum average maturity of five years.NGOs engaged in micro finance activities and Micro Finance Institutions (MFIs): Up to USD 10 million or its equivalent during a financial year. ECB up to USD 20 million or equivalent can have call/put option provided the minimum average maturity of three years is complied with before exercising call/put option.

Pricing?All-in-cost ceilings:

All-in-cost includes rate of interest, other fees and expenses in foreign currency except commitment fee, pre-payment fee, and fees payable in Indian Rupees. The payment of withholding tax in Indian Rupees is excluded for calculating the all-in-cost.The all-in-cost ceilings for ECB are reviewed from time to time.Ceilings applicable up to September 30, 2012 and subject to review thereafter:

Average Maturity PeriodAll-in-cost Ceilings over 6 month LIBOR*Three years and up to five years350 basis pointsMore than five years500 basis points* for the respective currency of borrowing or applicable benchmarkIn the case of fixed rate loans, the swap cost plus margin should be the equivalent of the floating rate plus the applicable margin.Purpose of ECBsECB can be raised for import of capital goods for new projects, modernization/expansion of existing production units in:Industrial sector including small and medium enterprises (SME),Infrastructure sector [power, telecommunication, railways, roads including bridges, sea port and airport, industrial parks, urban infrastructure (water supply, sanitation and sewage projects), mining, exploration and refining and cold storage or cold room facility] andSpecified service sectors, like hotel, hospital, softwarePurpose of ECBsOverseas Direct Investment in Joint Ventures (JV)/ Wholly Owned Subsidiaries (WOS).Acquisition of shares in the disinvestment process and also in the mandatory second stage offer to the public under the Governments disinvestment programme of PSU shares.For lending to self-help groups or for micro-credit or for bonafide micro finance activity.Payment for Spectrum Allocation.

Infrastructure Finance Companies (IFCs) i.e. Non Banking Financial Companies (NBFCs) categorized as IFCs by the Reserve Bank, are permitted to avail of ECBs, including the outstanding ECBs, up to 50 per cent of their owned funds, for on-lending to the infrastructure sector as defined under the ECB policy, Maintenance and operations of toll systems for roads and highways for capital expenditure provided they form part of the original project

End-uses not permittedOther than the purposes specified hereinabove, the borrowings shall not be utilized for any other purpose including the following:(a) For on-lending or investment in capital market or acquiring a company (or a part thereof) in India by a corporate [investment in Special Purpose Vehicles (SPVs), Money Market Mutual Funds (MMMFs), etc., are also considered as investment in capital markets].(b) for real estate sector,(c) for working capital, general corporate purpose and repayment of existing Rupee loans.

Security for the ECBsGuaranteesIssuance of guarantee, standby letter of credit, letter of undertaking or letter of comfort by banks, Financial Institutions and Non-Banking Financial Companies (NBFCs) from India is not permitted.

No-objection from ADs Before according no objection under FEMA, 1999, AD Category - I banks should ensure and satisfy themselves that:(i) the underlying ECB is strictly in compliance with the extant ECB guidelines, (ii) there exists a security clause in the loan agreement requiring the borrower to create charge on immovable assets / financial securities / furnish corporate or personal guarantee, (iii) the loan agreement has been signed by both the lender and the borrower and (iv) the borrower has obtained Loan Registration Number (LRN) from the Reserve Bank.

Parking of ECB proceedsBorrowers are permitted to either keep ECB proceeds abroad or to remit these funds to India, pending utilization for permissible end-uses.The proceeds of the ECB raised abroad meant for Rupee expenditure in India, such as, local sourcing of capital goods, on-lending to Self-Help Groups or for micro credit, payment for spectrum allocation, etc. should be repatriated immediately for credit to the borrowers Rupee accounts with AD Category I banks in India. In other words, ECB proceeds meant only for foreign currency expenditure can be retained abroad pending utilization. The rupee funds will not be permitted to be used for investment in capital markets, real estate or for inter-corporate lending.

Parking of ECB proceeds

Borrowers are permitted to either keep ECB proceeds abroad or to remit these funds to India, pending utilization for permissible end-uses.ECB meant for Rupee expenditure in India, such as local sourcing of capital goods, on-lending to Self-Help Groups or for micro credit, payment for spectrum allocation, etc. should be repatriated to India immediately.In other words, ECB proceeds meant only for foreign currency expenditure can be retained abroad pending utilization. The rupee funds, however, will not be permitted to be used for investment in capital markets, real estate or for inter-corporate lending.

Investment of ECBs Parked AbroadECB proceeds parked overseas can be invested in the following liquid assets:(a) Deposits or Certificate of Deposit or other products offered by banks rated not less than AA (-) by Standard and Poor/Fitch IBCA or Aa3 by Moodys (b) Treasury bills and other monetary instruments of one year maturity having minimum rating as indicated above, and (c) Deposits with overseas branches / subsidiaries of Indian banks abroad. The funds should be invested in such a way that the investments can be liquidated as and when funds are required by the borrower in India.

ECB PricingThe all-in-cost ceilings for ECB are reviewed from time to time. The following ceilings are applicable up to September 30, 2012 and subject to review thereafter:* for the respective currency of borrowing or applicable benchmarkIn the case of fixed rate loans, the swap cost plus the margin should be the equivalent of the floating rate plus the applicable margin.Prepayment of ECBsPrepayment of ECB up to USD 500 million may be allowed by AD banks without prior approval of Reserve Bank subject to compliance with the stipulated minimum average maturity period as applicable to the loan.

Refinancing of an existing ECBThe existing ECB may be refinanced by raising a fresh ECB subject to the condition that the fresh ECB is raised at a lower all-in-cost and the outstanding maturity of the original ECB is maintained.An existing ECB may, however, be refinanced by raising a fresh ECB at a higher all-in-cost under the approval route.

APPROVAL ROUTE

ECB with minimum average maturity of 5 years by Non-Banking Financial Companies (NBFCs) from multilateral financial institutions,Reputable regional financial institutions, Official export credit agencies and International banks to finance import of infrastructure equipment for leasing to infrastructure projects.

APPROVAL ROUTE

Eligible borrowers:On lending by the EXIM Bank for specific purposesBanks and financial institutions which had participated in the textile or steel sector restructuring package as approved by the Government are also permitted to the extent of their investment in the package and assessment by the Reserve Bank based on prudential norms. Any ECB availed for this purpose so far will be deducted from their entitlement.Infrastructure Finance Companies (IFCs) i.e. Non-Banking Financial Companies (NBFCs), categorized as IFCs, by the Reserve Bank,

Approval Route Eligible BorrowersForeign Currency Convertible Bonds (FCCBs) by Housing Finance Companies satisfying the following minimum criteria: (i) the minimum net worth of the financial intermediary during the previous three years shall not be less than Rs. 500 crore, (ii) a listing on the BSE or NSE, (iii) minimum size of FCCB is USD 100 million and (iv) the applicant should submit the purpose / plan of utilization of funds.Special Purpose Vehicles, or any other entity notified by the Reserve Bank, set up to finance infrastructure companies / projects exclusively, will be treated as Financial Institutions and ECB by such entities will be considered under the Approval Route.Multi-State Co-operative Societies engaged in manufacturing activityApproval Route Eligible BorrowersSEZ developers for providing infrastructure facilities within SEZ, as defined in the extant ECB policy like (i) power, (ii) telecommunication, (iii) railways, (iv) roads including bridges, (v) sea port and airport, (vi) industrial parks, (vii) urban infrastructure (water supply, sanitation and sewage projects), (viii) mining, exploration and refining and (ix) cold storage or cold room facility, including for farm level pre-cooling, for preservation or storage of agricultural and allied produce, marine products and meat.Approval Route Eligible BorrowersDevelopers ofNational Manufacturing Investment Zones (NMIZs)for providing infrastructure facilities within SEZ, as defined in the extant ECB policy like (i) power, (ii) telecommunication, (iii) railways, (iv) roads including bridges, (v) sea port and airport, (vi) industrial parks, (vii) urban infrastructure (water supply, sanitation and sewage projects), (viii) mining, exploration and refining and (ix) cold storage or cold room facilityApproval Route Eligible BorrowersCorporates in the services sector viz. hotels, hospitals and software sector can avail of ECB beyond USD 200 million or equivalent per financial yearService sector units, other than those in hotels, hospitals and software, subject to the condition that the loan is obtained from foreign equity holders. This would facilitate borrowing by training institutions, R &D, miscellaneous service companies, etcCorporates which have violated the extant ECB policy and are under investigation by the Reserve Bank and / or Directorate of Enforcement are allowed to avail of ECB only under the approval route.Cases falling outside the purview of the automatic route limits and maturity period guidelines.Pricing of ECB under the Approval RouteThe all-in-cost ceilings for ECB are reviewed from time to time. The following ceilings are applicable upto September 30, 2012 and subject to review thereafter:

* for the respective currency of borrowing or applicable benchmarkIn the case of fixed rate loans, the swap cost plus the margin should be the equivalent of the floating rate plus the applicable margin.

Average Maturity PeriodAll-in-cost Ceilings over 6 month LIBOR*Three years and up to five years350 basis pointsMore than five years500 basis pointsInvestment decisionsIntl.fin.187Investment in foreign countriesWhat is a companys motivation to invest capital abroad?Intl.fin.188Revenue-related motives:Attract new sources of demandEnter profitable marketsExploit monopolistic advantageReact to trade restrictionsDiversify internationallyCost-related motives:Benefit from economies of scaleUse foreign factors of productionUse of foreign raw materialsUse foreign technologyReact to exchange rate movements

International project detailsIntl.fin.189A firm is considering an investment in Freedonia, and the initial cash outlay is 1.5 million marks.The project has 4-year project life with cash flows given on the next slide.The appropriate required return for repatriated U.S. dollars is 18%.The appropriate expected exchange rates are given on the next slide.

International Capital Budgeting ExampleIntl.fin.1900 -1,500,0002.50 -600,000 -600,0001 500,000 2.54 196,850166,8222 800,000 2.59 308,880221,8333 700,000 2.65 264,151160,7704 600,000 2.72 220,588113,777Net Present Value = 63,202EndofYearExpectedCash Flow(marks)ExpectedCash Flow(U.S. dollars)Present Valueof Cash Flowsat 18%ExchangeRate (marksto U.S. dollar)How does a firm make an international capital budgeting decision?

Intl.fin.1911. Estimate expected cash flows in the foreign currency.2.Compute their US dollar equivalents at the expected exchange rate.3.Determine the NPV of the project using the US required rate of return, with the rate adjusted upward or downward for any risk premium effect associated with the foreign investment.

More on capital budgetingIntl.fin.192Only consider those cash flows that can be repatriated (returned) to the home-country parent.Discounting methods:NPV methodPayback periodInternal Rate of Return methodProfitability index method

1. Payback period is the expected number of years required to recover a projects cost.Example:yearProject LProject S0(Rs.100 lacs)(Rs.100 lacs)110302603038080>>

More on capital budgetingIntl.f