microsoft powerpoint - ifm module 1 [compatibility mode]iim-b
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International financial
management
Harisha.B.V. (Associate) finance andcontrol, IIMB 1
HARISHA.B.V
AIP(FINANCE AND CONTROL)
IIM BANGALORE
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Module 1
International financial environment. Nature of international risk exposure
Harisha.B.V. (Associate) finance andcontrol, IIMB 2
Determination of Exchange rates
Balance of payments
Interest parity
International fisher effect
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International FinancialEnvironment
No country is literally having any controlonce they crosses their nations border.
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one country to another in respect of
borrowing ,repayments, debt equity ,
taxation policy, production and mfgpolicies,sales markets etc.
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Though there are no particular characteristic featureof business economics in any country,developed
countries reflects the market mechanism and
individual choice is having greater freedom andimportance.
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e en ency o pos wor war as een omultilateral agreement and many international
organizations have been created to facilitate the
multilateral format.e.g. IMF,IBRD,GATT,BIS,OECD,OPEC , etc.
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Therefore it is described as being comprised
of a number of sovereign nation states with
distinct internal organizational structurescompeting against one another according to a
f i lin rmin m l il r l
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negotiations ,and which is monitored by the
moral authority of the international
organization created for this purpose
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FINANCE FUNCTION
TREASURERE CONTOLLER
FINANCIAL
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PLANNINGANALYSIS
FUND
ACQUISITION
INVESTMENT
FINANCING
MANAGEMENT
INVESTMENT
DECISIONS
RISK
MANAGEMENT
EXTERNAL
REPORTING
TAX PLAN
AND
MANGT
MIS
& MGTACCOUNTING
BUDGET
PLANNING
CONTROL
ACCOUNTS
RECEIVABLE
source.APTE P.G.
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IMPORTANCE /SCOPE OF IFM
MNCs AND CFO: International eventswhich affect the firm and steps can be takento gain through development or insulate
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aga nst arm u ones. Exchange rate behavior
Interest rate behavior
Economy
Assets value
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The emerging challenges
To keep update with significantenvironmental changes and analyze their
im lications for the firm.
Harisha.B.V. (Associate) finance andcontrol, IIMB 8
To understand and analyze the complex
interrelationships between relevant
environmental variables and corporateresponses-own and competitive-to the
changes in them.
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To be able to adapt the finance function to
significant changes in the firms own strategic
posture.A firms major change in the product market
mix,funding strategies,dividend policies,cash mgt
etc.
To take in stride ast failures and mistakes to
Harisha.B.V. (Associate) finance andcontrol, IIMB 9
minimize their adverse impact.- a wrong takeover,large foreign loans etc
To design and implement effective solutions to takeadvantage of the opportunities offered by the market
and advances in financial theory.-derivatives etc.
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Rewards of IFM
International trade & theory of Absoluteadvantage,comparative advantage,limitation.
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ams sm t s t eory o so uteadvantageDavid Ricardos comparative advantage
posners theory of limitationproduct life cycle theorytheory of intra-industry trade
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INTUTIVE THINKING
NO INTERNATIONAL TRADE, NOINTERNATIONAL FINANCE
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Investment enhancing and consumption
smoothing.
Investment enhancing
Gain from return differential.
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Gain of moving from a lower marginalefficiency (production without transport
facility)
Diversification(increasing returns without
increasing risks or reducing risks without
reducing returns.)
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CONSUMPTION SMOOTHINGE.g.:- 75 UNITS OF CONUMPTION
REQUIRMENT IN A COUNTRY.
YEARLY PRODUCE VARIES FROM
50 UNITS TO 100 UNITS.
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SO WHENEVER 50 UNITS ARE
PRODUCED BORROW 25 UNITS.
WHENEVER 100 UNITS ARE
PRODUCED LEND 25 UNITS.
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INTERNATIONAL RISKEXPOSURE
RISK CAN BE BROADLY CLASSIFIEDINTO TWO,NAMELY
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ENVIRONMENTAL RISKS
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RISK
Core business risks are operational riskssuch as an unsuccessful new productlaunch,interruptions in raw material
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supp ers, a or pro ems, Environmental risks arise out of
unpredictable fluctuations in financial
variables such as exchange rates,interestrates and stock prices,rise in prices of rawmaterials.government policies.
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FINANCIAL RISK
FINANCIAL RISK THUS CAN BECLEARLY SAID AS SUBSET OF
ENVIRONMENTAL RISKS.
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Core business risks are peculiar to particular
firm, but environmental risks are pervasive
and affect all firms in a given industry.
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Difference b/w risk and exposure
Exposure is a measure of the sensitivity ofthe firms performance-however-measured-
to fluctuations in the relevant risk factor .
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Risk is a measure of the extent of variability
of the performance measure attributable to
the risk factor.
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EXAMPLE
FOREIGN CURRENCYFLUCTUATIONS.
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DETERMINED BY MAGNITUDE OF
EXPOSURE.
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Numerical example Exposure firm with 90 days payable of
$500,000.
Spot rate 42.90
Forward rate 43.10
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eprec a on = . Therefore the loss will be Rs 100,000
Exposure =change in value of
payable/unanticipated change in exchange rate =100000/.20=500,000
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Explanation for the example
The change in the value of the payable perunit change in the exchange rate.
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much will the value of the payable change if
the rupee dollar rate changes by one rupee
per dollar?.
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Example for Risk
Suppose a financial consulting firm gives
the following forecast of the value of the
spot exchange rate three months from now.
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But it may go up to 45.50 or come down to
44.50 also.
Therefore exposure is .50 on either side butthe risk is different
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TYPES OF RISKS
ECONOMICAL AND POLITICAL RISKS GOVERNMENT AND TAXATION
EX HAN E RATE RI K
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INTEREST RATE RISK
MARKET IMPERFECTIONS
AGENCY PROBLEMS(conflict of interestbetween decision makers and the owners ofthe MNC)
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Goals of MNCs
To protect and increase the shareholders value Exploit the global resources
Understand the IF environment
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Use taxation tool effectively
Balancing between the holding and subsidiary
companys interests.
Market expansion
diversification
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INTERNATIONAL MONETARYSYSTMEM
EXCHANGE RATE REGIMES. MULTILATERAL FINANCIAL
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control, IIMB 24
CURRENCY BLOCKS SUCH AS THE
ECONOMIC AND MONETARY
UNION(EMU) IN EUROPE.
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EXCHANGE RATE REGIMES
Gold standard system(1870-1913) Inter country war period (1914-1944)
Br n r m n 1945-1973
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control, IIMB 25
Fluctuating currency system (1973
onwards)
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GOLD STANDARD SYSTEM
IN THE EARLY DAYS GOLD WAS USED ASA STORAGE OF WEALTH AND AS AMEDIUM OF EXCHAGE.
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control, IIMB 26
VALUE FOR ITS CURRENCY IN TERMSOF GOLD AND THEN TRY TO MAINTAINTHIS VALUE.
GOLD WAS MEASURED AS PER OUNCE 1OUNCE =31.1035GMS
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THREE IMPORTANT
FEATURES OF GOLD
STANDARD GOVERNMENT OF EACH COUNTRY
DEFINES ITS NATIONAL MONETARY UNIT
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control, IIMB 27
FREE IMPORT OR EXPORT OF GOLD
TWO WAY CONVERTIBILITY BETWEENGOLD AND NATIONAL CURRENCIES AT ASTABLE RATIO.
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EXAMPLE
UNITED STATES DECLARED-$20.67/OUNCE OF GOLD.
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4.2474/OUNCE OF GOLD.
THERE FORE EXCHANGE RATE WILL
BE 20.67USD/4.2474GBP=$4.86656/GBP
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DRAW BACKS WHEN INFLATION INCREAES IN
PARTICULAR COUNTRY THE CURRENCYLOSES THE COMPETITIVENESS IN THE
WORLD MARKET. IMPORTS BEING GREATER THAN EXPORTS
LET TO A DECLINE IN THE CONFIDENCE
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control, IIMB 29
OF THE CURRENCY. MANY TIMES GOLD WAS WITHDRAWN
FROM RESERVES AND SHIPPED ABROAD
TO PAY FOR IMPORTS. WITH LESS GOLD AT HOME,THE COUNTRYWAS FORCED TO REDUCE ITS MONEYSUPPLY
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CONTINUED
THIS RESULTED IN A SLOW DOWN IN
ECONOMIC ACTIVITY ,HIGH INTEREST
RATES,RECESSION,REDUCED NATIONALINCOME AND INCREASED
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control, IIMB 30
.
THIS LED TO CHAOS IN MANY
COUNTRIES INCLUDING US AND UK BECAUSE OF HIGHER INFLATION.
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THE INTER WAR YEARS
WORLD WAR I DISTURBED THESTABILITY OF EXCHANGE RATES
FOR CURRENCIES OF MAJOR
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control, IIMB 31
COUNTRIES. THE ROLE OF GREAT BRITAIN AS
THE WORLDS MAJOR CREDITOR
NATION ALSO CAME TO AN END
AFTER WORLD WAR I
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THE UNITED STATES BEGAN TO ASSUME
THE ROLE OF THE LEADING CREDITORNATION.
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control, IIMB 32
AFTER RECOVERING FROM WAR SOMECOUNTRIES TRIED TO RETURN TO THE
GOLD STANDARD SYSTEM,AND FEW
COUNTRIES LIKE US ,UK, SWISS,FRANCE,SCANDINAVIAN COUNTRIES EVEN
RESTORED GOLD SYSTEM.
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THE GREATEST MISTAKE DONE BY GREAT
BRITAIN HERE IS THEY RETURNED BACK
TO $4.87/POUND.
DURING THIS PERIOD US WAS FACING
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control, IIMB 33
INFLATION AT A LESSER RATE THAN UK.
THIS RESULTED IN INCRASEDUNEMPLOYMENT AND ECONOMIC
STAGNATION IN BRITAIN.
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IN 1934
IN 193 US DOLLAR WAS DEVALUED TO 35$
/OUNCE OF GOLD.THIS SYSTME IS CALLEDAS MODIFIED GOLD STANDARD OR GOLD
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control, IIMB 34
.
AFTER WORLD WARII ONLY NATIONCONTINUED TO REMAIN CONVERTIBLE
WAS THE DOLLAR.
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THE BRETTON WOODSYSTEM
THE DEPRESSION FOLLOWED BY WAR
IN 1930 DIMINI HED MMER IAL
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control, IIMB 35
TRADE.
REVIVAL OF SYSTEM BY
RECONSTRUCTION BEGAN WITHBRETTON WOODS AGREEMENT IN
NEW HAMPSHIRE. US.
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MAIN POINTS
THE GOLD STANDARD SYSTEM WASSCRAPPED.
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control, IIMB 36
THE BRITISH WANTED A REDUCEDROLE FOR GOLD.
THE AGREEMENT ESTABLISHED ADOLLAR BASED INTERNATIONAL
MONETARY SYSTEM
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TWO NEW INSTITUTIONS WERE CREATED ,
IMF AND IBRD(WORLD BANK).
DOLLAR REMAINED AT 35 PER OUNCE.
EACH COUNTRY WAS OBLIGATED TO
DEFINE ITS MONETARY UNITS IN TERMS OF
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control, IIMB 37
.
EACH CURRENCY WAS PERMITTED TO
FLUCTUATE WITHING PLUS OR MINUS 1%
TEN PERCENT DEVALUATION WAS
ALLOWED WITH APPROVAL OF IMF
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THE BREAKDOWN OF BWA
SOME OF THE DEVELOPED COUNTRIESCURRENCIES STARTED BECOMING
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control, IIMB 38
.
THERE WAS MUCH IMBALANCE
BETWEEN SURPLUS AND DEFICIT
NATIONS.
US DOLLAR FELL IN VALUE AGAINST A
NUMBER OF MAJOR CURRENCIES.
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SMITHSONIAN AGREEMENT
THE WORLDS LEADING COUNTRIES
CALLED THE G10 PRODUCED THE
SMITHSONIAN AGREEMENT ONDEC,18,1971.
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control, IIMB 39
NEW ET F R TE WERE FIXEDWITHOUT PERMISSION OF IMF.
THE US $ WAS FURTHER DEVALUED
FROM 35 TO 38 PER OUNCE OF GOLD.
THE FLUCTUATION OF 2.25% WAS
ALLOWED.
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FLEXIBLE EXCHANGE RATEREGIME,1973-PRESENT
AMERICA ABANDONED THE DOLLAR GOLD LINK IN 1971.
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control, IIMB 40
ARE PURELY DETERMINED BY FORCESOF DEMAND AND SUPPLY.
DIRTY FLOAT =AUTHORITIES HAVEINTERVENED MORE OR LESS INTENSELY
IN FOREIGN EXCHANGE MARKETS.
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AS OF NOW THERE IS NO CONSENSUSEITHER ACADEMIC ECONOMISTS OR
AMONG POLICY MAKERS OR AMONG
BUSINESSMEN AND BANKERS AS TO THEIDEAL EXCHANGE RATE REGIME.
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control, IIMB 41
MACRO ECONOMIC POLICY WITHIN ANECONOMY HAS BECOME AN EXTREMELY
COMPLEX.
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MULTILATERAL FINANCIALINSTITUTIONS
IMF International monetary fund. 29 countries signed in Bretton hood .
rr n m m r hi i 182 n ri
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control, IIMB 42
Each member contributes the reservesnamed quota
Quotas depends from country to country.
25% will be paid in gold and balance incurrency.
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When the country faces a BOP deficit ,IMF will
advance the reserves.
IMF was constituted to maintain the exchangerates.
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control, IIMB 43
Devaluation of currency requres prior approval ofIMF
Countries with chronic BOP deficits were allowedto depreciate their currencies.
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World bank
World bank lends for international projects and itlends at margin of half percent over its borrowingcost.
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control, IIMB 44
lending arm of world bank. IFC(international financial corporation) lends to
the private sector
World bank also provides assistance and advice todeveloping countries.
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Economic monetar nion
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Economic monetary union
In 1957 first step was taken towards the formation ofEMU by six countries.-GERMANY,BELGIUM,NETHERLANDS,ITALY,
LUXEMBURG AND FRANCE. In 1968 the same was converted to customs Union
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control, IIMB 46
outside the union.
It converted into common market in 1993-BRITAIN,DENMARK,SWEDEN,IRELAND,FINLAND,GREECE,SPAIN,PROTUGAL,AUSTRIA JOINED (15)
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Single currency unionThis converted into European community in
1999.single currency Monetary Union was formed.
Britain ,Sweden &Denmark opted out of the same,
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control, IIMB 47
Greece was not found eligible.Euro emerged as alternative currency to US$.
Here currency integrates without political integration.
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BALANCE OF PAYMENTS THE BALANCE OF PAYMENT IS
AN ACCOUNTING SYSTEM THATRECORDS THE ECONOMIC
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control, IIMB 49
RESIDENTS AND GOVERNMENTOF A PARTICUALR COUNTRY
AND THE RESIDENTS AND GOVTOF THE REST OF THE WORLDDURING A YEAR.
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THREE MAIN CATEGORIESOF BOP
THE CURRENT ACCOUNT THE CAPITAL ACCOUNT
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THREE MAIN CATEGORIESOF BOP
THE CURRENT ACCOUNT THE CAPITAL ACCOUNT
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control, IIMB 51
CURRENT ACCOUNT
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PARTICULARS DEBIT(OF) CREDIT(IF)
GOODS /SERVICES
BUY SELL
CURRENT ACCOUNT
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control, IIMB 52
UNILATERALTRANFERS GIVE RECEIVE
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CAPITAL ACCOUNT
PARTICULARS DEBIT (OF) CREDIT(IF)
FDI OUTBOUND INBOUND
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control, IIMB 53
PORTFOLIO OUTBOUND INBOUND
OTHER CF(BANKDEPOSITS ETC) DEPOSITING WITHDRAWING
Examples
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p
1.Export of goods against Bills ofExchange.Rs15000.
2.Realization of Bills of Exchange and deposit inforeign bank account.
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control, IIMB 54
3.Export of software services Rs 20000 for cash.
4. Sale of foreign exchange by bank to RBI.
5.Import on credit RS 30000
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6. Foreign investment RS 40000.
7. India received gift of $40000 from
America.
8.India made a gift of RS 12000 to Africa.
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control, IIMB 55
9.Indian bank draws foreign currency of$15000 from RBI.
Solution for the Example
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Question 1.Due from Foreigner A/C DR 15000
To Export of merchandise A/c 15000
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control, IIMB 56
.
To Due from Foreigner A/C 15000.
3.Foreign Assets A/C DR 20000To Trade in services A/C 20000
4 F i h A/ D 20000
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4 Foreign exchange reserve A/c Dr 20000
To Foreign exchange assets A/c 20000
5 Merchandise Imports A/c Dr 30000
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control, IIMB 57
To Liability to Foreigner A/c 20000
6 Foreign Exchange Assets A/c Dr 40000To FDI A/c 40000
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The official reserve account
Official reserves are government owned assets.
The official reserve account represents only
purchases and sales by the central bank of the
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control, IIMB 59
country.
If a country has BOP deficit then ,the central bank
has to run down its official assets such as gold
,foreign exchange ,SDR or borrow fresh from
foreign central banks.
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What moves exchange rates?
Since the advent of floating exchange ratesin 1973 economists, currency traders and
other rofessionals are ex endin enormous
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control, IIMB 60
intellectual effort to find out the forceswhich drive exchange rates and build
reliable exchange rate forecasting models.
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Exchange rate is the relative price of one currencyin terms of another.
It is the main component which influences trade,relative profitability of various industries, real
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control, IIMB 61
.
We like much of the profession are doubtful of the
value of the further time series modeling of
exchange rates.(frankel and rose 1995)
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Theories of exchange ratedetermination1. ARBITRAGE AND THE LAW OF ONE PRICE
2. PURCHASING POWER PARITY
3. THE FISHER EFFECT
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control, IIMB 62
4. THE INTERNATIONAL FISHER EFFECT
5. INTEREST RATE PARITY THEORY
6. THE RELATIONSHIP BETWEEN THE
FORWARD AND FUTURE SPOT RATE7. CURRENCY FORECASTING
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PART I. ARBITRAGE AND THE LAWOF ONE PRICE
I. THE LAW OF ONE PRICEA. Law states:
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control, IIMB 63
Identical goods sell for thesame price worldwide.
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ARBITRAGE AND THE LAW OFONE PRICE
B. Theoretical basis:
If the rice after exchan e-rate
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control, IIMB 64
adjustment were not equal,
arbitrage in the goods worldwide
ensures eventually it will.
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ARBITRAGE AND THE LAW OFONE PRICE
D. Five Parity Conditions Linkedby
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control, IIMB 66
1. The adjustment of variousrates and prices to inflation.
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ARBITRAGE AND THE LAW OFONE PRICE
2. The notion that moneyshould have no effect on
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control, IIMB 67
real variables (since theyhave been adjusted for
price changes).
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ARBITRAGE AND THE LAW OFONE PRICE
E. Inflation and home currencydepreciation:
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control, IIMB 68
.
growth of domestic moneysupply;
2. Relative to the growth of
domestic money demand.
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ARBITRAGE AND THE LAW OF
ONE PRICE
F. THE LAW OF ONE PRICE
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control, IIMB 69
- enforced by internationalarbitrage.
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Purchasing power parity theory
This theory was enunciated by GustavCassel.
Purchasing power of a currency is
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control, IIMB 70
determined by the amount of goods andservices that can be purchased with one unitof currency.
This reflects the relative purchasing powersof the currency
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Example
One parker pen in India = RS 150
The same pen in US= $ 3
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control, IIMB 71
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Two types of PPPT
Two versions
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control, IIMB 72
.
Relative purchasing power parity.
PPPT.xls
Absolute PPPT
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The level of exchange rate at any time equals theratio of purchasing powers of the two currencies.
Sa/b= Pa/Pb
Harisha.B.V. (Associate) finance and
control, IIMB 73
Sa/b= exchange rate between the currency of nationA and currency of nation B
Pa= price level in nation A Pb= price level in nation B.
Draw backs
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The rates can vary considerably due to thefactors like
1. Transportation cost.
2. Tariffs
Harisha.B.V. (Associate) finance and
control, IIMB 74
.
4. Government intervention ,directly in the
exchange markets.
5. Some goods cannot enter international trade-construction,transportation.
6. Service industry cost varies drastically.
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Relative
The proportionate change in exchange rate
between two currencies between two points
of time a roximatel e uals to difference
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control, IIMB 75
in the inflation rates in the two countriesover the same time interval.
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PURCHASING POWER PARITY
1. In mathematical terms:
( )tht ie +=
1
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control, IIMB 76
where et = future spot rate
e0 = spot rate
ih = home inflationif = foreign inflation
t = the time period
fie +10
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PURCHASING POWER PARITY
2. If purchasing power parity is
expected to hold, then the best
Harisha.B.V. (Associate) finance and
control, IIMB 77
-
spot rate should be
( )
( )tf
t
h
t i
i
ee +
+=
1
1
0
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PURCHASING POWER PARITY
3. A more simplified but less precise
relationship is
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control, IIMB 78
that is, the percentage change should be
approximately equal to the inflation ratedifferential.
fh
t
iie=
0
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PURCHASING POWER PARITY
4. PPP saysthe currency with the higher
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control, IIMB 79
n at on rate s expecte to
depreciate relative to the
currency with the lower rate of
inflation.
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PURCHASING POWER PARITY
B. Real Exchange Rates:the quoted or nominal rate
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control, IIMB 80
a us e or a coun ry s
inflation rate is
t
h
t
f
tt i
i
ee )1(
)1('
+
+
=
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Draw back
Previously said all draw back holdgood.
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control, IIMB 81
peop e are some mes more appe e
towards particular currency.
Asset market approach.
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Forecasting
By making use of PPPT theory futurespot rate can be forecasted as follows.
Harisha.B.V. (Associate) finance and
control, IIMB 82
S1=S0*(1+ rA / 1+ rB)
Fishers Effect.
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The fisher effect holds that the level ofnominal interest rates in a given country is
related to both real return and expected rateof inflation .
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control, IIMB 83
The currency with higher rates of inflationshould bear higher nominal interest rates andvice versa.
If the real return is x % and inflation is y%then the nominal rate should be x% + y%
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Formula
1 + NR = (1 + RR) * ( 1+ IR)
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control, IIMB 84
What do you mean by Nominal interest rate
and real interest rate?
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Nominal interest Rate Nominal rate express the ratio of exchange
between current money and future money . 100 RS invested today @10 % will be 110
Harisha.B.V. (Associate) finance and
control, IIMB 85
RS at the end of the year.
It does not explain how many more goods
or services we can purchase with this 10
RS because value of money will changeover.
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Real interest Rate
Real interest rate represents the rate atwhich current goods and services are
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control, IIMB 86
and services. Therefore it is the real interest rate and
not the nominal interest rate thatinterests the investors.
l
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Example Suppose investor requires real return to
be 3%,and the rate of inflation over theyear is expected to be 5%.
Harisha.B.V. (Associate) finance and
control, IIMB 87
GBP = 1/1.05 = 0.9524 or 95.24 %
Therefore nominal interest rate
expected will be GBP 0.9524*(1+r ) =1.03
r = 8.15 %
Relevant equation
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If no government intervention is practiced and
law of one price holds then interest rate
differentials should reflect inflation
differentials .
Harisha.B.V. (Associate) finance and
control, IIMB 88
rh - rf = ih - if According to the Fisher Effect, countries with
higher inflation rates have higher interest rates.
Due to capital market integration globally,
interest rate differentials are eroding.
International Fisher Effect
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The international holds that differences in
the rate of appreciation or depreciation
between two currencies is related tonominal interest rates between two
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control, IIMB 89
countries .
Currency with a low interest rates is
expected to appreciate relative to a
currency of a country with high interestrates and vice versa.
IFE = PPP + FE
THE INTERNATIONAL FISHER
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THE INTERNATIONAL FISHER
EFFECT
IFE = PPP + FE
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control, IIMB 90
t
f
tht
r
r
e
e
)1(
)1(
0 +
+=
Example
If 1 i i 7 % U S
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If 1 year interest is 7 % on U.S.treasury bills and 4 % on Swiss Franc
Treasury Bills and current exchangerate is $ 0.63 = 1 CHF.
Harisha.B.V. (Associate) finance and
control, IIMB 91
Expected future spot rate in one yearare
S1/0.63 = ( 1+0.07) / ( 1+ 0.04) S1 = .06482
THE INTERNATIONAL FISHER
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THE INTERNATIONAL FISHER
EFFECT
B. Fisher postulated
Harisha.B.V. (Associate) finance and
control, IIMB 92
1. The nominal interest ratedifferential should reflect
the inflation rate differential.
THE INTERNATIONAL FISHER
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THE INTERNATIONAL FISHEREFFECT
B. Fisher postulated
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control, IIMB 93
2. Expected rates of return areequal in the absence of
government intervention.
THE INTERNATIONAL FISHER
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THE INTERNATIONAL FISHEREFFECT
C. Simplified IFE equation:
Harisha.B.V. (Associate) finance and
control, IIMB 94
rf s re at ve y sma
1 0
0
h f
e er r
e
=
THE INTERNATIONAL FISHER
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THE INTERNATIONAL FISHEREFFECT
D. Implications of IFE
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control, IIMB 95
1.Currency with the lower interestrate expected to appreciate relative toone with a higher rate.
THE INTERNATIONAL FISHER
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THE INTERNATIONAL FISHEREFFECT
D. Implications of IFE
Harisha.B.V. (Associate) finance and
control, IIMB 96
2. Financial market arbitrage:
insures interest rate differential
is an unbiased predictor of change in
future spot rate.
Theory of interest Rate Parity
First developed by J M Keynes 1930
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First developed by J.M.Keynes 1930 .
Like PPPT ,IRPT is also law of one price.
The premium or discount of one currency against another
Harisha.B.V. (Associate) finance and
control, IIMB 97
should reflect the interest differential between the two
currencies.
In a perfect market situation ,where there is no restriction
on the flow of money ,one should be able to gain the same
real value on ones monetary assets irrespective of the
country where they are held.
Forecasting
(F S)/S = (rh rf)
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(F - S)/S = (rh - rf)
where rh = the home rate rf = the foreign rate
The appreciation or depreciation of one
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control, IIMB 98
approximately equal to the interest ratedifferential.
PPPT is law of one price in the market ofgoods and services and IRPT is in securitiesmarket
INTEREST RATE PARITY
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INTEREST RATE PARITYTHEORY
In equilibrium, returns on currencieswill be the same
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control, IIMB 99
. .
interest parity exists which can bewritten
(1 + rh) = F
(1 + rf) S
INTEREST RATE PARITY
THEORY
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THEORY
Covered Interest Arbitrage
1. Conditions required:
Harisha.B.V. (Associate) finance and
control, IIMB 100
nterest rate erent a oes not equa
the forward premium or discount.
2. Funds will move to a country with a
more attractive rate.
INTEREST RATE PARITY
THEORY
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THEORYMarket pressures develop:
As one currency is more demanded spot and sold
forward.
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control, IIMB 101
Inflow of fund depresses interest rates.
Parity eventually reached.
INTEREST RATE PARITY
THEORY
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THEORYSummary:Interest Rate Parity states:
1.Higher interest rates on a currency offset by
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control, IIMB 102
.
2.Lower interest rates are offset by forwardpremiums.
Criticisms Availability of funds that can be used for arbitrage is
not infinite.
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not infinite.
Markets are not always perfect, governmentintervention will be there which leads to dirty float.
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control, IIMB 103
Capital flows depends not only on interest rates butdepends on also liquidity and the ease of placement.
Speculation becomes important when market losesconfidence in the future of a currency.
Forecasting exchange rate in short
term
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term
Method of advanced indicators
Harisha.B.V. (Associate) finance and
control, IIMB 104
future spot rate
Graphical methods
Method of advanced indicators
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Method of advanced indicators
Here country's reserves to its imports are
considered as a main indicators. N = R / I * 12.
Harisha.B.V. (Associate) finance and
control, IIMB 105
N = number of months
R= reserves
I = imports
If N is less than 3 months the currency isvulnerable and may face devaluation
Forward rate as Predictor of future
spot rate
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spot rate.
Some authors believe that forward rates
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control, IIMB 106
are e y o e an un ase pre c or o
the future spot rate.
Graphical methods
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Graphical methods
Bar chart
Curve of support
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control, IIMB 107
Rate Time curve
Forecasting in medium and long
term
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term
Harisha.B.V. (Associate) finance and
control, IIMB 108
Economic approach
Sociological and political approach.
Economic approach
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Economic approach
Structure of the balance of Payments
Examination of interest rates
Harisha.B.V. (Associate) finance and
control, IIMB 109
rates Comparative examination of inflation
rates
Study of activity and employment level.
Sociological and political approach
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g p pp
Proximity of elections
Behavior of opposition parties
Recommendation of IMF etc
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control, IIMB 110
Rigorous control of foreign exchange
Interest rate hike Deflationary policy