Notes and Points On IMF
Notes and Points On IMF
SYLLABUS
Balance of Payment
Component of Balance Payment; Collection Reporting and Presentation of Statistics; International Flow of
Goods, Service and Capital; Alternate Concept of BOP Surplus and Deficits
Taxation
Objective of Taxation on International Investment; U.S. Taxation of Multinational Investment Corporation; Tax
Incentives for Foreign Trade
Suggested Readings:
1. Apte, P.G., International Financial Management, Tata McGraw Hill
2. Shapiro, A.C., Multinational Financial Management, Prentice hall of India.
3. Buckley, A, International Capita Budgeting, Tata McGraw Hill.
4. Bhattacharya, B., Going International: Response Strategies of the Indian Sector, Wheeler Publishing,
New Delhi.
INTERNATIONAL FINANCE MANAGEMENT
International Finance Management
COURSE OVERVIEW
As a student of Management, you must all be aware that To understand the scope of investment under fast changing
following a series of economic, financial and banking reforms, globalised economic and business environment.
initiated in 1991,and subsequent entry into W.T.O. in 1995,In- To understand the imperatives for Indias participation in the
dian economy has been integrated with the global economy. field of International Finance in the liberalized and
This, in turn, has systematically removed the barriers to deregulated environment.
international flow of goods, services and investments along
The Course-Pack, should, hopefully equip the students with an
with Indias participation prospects and investment opportuni-
introduction and exposure to International Finance Manage-
ties in international trades and projects with global leaders/
ment systems by examining some of the fundamental aspects
partners; especially involving Multinational Corporations/
of financial management that are unique to and affected by
Companies.
international issues and functionalities of international financial
A phenomenal development and advancement in technical
institutions and their market conditions. The course curricula
manpower and global leadership in Telecommunication and
have also been so structured as to provide the students a sound
Information Technology has further brightened the prospects
theoretical basis to international decision making; thereby
of Indian entrepreneurs, industrialists and investors to
developing the use of financial skills to obtain solutions to
participate more actively in International Trade. To match the
problems of International Financial Management. The Course-
heightened business prospects, which are fast opening- up in
Pack encapsulates a broad range of topics in the emerging areas
the global scene, vis--vis our domestic potentialities and
of International Finance, such as International Monetary
capabilities (i.e. Advantage- India), we are badly in the need of a
Instruments, International Financial Markets, Foreign Exchange
battery of young, enthusiastic, imaginative and dynamic
Market, Internationalisation Process and Foreign Direct
business managers with core competence in International
Investment, Management of Foreign Exchange and Exposure
Business Management, with focus on International Finance
Risks, Special Financing Vehicles for Derivative Markets,
Management. Bearing in mind this central approach, the present
International Capital Budgeting for MNCs, International Tax
Course- pack on International Finance Management has been
Management etc.
designed with the following four constituent Modules:
By the end of the Course, you are expected to develop the
I. Core Concept of International Finance Management
following Managerial skills in International Finance Manage-
II. International Banking and Financial Markets ment:
III. Foreign Exchange Risk Management Ability to Evaluate sources of Finance from International
IV. International Capital Budgeting Banking and Financial Markets
The main objectives in developing these Modules into this Should be able to Identify various theories and techniques
Course Pack spread over 15 logically sequentialised Chapters used in Foreign Exchange Risk Management
and divided into 40 Lessons, are basically to help develop a fairly To be able to Discuss the implications of International
good understanding amongst the students on the following Capital Budgeting; with special reference to Indias
core issues: investment opportunities in International Projects.
Concept of Financial Management in the context of Global
Trade.
To understand Financial Management as an International
Investment Opportunity.
i
INTERNATIONAL FINANCE MANAGEMENT
INTERNATIONAL FINANCE MANAGEMENT
CONTENT
Lesson No. Topic Page No.
v
INTERNATIONAL FINANCE MANAGEMENT
CONTENT
. Lesson No. Topic Page No.
Lesson 28 Currency and Interest Rates Futures 83
Lesson 29 Currency Options 87
Lesson 30 Financial Swaps 90
Lesson 31 Theories of Exchange Rates Movement: Arbitrage
and Law of one price 92
Lesson 32 Inflation Risk and Currency Forcasting 97
vi
UNIT 1
CORE CONCEPT OF INTERNATIONAL
FINANCE MANAGEMENT
SIGNIFICANCE OF INTERNATIONAL
CHAPTER 1: FINANCIAL MANAGEMENT
FINANCIAL MANAGEMENT
IN A GLOBAL CONTEXT
Learning Objectives Financial deregulation, first in the United States, and then in
1
INTERNATIONAL FINANCE MANAGEMENT
2
Exhibit 1: Major International Currencies and Their
Notes
3
INTERNATIONAL FINANCE MANAGEMENT
Growth in World Trade In Past Five 1981 1904.8 1238.3 172.924 493.637
Decades 1991 3501.4 2503.3 511.524 486.597
The five decades, following the second war, have witnessed an 1995 5122.9 3470.7 926.205 726.298
enormous growth in the volume of international trade. This
1996 5352.3 3560.8 966.953 824.473
was also the period when significant progress was made
towards removing the obstacles to the free flow of goods and 1997 5534.8 3640.5 1029.828 864.515
services across nations. However, today, the case for and against 1998 5444.9 3656.5 974.751 813.431
free trade continues to be debated, international trade disputes
in various forms erupt between nations every once in a while, 1999 5577.2 3469.8 1041.820 803.540
and protectionism in novel disputes in various forms erupt 2000 3134.7 1980.4 583.130 510.800
between nations every once in a while, and protectionism in
novel disguised is raising its head once again. Nevertheless, Table 2. Annual Growth Rates of Real GDP and Exports
there is no denying the fact that the rapid economic growth and
1982 -91 1992 1995 2000
increasing prosperity in the west and in some parts of Asia is
GDP EXP GDP EXP GDP EXP GDP EXP
mostly because of this ever- growing flow of goods and Advanced 3.1 5.5 2.1 4.6 2.7 9.0 3.6 7.8
services in search of newer and more remunerative markets, and economies
the resulting changes in the allocation of resources within and Developing 4.3 4.2 6.4 10.4 6.1 11.9 5.4 10.2
across countries. Table 1 gives some idea of the pervasiveness countries
of cross-border trade in goods and services and its phenomenal
A unified market determined exchange rate, current account
growth since 1950.
convertibility, and a slow but definite trend in the direction of
However, the growth in world trade has not been even, spatially liberalizing the capital account opened up the India economy to
or over different sub-periods, during the four decades following a great extent.
the Second World War. But it has grown at a pace much faster
In keeping with the commitments made to WTO, all quantita-
than the world output so that for many countries the share of
tive restrictions on trade were abolished at the end of March
exports in GDP has increased significantly. Table 2 provides
2001. Further lowering of tariff barriers, greater access to foreign
some data on the comparative average annual growth rates in
capital, and finally, capital account convertibility were certainly on
real GDP and exports for different country groupings, over
the reform agenda of the Indian government.
different time periods.
The apparently inexorable trend towards opening up of
Even developing countries like India, which for a long time,
national economies and financial markets and their integration
followed an inward looking development strategy, concentrating
into a gigantic global marketplace appeared to have suffered a
on import substitution have, in recent years, recognized the vital
serous setback in 1997 and 1998 following the east-Asian crisis
necessity of participating vigorously in international exchange
4
and the Russian debacle. In particular, doubts were raised
5
Along with an increasing flow of inward foreign investment, international capital markets? How will a takeover of a major
INTERNATIONAL FINANCE MANAGEMENT
Indian companies have also been venturing abroad for setting competitor by an outsider affect competition within the
up joint ventures and wholly owned subsidiaries. At the end of industry? If a hitherto publicly owned financial institution is
September, 1999, there were 912 active joint ventures abroad as privatized, how will its policies change and how will that
compared to 788 at the end of September 1998 out of the change affect the firm?
former, 392 were in production/ operation and 520 under 3. To be able to adapt the finance function to significant
various stages of implementation. The approved equality of changes in the firms own strategic-posture. A major change
these 912 active joint ventures amounted to USD 1,150.32 in the firms product-market mix, opening up of a sector or
million. The number of fresh and supplementary proposals an industry so far prohib-ited to the firm, increased pace of
approved in respect of joint ventures during the period April to diversification, a significant change in operating results,
September 1999 was 42 and 11 respectively involving a total substan-tial reorientation in a major competitors strategic
investment of USD 46.33 million by way of equity and USD stance are some of the factors that will call for a major
1.53 million by way of loans. The total of 912 active joint financial restructuring, exploration of innovative funding
ventures are dispersed over 91 countries with almost 80% of strategies, changes in dividend poli-cies, asset sales etc to
them being concentrated in 21 countries, that is USA (97), UK overcome temporary cash shortages and a variety of other
(74) UAE (68) Russian (38) etc. out of the 42 cases of fresh responses.
approvals for new joint ventures during the period April -
4. To take in stride past failures and mistakes to minimize the
September 1999, 20 proposals involving an equity investment
adverse impact. A wrong takeover de-cision, a large foreign
of USD 31.58 million were in the non -financial services sector,
loan in a currency that has since started appreciating much
primarily in the field of computer software, followed by 12
faster than ex-pected, a floating rate financing obtained when
proposals involving USD 5.42 million for manufacturing
the interest rates were low and have since been rising rapidly,
activities, 7 proposals involving USD 2.49 million for trading
a fix-price supply contract which becomes insufficiently
activities and 3 proposals involving USD 0.04 million for other
remunerative under current conditions and a host of other
activities. Of course by global standards, these are small
errors of judgment which are inevitable in the face of the
amounts but Indian presence abroad is bound to grow at an
enormous uncer-tainties. Ways must be found to contain the
accelerated pace.
damage.
The Emerging Challenges 5. To design and implement effective solutions to take
A firm as a dynamic entity has to continuously adapt itself to advantage of the opportunities offered by the markets and
change in its operating environment as well as in its own goals advances in financial theory. Among the specific solutions,
and strategy. An unprecedented pace of environmental changes we will discuss in detail later, are uses of options, swaps and
characterized the 1980s and 1990s for most Indian firms. futures for effective risk management, securitisation of assets
Political uncertainties at home and abroad, economic liberaliza- to increase liquidity, innovative funding techniques etc. More
tion at home, greater exposure to international markets, marked generally, the increased complexity and pace of
increase in the volatility of critical economic and financial environmental changes calls for greater reliance on financial
variables, such as exchange rate and interest rates, increased analysis, forecasting and plan-ning, greater coordination
competition, threats of hostile takeovers are among the factors between the treasury management and control functions and
that have forced many firms to thoroughly rethink their strategic extensive use of computers and other advances in
posture. information technology. -
The responsibilities of todays finance managers can be The finance manager of the new century cannot afford to
understood by examining the principal challenges they are remain ignorant about intentional financial markets and
required to cope with. Following five key categories of emerging instruments and their relevance for the treasury function. The
challenges can be identified: financial markets around the world are fast integrating and
1. To keep up-to-date with significant environmental changes evolving around a whole new range of products and instru-
and analyse their implications for the changes in industrial ments. As nations economies are becoming closely knit
tax and foreign trade policies, stock market trends, fiscal and through cross-border trade and investment, the global financial
monetary developments, emergence of new financial system must innovate to cater to the ever-changing needs of the
instruments and products and so on. real economy. The job of the finance manager will increasingly
2. To understand and analyze the complex interrelationships become more challenging, demanding and exciting.
between relevant environment variables and corporate
responses-own and competitive-to the changes in them.
Numerous examples can be cited. What would be the impact
of a stock market crash on credit conditions in the
international financial markets? What opportunities will
emerge if infrastructure sectors are opened up to private
investment? What are the potential threats from
liberalization of foreign investment? How will a default by a
major debtor country affect funding prospects in
6
UNIT 1
CORE CONCEPT OF INTERNATIONAL
FINANCE MANAGEMENT
THE MULTINATIONAL FINANCIAL CHAPTER 2: INTERNATIONAL
SYSTEMS CORPORATE FINANCING
7
Despite the frequent presence of governmental regulations or Operating globally confers other advantages as well: It increases
INTERNATIONAL FINANCE MANAGEMENT
limiting contractual arrangements, most MNCs have some the bargaining power of multinational firms when they
flexibility as to the timing of fund flows. This latitude is negotiate investment agreements and operating conditions with
enhanced by the MNCs ability to control the timing of many foreign governments and labour union; it gives MNCs
of the underlying real transactions. For instance, shipping continuous access to information on the newest process
schedules can be altered so that one unit carries additional technologies available overseas and the latest research and
inventory for a sister affiliate. development activities of their foreign competitors; and it helps
them to diversify their funding sources by giving them ex-
Value
panded access to the worlds capital markets.
By shifting profits from high-tax to lower-tax nations, the
MNC can reduce its global tax payments. Similarly, the MNCs Relationship to Domestic Financial
ability to transfer funds among its several units may allow it to Management
circumvent currency controls and other regulations and to tap In recent years, there has been abundance of researches in the
previously inaccessible investment and financing opportunities. area of international corporate finance. The major thrust of
However, since most of the gains derive from the MNCs skill these works has been to apply the methodology and rationale
at taking advantage of openings in tax laws or regulatory of financial economics as a strategy to take key international
barriers, governments do not always appreciate the MNCs financial decisions. Critical problem areas, such as foreign
capabilities and global profit-maximizing behavior. Thus, exchange risk management and foreign investment analysis,
controversy has accompanied the international orientation of have benefited from the insights provided by financial economics-
the multina-tional corporation. a discipline that empha-sizes the use of economic analysis to
Functions of Financial Management understand the basic workings of financial markets, particularly
Financial management is traditionally separated into two basic the measurement and pricing of risk and the inter- temporal
functions: the acquisi-tion of funds and the investment of allocation of funds.
these funds. The first function, also known as the financing By focusing on the behavior of financial markets and their
decision, involves generating funds from internal sources or from participants, rather than on how to solve specific problems, we
sources external to the firm at the lowest long-run cost possible. can derive fundamental principles of valuation and develop
The investment decision is concerned with the allocation of funds from them superior approaches to financial management-much
over time in such a way that shareholder wealth is maximized. as a better under-standing of the basic laws of physics leads to
Many of the concerns and activities of multinational financial better-designed and -functioning products. We can also better
management, however, cannot be categorized so neatly. gauge the validity of existing approaches to financial decision
Internal corporate fund flows such as loan repayments are often making by seeing whether their underlying assumptions are
undertaken to access funds that are already owned, at least in consistent with our knowledge of financial markets and
theory, by the MNC. Other flows such as dividend payments valuation principles.
may take place to reduce taxes or currency risk. Capital structure Three concepts arising in financial economics have proved to be
and other financing decisions are frequently motivated by a of particular impor-tance in developing a theoretical foundation
desire to reduce investment risks as well as financing costs. for international corporate finance: arbitrage, market efficiency,
Furthermore, exchange risk management involves both the and capital asset pricing.
financing decision and the investment decision.
Arbitrage
Financial executives in multinational corporations face many Arbitrage has traditionally been defined as the purchase of
factors that have no domestic counterparts. These factors securities or commodities on one market for immediate resale
include exchange and inflation risks; international differences in on another in order to profit from a price discrepancy. However,
tax rates; multiple money markets, often with limited access;
in recent years, arbitrage has been used to describe a broader
currency controls; and political risks, such as sudden and
range of activities. Tax arbitrage, for example, involves the
creeping expropriation.
shifting of gains or losses from one tax jurisdiction to another
When examining the unique characteristics of multinational in order to profit from differences in tax rates. In a broader
financial management, it is understandable that companies context, risk arbitrage or speculation, describes the process that
normally emphasize the additional political and economic risks leads to equality of risk-adjusted returns on different securities,
faced when going abroad. However, a broader perspective is unless market imperfections that hinder this adjustment
necessary if firms are to take advantage of being multinational. process exist. In fact, it is the process of arbitrage that ensures
The ability to move people, money, and material on a global market efficiency.
basis enables the multina-tional corporation to be more than
Market Efficiency
the sum of its parts. By having operations in different coun-
An efficient market is one in which the prices of traded securities
tries, the MNC can access segmented capital markets to lower its
readily incorporate new information. Numerous studies of U.S.
overall cost of capital, shift profits to lower its taxes, and take
and foreign capital markets have shown that traded securities are
advantage of international diversification of markets and produc-
correctly priced in that trading rules based on past prices or
tion sites to reduce the riskiness of its earnings. Multinationals
have taken the old adage of dont put all your eggs in one publicly available information cannot consistently lead to profits
basket to its logical conclusion. (after adjusting for transactions costs) in excess of those due
solely to risk taking.
8
The predictive power of markets lies in their ability to collect in These considerations justify the range of corporate hedging
9
INTERNATIONAL FINANCE MANAGEMENT
Leaning Objectives makes many small loans. Put another way, in retail banking, risk
To expose you about emerging and diversified areas of pooling takes place within the bank, while in wholesale
international banking for international corporate financing banking- it occurs outside the firm. Improved information
flows and global integration constitutes a major challenge to
To help you learn about the importance of equity as a viable
wholesale banking. Retail banking is threa-tened by new process
source of international finance.
technologies. These points are discussed in turn, below. Even
Many banks in OECD countries engage in international though the sophistication of some wholesale banking custom-
banking activities. To the extent that these activities are interna- ers might lead one to think they do not need banking services,
tional extensions of the intermediary and payment functions the reality is quite differ-ent. To see why banks profit from
the presence of international banks does not contradict the basic intermediary and payment functions offered to wholesale
model of banking. However international banking being such customers, it is important to understand why large corporate
an important aspect of modern banking that an overall bank customers tend to concentrate their loans and deposits
awareness about the main domens of international and with one or two banks, and why depositors do not effectively
multinational banking systems is a must for students to insure themselves against liquidity needs by pooling them with
develop good understanding of international financial manage- other groups of depositors, through a wholesale market. The
ment. answer is twofold. First, correspondent banking and inter bank
Financial Conglomerates relationships signal that banks trust each other, enabling them
Increasingly, banks are part of financial conglomerates that are to transact with each other more cheaply, thereby reducing costs
active in both informal markets and in organized financial for customers. Second, it is cheaper for banks to delegate the
markets. The existence of financial conglomerates does not alter task of evaluating and monitoring a borrow-ing firm to one or
the fundamental reasons of why banks exist. Like many profit- more group leaders than it is to have every bank conduct the
maximizing organizations banks may expand into other monitoring. Loan syndicates make it possible for one bank to
non--banking financial activities as part of an overall strategy to act as lead lender, specializing in one type of lending operation.
maximize profits and shareholder value-added. American investment banks and British merchant banks are good
Non-bank Financial Services examples of financial institutions that engage in wholesale
Banks dont just take loans and offer deposits; they typically banking activities. US invest-ment banks began as underwriters
offer a range of financial services to customers, including unit of corporate and government securities issues. The bank would
trusts, stock broking facilities, insurance policies, pension funds, purchase the securities and sell them on to final inves-tors.
asset management, or real estate. Non - -banking financial Modern investment banks can be described as finance wholesal-
bank/ financial institutions for two reasons offer services. First, ers engaged in underwriting, market making, consultancy,
a bank provides intermediary and liquidity services to its mergers and acquisi-tions, and fund management. The
borrowers and depositors, thereby reducing the financing costs traditional function of the merchant bank was to finance trade
for these customers, compared to the costs if they were to do it by charging a fee to guarantee (or accept) merchants bills of
themselves. If a bundle of services are demanded by the exchange. Over time, this function evolved into one of more
customer (because it is cheaper to obtain it in this way), then general underwriting, and initiating or arranging financial
banks may be able to develop a competitive advantage and transactions. Big Bang (in 1986) gave merchant banks the
profit from offering these services. Second, buying a basket of opportunity to expand into market making mergers and
financial services from banks helps customers to overcome acquisitions, and dealing in securities on behalf of investors.
information asymmetries, which can make it difficult to judge Today, many UK merchant banks perform functions similar to
qual-ity. For example, if a bank earns a reputation from its their US CO11-sins, the investment banks, though they are not
intermediary role, it can be used to market other financial restricted to these activities by statutory regulations such as the
services. In this way, banks become marketing intermediaries. Glass-Steagall Act. The terms merchant and investment
banks are now used interchangeably.
Wholesale and Retail Banking
Financial market reforms, the increasing ease with which
Wholesale banking typically involves a small number of very
financial instru-ments are traded, the use of derivatives to
large customers such as large corporate and governments,
improve risk management, and communications technology
whereas retail banking consists of a large number of small
which enhances global information flows, have contributed to
customers who consume personal banking and small business
the integration of global financial markets over the last two
services. Wholesale banking is largely inter bank: banks use the
decades. The challenge for wholesale banks is to maintain a
inter -bank markets to borrow from or lend to other banks, to
competitive advantage as intermediaries in global finance,
participate in large bond issues, and to engage in syndicated
though some might survive as financial boutiques. This point
lending. Retail banking is largely intra- bank: the bank itself
10
is supported by recent takeovers of relatively small British diary function will remain. Banks with a competitive advantage
11
sell mortgage assets, thereby moving the assets off-balance In order to protect the lessees interest in the residual value, lease
INTERNATIONAL FINANCE MANAGEMENT
sheet. Third, to the extent that regulators focus on bank balance agreements can provide for a renewal, at the option of the
sheets, OBS instruments, in some cases, may make it easier for a lessee, of the primary lease at nominal rentals. Again, the lease
bank to meet capital standards. These instruments may also agreements may provide for the lessee to be given a rebate on
assist the bank in avoiding regulatory taxes, which stem from the rental amounts he has already paid, to the extent of say 95
reserve requirements and deposit insurance levies. per cent or more of the sale value of the asset at the market rate
Securitisation is the process whereby traditional bank assets (for prevailing on expiry of the primary or extended period -of the
example, mortgages) are sold by a bank to a trust or corpora- lease.
tion, which in turn sells the assets as securities. Thus, while the Equity as a Source of External Finance
process may commence in an informal market (usually with a Equity has become an increasingly important source of external
bank locating borrowers), the traditional functions related to the finance for developing countries Annual foreign investment
loan asset are unbundled so that they can be marketed as secu- worldwide totals $ 2 trillion currently. The erstwhile highly
rities on a formal market. restrictive policies followed by India have been reversed in recent
The growth of off-balance sheet and securitisation activities is years. Other Asian and Latin American countries, and the post-
not inconsis-tent with the basic principles of banking outlined communist countries in east Europe, are far more aggressive.
earlier. The growth of the derivatives and securities markets has Equity investments in individual south East Asian countries
expanded the intermediary role of banks to one where they act like Indonesia and Thailand are estimated at several billion
as intermediaries in risk management dollars a year. Mainland China has in recent years been attracting
equity inflows on an even bigger scale - $ 45 bn in 1998.
International Leasing
Cross border leases have, over the years, become an important Foreign Equity Investments can be of
source of international finance for acquiring assets like ships and Three Types
aircraft not that cross border leasing of other capital assets is Foreign Direct Investments (FDI)
altogether unknown. The main advantage of lease finance is Equity investments in new projects or for takeover of existing
that it is usually for the full value of the asset acquired, unlike units, accompanied by technology and management from the
traditional loans, which, in general, would be for only part of foreign investors are referred to as FDI; this is by far the largest
the total value of the asset. element of equity funds for some country
The economics of cross border leasing is dependent essentially
Portfolio Investments
on the tax laws of the country in which the leaser is located. The
These are aimed at capital appreciation and portfolio investors
calculations are similar to the costing of domestic leases and it is
have little say in management of the invested companies. They
not the intention to go into the details here. However, some
also do not bring in any technology. Portfolio investments are
important considerations are listed hereunder:
of four types:
The economics of leasing as compared to purchasing an
Close-ended country funds floated abroad
asset hinge on the fact that, in the former case, the leaser, as
the owner, is enti-tled to capital allowances like depreciation These operate like domestic mutual funds. Close-ended
on the asset, which goes to postpone the leasers tax liability funds have a specific maturity date and the fund manager is
on the rental income. The les-see, on the other hand, writes under no obligation to buy the units from the subscribers
off the lease rentals as revenue expenditure as far as his tax during the currency of the fund- the holders are however free
liability is concerned. Given the depre-ciation rates in the to sell to foreign buyers at the market price, which depends
leasers country and other relevant tax regula-tions, the on the demand and supply, and often varies widely from the
effective cost of a lease can work out to lower than the after- net asset values. All the initial India funds floated abroad
tax cost of purchasing the asset by raising an equivalent were close-ended ones.
amount of loan. Open ended country funds
Most countries laws do not allow the lessor to provide for a These too are mutual funds but with no specific maturity
pur-chase option in favour of the lessee on expiry of the date. Also, the fund manager is obliged to quote bid and
primary period of the lease of such a purchase option at a offered prices, depending on the net asset value of the fund;
pre-determined price is a part of the transaction; the laws in and any investor is free to buy or sell at these prices. Several
most countries would consider the transaction as hire open- ended India funds have been floated in the last few years.
purchase rather than lease. And, in that case, the leaser will not
Foreign Institutional Investors (FIIs)
be entitled to the capital allowances (deprecia-tion). The
documentation pertaining to international lease transac-tions Directly Investing in the Local Stock
is, therefore, extremely complex and is a highly specialized one. Market
As stated above, in general, a lease would not have a India has recently permitted many FIIs to do so. They purchase
purchase op-tion in favour of the lessee. Since the lease rupees against foreign currencies for making in-vestments at
rentals are so structured as to service, during the primary market prices and are free 10 sell when they choose; the resultant
period of the lease, the entire cost of the leased asset, the rupees, after payment of any local taxes, can then be used to buy
lessee has obvious interest in the residual value of the asset fore in the market for repatriation of the investments.
on expiry of the lease period.
12
Equity (or convertible bond) issues in foreign markets Notes
13
UNIT 2
INTERNATIONAL BANKING AND
FINANCIAL MARKET
EXCHANGE RATE REGIME -
CHAPTER 3: INTERNATIONAL FINANCE
A HISTORICAL RETROSPECTIVE
SYSTEM: MONETARY INSTRUMENTS
INTERNATIONAL FINANCE MANAGEMENT
Chapter Orientation
Trade and exchange are probably older than the invention of money, but in the absence of this wonderful contrivance, the
volume of trade and gains from specialization would have been rather miniscule. What is true of trade and capital flows within a
country is true, perhaps more strongly, of international trade and capital flows. Both require an efficient world monetary order to
flourish and yield their full benefits.
From the point of view of a firm with world wide transactions in goods, services and finance, an efficient multilateral financial
organization facilitates transfer of funds between parties, conversion of national currencies into one another, acquisition and
liquidation of financial assets, and international credit creation. The international monetary system is an important constituent of
the global financial system.
The purpose of this chapter is to familiarize you with the organization and functioning of the international monetary system.
Our approach will be partly analytical and partly descriptive. The discussion will be structured around the following aspects of the
system, which we consider to be the key areas the finance manager must be acquainted with:
(i) Exchange rate regime: a Historical Overview
(ii) International Monetary Fund: Modus operandi
(iii) The functionalities of Economic and Monetary Union
The deeper analysis of these aspects belongs to the discipline of international monetary economics. Here we attempt to provide
you an introductory treatment to serve as a back drop to the discussions that will follow in subsequent monetary systems
including the historical evolution of the various exchange rate regime along with emerging issues related to adequacy of interna-
tional reserve and problem of their adjustment.
14
The exchange rate between any pair of currencies will be The novel feature of the regime, which makes it an adjustable peg
15
criterion, or discretionary in response to changes in se-lected asserts that a country can achieve any two of three policy goals
INTERNATIONAL FINANCE MANAGEMENT
quantitative indicators such as inflation rate differentials. Six but not all three:
countries were under such a re-gime in 1999. . 1. A stable exchange rate
6. Crawling Bands: The currency is maintained within certain 2. A financial system integrated with the global financial system,
margins around a central parity. Which crawls as in the that is an open capital account ; and
crawling peg regime either in a pre-announced fashion or in
3. Freedom to conduct an independent monetary policy. Of
response to certain indicators. Nine countries could be
these (i) and (ii) can be achieved with a currency union or
characterized as having such an arrangement in 1999.
board, (ii) and (Iii) with an independently floating exchange
7. Managed Floating with no Pre-announced Path for the rate and (i) and (iii) with capital controls. Figure given below
Exchange Rate: The central bank influences or attempts to provides a graphical representation of the impossible trinity
influence the exchange rate by means of active intervention argument.
in the foreign exchange market-buying or selling foreign
currency against the home currency-without any commitment
to maintain the rate at any particular level or keep it on any Full Capital Controls
pre-announced trajectory. Twenty-five coun-tries could be Monetary Exchange Rate
classified as belonging to this group. Independence Stability
8. Independently Floating: The exchange rate is market
determined with central bank intervening only to moderate
the speed of change and to prevent excessive fluctuations,
but not attempting to main-tain it at or drive it towards any Pure Currency
particular level. In 1999, forty-eight countries including India Float Union
characterized themselves as independent floaters.
It is evident from this that unlike in the pre-I973 years, one
cannot characterize the international mon-etary regime with a Integration with Global
single label. A wide variety of arrangements exist and countries Financial Markets
move from one cat-egory to another at their discretion. This has
prompted some analysts to call it the international monetary Macroeconomic policy making within an economy has become
non-system. an extremely complex and demanding task. With open
economies and integrated financial markets, a given monetary or
Is there an Optimal Exchange Rate
fiscal policy action can have a variety of conflicting or comple-
Regime?
mentary impacts on important policy targets like employment,
The world has experienced three different exchange rate regimes
inflation, and external balance. Market overreaction and
in this century in addition to some of their variants tried out by
speculative asset price bubbles can do lasting damage as
some countries. Starting from the gold standard regime of
evidenced by the currency crises, which ravaged the East Asian
fixed rates, passing through the adjustable peg system after the
economies in 1997. Under these conditions, a policy combina-
Second World War, it finally ended up with a system of man-
tion of extensive capital controls and a pegged exchange rate
aged floats after 1973. Since 1985, the pendulum has started
with of course an adjustable peg is becoming attractive
swinging, though very slowly and erratically,
particularly for developing economics.
In the direction of introducing some amount of fixity and rule
based management of exchange rates. The fixed versus floating
exchange rates controversy is at least four decades old. Even a
brief review requites some understanding of open economy
macroeconomics. Suffice it to say that after the actual experience
of floating rates for nearly two decades, the sober realization has
come that the claims made in their favor during the fifties and
sixties were rather exaggerated. There is a school of thought
within the profession which argues that in the years to come
there will be only tow types of exchange rate regimes: truly fixed
rate arrangements like currency unions or currency boards or
truly market determined, independently floating exchange rates.
The middle ground regimes such as adjustable pegs,
crawling pegs, crawling bands and managed floating will pass
into history. Some analysts even predict that three currency
blocks the US dollar block, the Euro block, and the Yen block
will emerge with currency union within each, and free floating
between them. The argument for the impossibility of the
middle ground refers to the impossible trinity that is, it
16
INTERNATIONAL FINANCE MANAGEMENT
IMF-MODUS OPERANDI
Learning objectives been initiated in 1998 and Implemented in January 1999. Till
To help you develop understanding how the International the quotas decide the voting powers of the members within the
Monetary fund (IMF) has become the central piece of the policy making bodies of IMF. The maximum amount of
World Monetary Order financing a member country can obtain from the IMF IS also
determined by its quota. For more details on quotas, the
To explain you further how effectively IMF has contributed
students can consult the IMF Annual Report of 2000.
to increasing international monetary cooperation, growth of
trade, exchange rate stabilization, induction of multilateral In addition to the quota resources, the Fund has from time to
payment systems, eliminating of exchange restricting, time borrowed from member (and non-member) countries
convertibility of member currencies and in, building reserve additional resources to fund its various lending facilities. Since
base 1980, the Fund has been authorized to borrow from commer-
cial capital markets.
Defining and explaining you about the international liquidity
perspectives and special drawing right option under IFM Funding Facilities
system As we have seen above, operation of the adjustable peg requires
Providing you with a broad contour of funding facilities that a country to intervene in the foreign ex-change markets to
are available to IMF member countries support its exchange rate when it threatens to move out of the
permissible band. When a country faces a BOP deficit, it needs
The International Monetary Fund (IMF) reserves to carry out the intervention-it must sell foreign
The Role of IMF currencies and buy its own currency. When its own reserves are
The international monetary fund has been the centerpiece of the inadequate it must borrow from other countries of the IMF.
world monetary order since its creation in 1944 through its (Note that a country, which has a surplus, does not face this problem).
supervisory role in exchange rate arrangements has been Any member can unconditionally borrow the part of its quota,
considerably weakened after the advent of floating rates in 1973 which it has contributed in the form of SDRs or foreign
As mentioned above, restoration of monetary order after the currencies. This is called the Reserve Tranche. (The word tranche
Second World War was to be achieved within the framework of means a slice.) In addition, it can borrow up to 100% of its
the Articles of Agreement adopted at Bretton Woods. These quota in four further tranches called Credit Tranches. There are
articles required the member countries to cooperate towards: increasingly stringent conditions attached to the credit tranches
Increasing international monetary cooperation
ill terms of policies the country must agree to follow to
overcome its BOP deficit problem.
Promoting the growth of trade
In addition to this, the Fund over the years has considerably
Promoting exchange rate stability. expanded the lending facilities available to the members. Some
Establishing a system of multilateral payments, eliminating are meant to tide over short-term problems such as a temporary
exchange restrictions, which hamper the growth of world shortfall in exports or an unanticipated bulge in imports, while
trade, and encouraging progress towards. Convertibility of others are medium-term facilities designed to help a country
member currencies over-come some structural weaknesses, remove inefficiencies in
Building a reserve base
its production structure and increase its interna-tional competi-
tiveness. To be able to borrow from these facilities, the member
The responsibility for collection and allocation of reserves was
country must agree to a policy package worked out in consulta-
given to the role. It was also given the role of supervising the
tion with the Fund. Resources are made available in
adjustable peg system, rendering advice to member countries on
installments arid the IMF monitors the countrys performance
their international monetary affairs, promoting research in
with regard to the commitments it has given, the next install-
various areas of international economics and monetary
ment being released only after the fund is satisfied that the
economics, and providing a forum for discussion and consulta-
agreed upon policies are-being implemented.
tions among member notions.
IMFs approach towards providing structural adjustment
The initial quantum of reserves was contributed by the assistance and the associated conditionality has been the target
members according to quotas fixed for each. The size of the of criticism from various quarters. One type of criticism,
quota for a country depends upon its GNP, its importance in directed more at the govern-ments of the recipient countries,
international trade and related considerations. Each member comes from certain sections within those countries. One hears
country was required to contribute 25% of its quota m gold talk of capitulation to the IMF, selling out the countrys
and the rest m its own currency. Thus the Fund began with a interests and so on. In our view this sort of criticism is rather
pool of currencies of its members. The quotas have been misplaced. It is to be noted that many countries resort to IMF
revised several times since then, the last (11th) revision having
17
assistance at a point when other avenues of borrowing are more Table 2: Currency Composition of Foreign Exchange
INTERNATIONAL FINANCE MANAGEMENT
or less closed and the country is already in dire straits. Under Reserves
these condi-tions, it is natural that the lender would demand Currency Holding as of end of year 1999
certain covenants from the borrower. There can certainly be a
Billion SDRs Share (%)
debate about whatever the country should have opted for IMP
assistance or could have extricated itself out of the difficult US dollar 800.00 66.2
situation other means. We will not pursue that controversy here. Pound sterling 48.028 4.0
The other type of criticism, in our view more thoughtful, Swiss franc 8.406 0.7
concerns the appropriateness of lMFs policy package in the light Japanese yen 61.089 5.1
of the specific circumstances prevailing in the recipient country.
Particularly during the earlier year of operation of these facilities,
Euro 150.956 12.5
the IMF was accused of forcing a uniform, strait jacketed policy Total 1286.799
prescription on all countries irrespective of their individual
circumstances. Also, it was said, that the IMF did not take into Special Drawing Rights (SDRs)
account the social and political costs of enforcing the policies We have seen above that the dominant constituents of
and hence the ability of some governments to do so despite imitational reserves are gold and foreign exchange. (We can ignore
their best intentions. This line of criticism was voiced again after the reserve positions, which are rather small.) How is the stock of
the Asian crisis when interest rates in some of the affected these assets at a point in time determined? How is it related to
countries skyrocketed with considerable damage to their the liquidity requirements of the world monetary system?
economies and no significant reversal of capital outflows. This A short answer would be that they are determined arbitrarily by
debate too is outside the scope of this book. considerations unrelated to the needs of the system. The stock
International Liquidity and Special of gold depends upon new discoveries of gold deposits and
Drawing Rights (SDR) additions due to mining, of new gold, net of its other uses. Its
value is determined by market demand and supply with a large
International Liquidity and International element of speculative force
Reserves As to foreign exchange, its largest component, viz. US dollar
International liquidity refers to the stock of means of interna- assets depend upon the BOP deficits of US. We have seen
tional payments. International Reserves are assets, which a country above how this peculiar role of the key currency leads to the
can use in settle-ment of payment imbalances that arise in its Tiffin Paradox.
transactions with other countries. These are held by the mon-
During the sixties, several ideas were floated for the creation of
etary authority of a country and are used by them in carrying out
international fiat money, the stock of which can be monitored
interventions on the foreign exchange markets. In addition,
and controlled by some sort of a supranational monetary
private markets can provide liquidity by lending to deficit
authority, which would become the principal reserve asset. It
countries out of funds de-posited with them by the surplus
was felt that the addition to the stock of such an asset can be
countries. This sort of private financing of BOP deficits took
tuned to the growing liquidity would not then have to depend
place on a large scale during the post oil-crisis years and has
upon the vagaries of gold mining or the vicissitudes of US
come to be known as recycling of petrodollars. Table 1 provides
balance of payments.
some data on official holdings of reserve assets; while Table 2
shows the shares of the major convertible currencies in official At the 1967 Rio de Janeiro Annual Meeting of the IMF it was
holdings of foreign exchange assets. The unit of account in decided to create such an asset, to be called Special Drawing Rights
both these tables is SDRs, which are explained below. or SDRs. The required amendment to IMFs articles of agree-
ment was ef-fected in 1969. The IMF would create SDRs by
Table 1: Official Holding Of Reserve Assets
simply opening an account in the name of each member
country and crediting it with a certain amount of SDRs. The
Item Holding as of end march
total volume created has to be ratified by the governing board
2000 (in billions)
and its allocation among the members is proportional to their
Reserve position in the 54.30
quotas. The members can use it for settling payments among
IMF
themselves (subject to certain limits) as well as for transactions
SDRs 18.20 with the Fund e.g. paying the reserve tranche contribution of
Foreign exchange 1330.50 any increase in their quotas. The value of a SDR was initially
Total excluding gold 1402.80 fixed in terms of gold with the same gold content as the 1970
Gold US dollar. In 1974, SDR became equivalent to a basket of 16
currencies, and then in 1981 to a basket of five currencies (dollar,
Quality (millions of 960.70
sterling, deutschemark, yen, and French franc). After the birth of
ounces0
Euro the SDR basket includes four major freely usable
Value 197.40 currencies- viz. US dollar, Euro, British pound and Japanese yen.
Total including gold 1600.20
18
The Role of IMF in the normally made quarterly, with their release conditional upon
19
Contingent Credit Lines (CCLs) were established in 1999. Like
INTERNATIONAL FINANCE MANAGEMENT
accounts that requires an immediate IMF response. The EFM
the supplemental reserve facility, the CCL is designed to provide was established in September 1995 and was used to 1997 for
short term financing to help members overcome exceptional the Philippines, Thailand, Indonesia, and Korea, and in 1998
balance of payment problems arising from a sudden and for Russia.
disruptive loss of markets confidence. A key difference is that
Notes
the SRF is for use by members already in the midst of a crisis,
whereas the CCL is a preventive measure solely for members
concerned with their potential vulnerability to contagion but
not facing a crisis at the time of the commitment. In addition,
the eligibility criteria confine potential condidat4s for a CCL to
those members implementing policies considered unlikely to
give rise so a need to use IMF resources, whose economic
performance and progress in adhering to relevant internation-
ally accepted standards has been assessed positively by the
LMF in the latest article IV consultation and thereafter, and
which have constructive relations with private sector creditors
with a view to facilitating appropriate private sector involve-
ment. Resources committed under a CCL can be activated only
if the Board determines that the exceptional balance of
payments financing needs faced by a member have arisen owing
to contagion that is circumstances largely beyond the mem-
bers control stemming primarily from adverse developments in
international capital markets consequent upon developments in
other countries. The repayment period for and rate of charge on
CCL financing are the same as for the SRF.
The Compensatory Financing Facility (CFF), formerly the
compensatory and contingency financing facility (CCFF),
provides timely financing to members experiencing a temporary
shortfall in export earnings or an excess in cereal import costs, as
a results of forces largely beyond the members control. In
January 2000, the executive board decided to eliminate the
contingency element of the CCFF since it had rarely been used;
see the discussion in this chapter.
The IMF also provides emergency assistance to a member facing
balance of payment difficulties caused by a natural disaster. The
assistance is available through outright purchases, usually
limited to 25 percent of quota, provided that the member is
cooperating with the IMF to find a solution to its balance of
payments difficulties. In most cases, this assistance has been
followed by an arrangement with the IMF under one of its
regular facilities in 1995 the policy on emergency assistance was
expanded to include well defined post conflict situations where
a member institutional and administrative capacity has been
disrupted as a result of conflict, but where there is still sufficient
capacity for planning and policy implementation and a demon-
strated commitment on the part of the authorities. And where
there is an urgent balance of payments need and a role for the
IMF in catalyzing support from official sources as part of a
concerned international effort to address the post conflict
situation. The authorities must state their intention to move as
soon as possible to a stand by extended, or poverty reduction
and growth facility arrangement.
The Emergency Financing Mechanism (EFM) is a set of
procedures that allow for quick executive Board approval of
IMF financial support to a member facing a crisis in its external
20
INTERNATIONAL FINANCE MANAGEMENT
FUNCTIONALITIES OF THE ECONOMIC AND MONITORY UNION (EMU)
21
Table 3: Fixation of Uro Currency vs. Other Currencies
INTERNATIONAL FINANCE MANAGEMENT
22
UNIT 2
INTERNATIONAL BANKING AND
FINANCIAL MARKETS
THE GLOBAL FINANCIAL MARKET CHAPTER 4: INTERNATIONAL
FINANCIAL MARKET
23
adoption of capi-tal adequacy norms proposed by the Basle
INTERNATIONAL FINANCE MANAGEMENT
24
INTERNATIONAL FINANCE MANAGEMENT
DOMESTIC AND OFF-SHORE MARKETS
Learning Objectives Finally, it must be pointed out that though nature of regulation
To let you know how domestic financial market is different continues to distinguish domestic from offshore markets,
from off- shore market in terms of regularly instrument put almost all domestic markets have segments like private place-
in place ments, unlisted bonds, and bank loans where regulation tends
to be much less strict. Also, the recent years have seen emergence
To help you to learn further how Basle Accord is presently
of regu-latory norms and mechanisms, which transcend
helping achieve common global regulation and minimize
national boundaries. With removal of barriers and increasing
regulatory distinction between domestic and off- shore
integration, authorities have realized that regulation of financial
capital market
markets and institutions cannot have a narrow national focus
To explain you the rationale of creation of Euro market and the markets will simply move from one jurisdiction to another.
its impact on off- shore markets To minimize the probability of systemic crises, banks and over
Financial assets and liabilities denominated in a particular financial institutions must be subject to norms and regulatory
currency-say the US dollar-are traded primarily in the national provisions that are common across countries. One example of
financial markets of that country. In addition, in the case of such transnational regulation is the Basle Accord under which
many convertible curren-cies, they are traded outside the country the advanced OECD economies have imposed uniform capital
of that currency. Thus bank deposits, loans, promissory notes, adequacy norms on banks operating within their jurisdictions.
bonds denominated in US dollars are bought and sold in the In the near future other sequent of the financial markets may
US money and capital markets such as New York as well as the also be subjected to common global regulation, which will
financial markets in London, Paris, Singapore and other centers reduce, if not eliminate the regulatory distinctions between
outside the USA. The former is the domestic market while the domestic and offshore markets.
latter is the offshore market in that currencies each, often in turn,
As mentioned above, the Eurocurrencies market is the oldest
will have a menu of funding avenues. Neither while it is true
and largest offshore market. We now proceed to describe the
that both markets will offer all the financing options nor that
essential features of this market.
any entity can access all segments of a particular market, it is
generally seen that a given entity has access to both the markets, Euro Markets
for placing as well as for raising funds. Are they then really two What are they?
distinct markets or should we view the entire global financial Prior to 1980, Euro currencies market was the only truly
market as a single market? international financial market of any significance. It is mainly an
There is no unambiguous answer to this question. On the one interbank market trading in time deposits and various debt
hand, since as mentioned above, a given investor or borrower instruments. A Eurocurrency Deposit deposit is a deposit in
will normally have equal access to both the markets, arbitrage the relevant currency with a bank outside the home country of
will ensure that they will be closely linked together in terms of that currency. Thus, a US dollar deposit with a bank in London
costs of funding and returns on assets. On the other hand, they is a Eurodollar deposit; a Deutschemark deposit with a bank in
do differ significantly on the regulatory dimension. Major Luxembourg is a Euro mark deposit. Note that what matters is
segments of the domestic markets are usually subject to strict the location of the bank neither the ownership of the bank nor
supervision and regulation by relevant national authorities such ownership of the deposit. Thus a dollar deposit belonging to
as the SEC, Federal Reserve in the US, and the Ministry of an American company held with the Paris subsidiary of an
Finance in Japan and the Swiss National Bank in Switzerland. American bank is still a Eurodollar deposit. Similarly a Eurodol-
These authorities regulate non-resident entities access to the lar Loan is a dollar loan made by a bank outside the US to a
public capital markets in their countries by laying, down customer or another bank. The prefix Euro is now outdated4
eligibility criteria, disclosure and accounting norms, and since such deposits and loans are regularly traded outside
registration and rating requirements. Domestic banks are also Europe, for instance in Singapore and Hong Kong (These are
regulated by the concerned monetary authorities and may be sometimes called Asian dollar markets). While London,
subject to reserve re-quirements, capital adequacy norms and Continues to be the main Earmarked center for tax reasons
deposit insurance. The offshore markets on the other hand loans negotiated in London are often booked in tax haven
have minimal regulation often no registration formalities and centers such as Grand Cayman and Nassau.
importance of rating varies. Also, it used to be the case that
Over the years, these markets have evolved a variety of instru-
when a non-resident entity tapped a domestic market, tasks like
ments other than time deposits and short-term loans. Among them
managing the issue, under- writing and, so on, were performed
are Certificates of Deposit (CDs), Euro Commercial Paper (ECP),
by syndicates of investment banks based in the country of issue
medium to long-term floating rate loans, Eurobonds5, Floating
and, investors were, mostly residents of that country.
Rate Notes (FRNs) and Euro Medium-Term Notes (EMTNs).
25
As mentioned above, the key difference between Euro markets Against these .are to be set the obvious advantages of the
INTERNATIONAL FINANCE MANAGEMENT
and their domestic counterparts is one of regulation. For markets such as (I) more efficient allocation of capital world-
instance, Euro banks are free from regulatory provisions such as wide, (2) smoothing out the effects of sudden shifts in balance
cash reserve ratio, deposit insurance and so on, which effectively of payments imbalances e.g. recycling of petrodollars men-
reduces their cost of funds. Eurobonds are free from rating and tioned above without which a large number of oil importing
dis-closure requirements applicable to many domestic issues as countries would have had to severely deflate their economies
well as registration with securities exchange authorities. This after the oil crisis), and (3) the spate of financial innovations
feature makes it an attractive source of funding for many that have been created by the market which have vastly enhanced
borrowers and a preferred invest-ment vehicle for some the ability of companies and government to better manager
investors compared to a bond issue, in the respective domestic their financial risks and so on.
markets.
An Overview of Money Market
Multiple Deposit Creation by Euro Banks Instruments
Like any other fractional reserve banking system, Euro banks During the decade of the eighties the markets have evolved a
can generate multiple expansions of Euro deposits on receiving wide array of funding instruments. The spec-trum ranges from
a fresh injection of cash. the traditional bank loans to complex borrowing packages
The traditional approach to this issue treats Euro banks involving bonds with a variety of special features coupled with
analogously with banks within, a domestic monetary system derivative products such as options and swaps. The driving
except that the cash reserve ratio of the former is voluntarily forces behind these innovations have diverse origins. Such as
decided, while for the latter it is often statutorily fixed. (Actually floating rate loans and bonds, reflect investor pref-erence
even in the latter case, authorities specify only the minimum towards short-term instruments in the light of interest rate
reserve ratio. Banks can hold excess reserves). Following the volatility. Some, such as Note Issuance Facilities, permit the
traditional reasoning, deposits give rise to loans which in turn borrower to raise cheaper funds directly from the investor while
give rise to deposits perhaps with some leakages, at each stage a having a fallback facility. Some, such as swaps, have their origins
fraction being added to reserves. in the borrowers desire to reshuffle the composition of their
liabilities (as also investors desire to reshuffle their asset
Economic Impact of Euro Markets portfolios). Some, such as medium term notes, were designed
And Other Offshore Markets to fill the gap between very short-term instruments such as
The emergence and vigorous growth of Euro markets and their commercial paper and Long-term instruments such as bonds.
(alleged) ability to create multiple deposit expansion without Some - an example is swaps again have their genesis in market
any apparent control mechanism, have given rise to a number participants drive to exploit capital market inefficiencies and
of concerns regarding their impact on international liquidity, on arbitrage possibilities created by differences across countries in
the ability of national monetary authorities to conduct an effec- tax regulations.
tive monetary policy, and on the soundness of the international Notes
financial system. Among the worries expressed are:
1. The market facilitates short-term speculative capital flows-the
so-called hot money-creating enormous difficulties for
central banks in their intervention operations designed to
stabilize ex-change rates.
2. National monetary authorities lose effective control over
monetary policy since domestic residents can frustrate their
efforts by borrowing or lending abroad. It is known that
with fixed or managed exchange rates; perfect capital mobility
makes monetary policy less effective. Euro markets contrib-
ute to increasing the degree of international capital mobility.
3. The market is based on a tremendously large volume of
interbank lending. Further, Euro banks are engaged in
maturity transformation, borrowing short and lending long.
In the absence of a lender of last resort a small crisis can
easily turn into a major disaster in the financial markets.
4. Euro markets create private international liquidity and in
the absence of a central coordinating au-thority they could
create too much contributing to inflationary tendencies in
the world economy.
5. The markets allow central banks of deficit countries to
borrow for balance of payments purposes thus enabling
them to put off needed adjustment measures.
26
UNIT 2
INTERNATIONAL BANKING
AND FINANCIAL MARKET
STRUCTURE OF FOREIGN
CHAPTER 5: FOREIGN EXCHANGE
EXCHANGE MARKET
MARKET
CHapter Orientation
Learning Objectives the near future, However, for corporate customers of banks,
To help you understand foreign exchange market structure as dealing on the telephone-will con-tinue to be an important
a central trade clearing mechanism channel.
To acquaint you with the functioning of the exchange market Geographically, the markets span all the time zones from New
as a retail market and Inter- bank market Zealand to the West Coast of the United States. When it is 3.00
p.m. in Tokyo it is 2.00 p.m. in Hong Kong. When it is 3.00
To let you know about types of transactions and settlement
p.m. in Hong Kong it is 1.00 p.m. in Singapore. At 3.00 p.m. in
procedure
Singapore, it is 12.00 noons in Bahrain. When it is 3.00 p.m. in
Impart knowledge on the functioning of exchange rate Bahrain it is noon in Frankfurt and Zurich and 11.00 a.m. in
quotations and arbitrage and the mechanics of interbank London. 3.00 p.m. in London is 10.00 a.m. in New York. By
trading. the time New York is starting to wind down at 3.00 p.m., it is
Foreign Exchange Market as a noon in Los Angeles. By the time it is 3.00 p.m. in Los Angeles
it is 9.00 a.m. of the next day in Sydney. The gap between New
Central Trade Clearing House
York closing and Tokyo opening is about 2.5 hours. Thus, the
The foreign exchange market is an over-the-counter market; this
market functions virtually 24 hours enabling a trader to offset a
means that there is no single physical or electronic market place
position created in one market using another market. The five
or an organized exchange (like a stock exchange) with a central
major centers of inter-bank currency trading, which handle more
trade clearing. Mechanism where traders meet and exchange
than two thirds of all forex transactions, are London, New
currencies, The market itself is actually a worldwide network
York, Tokyo, Zurich, and Frankfurt. Transactions in Hong
9finter-bank traders, consisting primarily of banks, connected
Kong, Singapore, Paris and Sydney account for bulk of the rest
by telephone lines and computers, While a large part of inter-
of the market.
bank trading takes place with electronic trading systems such as
Reuters Dealing 2000 and Electronic Broking Systems, banks Exchange-Rate Definitions:
and large commercial, that is, corporate customers still use the The exchange rate is simply the price of one currency in terms
tel-ephone to negotiate prices and conclude the deal. After the of another, and there are two methods of expressing it:
transaction, the resulting market bid/ask price is then fed into 1. Domestic currency units per unit of foreign currency - for
computer terminals provided by official market reporting service example, taking the pound sterling as the domestic currency,
companies (networks such as Reuters@, Bridge Information on 16 August 1997 there was approximately 0.625 required
Systems@, Telerate@), The prices displayed on official quote to purchase one US dollar.
screens reflect one of maybe dozens of simultaneous deals 2. Foreign currency units per unit of the domestic currency -
that took place at any given moment. New technologies such as again taking the pound sterling as the domestic currency, on
the Interpreter 6000 Voice Recognition System-VRS-which 16 August 1997 approximately $1.60 were required to obtain
allows forex traders to enter orders using spoken commands, one pound.
are presently being tested, and may be widely adopted by the in-
ter-bank community in the years to come, On-line trading The students will note that second method is merely the
systems have also been devised and may become the norm in reciprocal of the former. While it is not important which
27
method of expressing the exchange rate is employed, it is important foreign exchange centres are London, New York,
INTERNATIONAL FINANCE MANAGEMENT
necessary to be careful when talking about a rise or fall in the Tokyo, Singapore and Frankfurt. The net volume of foreign
exchange rate because the meaning will be very different exchange dealing globally was in April 1995 estimated to be in
depending upon which definition is used. A rise in the pounds excess of $1250 billion per day, the most active centres being
per dollar exchange rate from say 0.625/$1 to 0.70/$1 means London with a daily turnover averaging $464 billion, followed
that more pounds have to be given to obtain a dollar, this by New York with $244 billion and Tokyo with $161 billion,
means that the pound has depreciated in value or equivalently Singapore $105 billion with Paris $58 billion and Frankfurt $76
the dollar has appreciated in value. If the second definition is billion. Table 1 shows the global foreign exchange turnover
employed, a rise in the exchange rate from $1.60/1 to say between the years 1989 to 1995, the most heavily used currencies
$1.80/1 would mean that more dollars are obtained per and the most important centres for foreign exchange business.
pound, so that the pound has appreciated or e9uivalently the Easily the most heavily traded currency is the US dollar, which is
dollar has depreciated. known as a vehicle currency - because it is widely used to
Important Note denominate interna-tional transactions. Oil and many other
For the purposes of this chapter we shall define the exchange important primary products such
rate as foreign currency units per unit of domestic currency. This Note: I the estimated totals are net figures excluding the effects
is the definition most commonly employed in the UK where of local and cross-border double counting.
the exchange rate is quoted as, for example, dollars, Source - Bank for International Settlements.
deutschmarks or yen per pound, and is the definition most As tin, coffee and gold all tend to be priced in dollars. Indeed,
frequently employed when compiling real and nominal because the dollar is so heavily traded it is usually cheaper for a
exchange rate indices for all currencies. However, we shall British foreign exchange dealer wanting Mexican pesos, to firstly
normally be using the first definition, which is most often purchase US dollars and then sell the dollars to purchase pesos
employed in the theoretical economic literature. It is important rather than directly purchase the pesos with pounds.
when reading newspapers, articles or other textbooks that
The main participants in the foreign exchange market can be
readers familiarize themselves with the particular exchange-rate
categorized as follows and are shown in Exhibits 1 & 2.
definition being employed.
Retail Clients - these are made up of businesses, international
Structure of Foreign Exchange Market:
investors, multinational corporations and the like who need
Characteristics and Participants of the foreign exchange for the purposes of operating their busi-
Foreign Exchange Market nesses. Normally, they do not directly purchase or sell foreign
The foreign exchange market is a worldwide market and is made currencies themselves; rather they operate by placing buy sell
up primarily of commercial banks, foreign exchange brokers and order with commercial banks.
other authorized agents trading in most of the currencies of the
Commercial Banks - the commercial banks carry our buy/sell
world. These groups are kept in close and continuous contact
orders from their retail clients and buy/sell currencies on their
with one another and with developments in the market via
own account (known proprietary trading) so as to alter the
telephone, computer terminals, telex and fax. Among the most
structure of their assets and liabilities in different currencies. The
Tabl Foreign Exchange Market banks deal either directly with other banks of through foreign
e 1. Turnover exchange brokers. In addition to the commercial banks other
1989 1992 1995 financial institutions such as merchant banks are engaged in
buying and selling of currencies both for proprietary purposes
Global estimated and on behalf of their customers in finance-related transactions.
590 820 1190
turnovers
(US $ billions)
Currency composition (%) Customer buys $
US dollar 45 41 41.5 with DM
Deutschmark 13.5 20 18.5
Japanese yen 13.5 11.5 12 Stockbroker
Pound sterling 7.5 7 5 Local bank
Other 20.5 20.5 23
100 100 100
Total Foreign Major banks IMM LIFE
PSE
Geographic composition (%) exchange broker interbanks market
United Kingdom 26 27 30
United States 16 16 16
Japan 15 11 10 Local bank
Singapore 8 7 7 Stockbroker
Hong Kong 7 6 6
Switzerland 8 6 5 Customer buys
DM with $
Other 20 27 26
Total 100 100 100
28
Exhibit 1. Structure of Foreign Exchange Markets exchange to seek out one another, a foreign exchange market
29
OM per pound. If this were not the case and actual rate was 3 the European quote was $1 = SFr 1.4780. Nowadays, in trades
INTERNATIONAL FINANCE MANAGEMENT
OM per pound, then a UK dealer wanting dollars would do involving dollars, all except U.K. and Irish exchange rates are
better to first obtain 3 OM which will then buy $1.65, making expressed in European terms.
nonsense of a $1.60/1 quotation. The increased demand for In their dealings with non-bank customers, banks in most
deutschmarks would quickly appreciate its rate against the countries use a system of direct quotation. A direct exchange rate
pound to the 2.9091 OM levels, which level the advantage to quote gives the home currency price of a certain quantity of the
the UK dealer in buying deutschmarks first to then convert into foreign currency quoted (usually 100 units. but only one unit in
dollars disappears. Table 2 shows a set of cross rate for the the case of the U.S. dollar or the pound sterling). For example,
major currencies. the price of foreign currency is expressed in French francs (FF) in
France and in Deutsche marks (OM) in Germany. Thus, in
Table 2. Foreign Exchange Cross rates France, the Deutsche mark might be quoted at FF 4 while, in
On close of business August 11, 1997 Germany; the franc would be quoted at OM 0.25.
$ DM Yen F Fr S Fr Fl Ura C$ B Fr
There are exceptions to this rule, though. Banks in Great Britain
UK quote the value of the pound sterling (f) in terms of the
Pound 1 1.591 2.950 184.1 9.937 2.422 3.323 2878 2.217 60.96
()
foreign currency for example, f1 = $1.7625.This method of
US indirect quotation is also used in the United States for domestic
Dollar 0.629 1 1.854 115.7 6.247 1.522 2.089 1809 1.394 38.32
($) purpose and for the Canadian dollar. In their foreign exchange
German activities abroad, however, U.S. banks adhere to the European
Mark 0.339 0.539 1 62.41 3.369 0.821 1.127 975.7 0.751 20.66
(DM) method of direct quotation.
Japanese
Yen'> 0.543 0.864 1.602 100 5.398 1.315 1.805 1563 1.204 33.11 Banks do not normally charge a commission on their currency
(Y)
French
transactions, but profit from the spread between the buying
Franc" 1.006 1.601 2.969 185.3 10 2.437 3.345 2896 2.231 61.34 and selling rates. Quotes are always given in pairs because a
(F Fr)
Swiss
dealer usually does not know whether a prospective customer is
Franc
(S Fr)
0.413 0.657 1.218 76.03 4.104 1 1.372 1189 0.915 25.17 in the market to buy or to sell a foreign currency. The first rate is
Dutch the buy, or bid, price: the second is the sell, or ask, or offer, rate.
Guilder 0.301 0.479 0.888 55.39 2.990 0.729 1 866.0 0.667 18.34
(FI) Suppose the pound sterling is quoted at $1.7019-36. This quote
Italian 0.035 0.055 0.103 6.397 0.345 0.084 0.115 100 0.077 2.118
means that banks are willing to buy pounds at $1.7019 and sell
Lira* (L)
Canadian
them at $1.7036. In practice, dealers do not quote the full rate to
Dollar 0.451 0.718 1.331 83.05 4.483 1.092 1.499 1298 1 27.50 each other; instead, they quote only the last two digits of the
(C$)
Belgian decimal. Thus, sterling would be quoted at 19-36 in the above
Franc* 1.641 2.610 4.839 302.0 16.30 3.973 5.452 4721 3.636 100
(B Fr)
example. Any dealer who isnt sufficiently up-to-date to know
the preceding numbers will not remain in business for long.
Source: Financial Times, August 12, 1997. The Spot Exchange Rate
Note: The exchange rate is the units of the currency in the top The spot exchange rate is the quotation between two currencies
row per unit of the currency listed in the left-hand column. immediate delivery. In other words the spot exchange rate is
Where the following applies to the units on the left-hand the current exchange rate of two currencies vis--vis each other. In
column. practice, there is normally a two-day lag between a spot purchase
. French Francs 10, Yen 100, Lira 100, Belgian Francs 100. sale, and the actual exchange of currencies to allow for verifica-
tion, paperwork and clearing of payments.
The Spot Market
Transaction Costs
This section examines the spot market in foreign exchange. It
The bid-ask spread-that is, the spread between bids and asks rates
covers spot quotations, transaction costs, and the mechanics of
for a currency is based on the breadth and depth of the market for
spot trading.
that currency as well as in the currency volatility. This spread is
Spot Quotations usually stated as a percentage cost of transacting n the foreign
Almost all-major newspapers print a daily list of exchange rates. exchange market, which is computed as follows:
For major currencies, up to four different quotes (prices) are Illustration
displayed. One is the spot price. The others might include the 30- Calculating the Direct Quote for the Pound in Frankfurt.
day, 90-day, and 180-day forward prices. These quotes are for Suppose that sterling is quoted at $1. 7019-36. While the
trades among dealers in the interbank market. When interbank Deutsche mark is quoted at $0.6250 - 67. What is the direct
trades involve dollars (about 60% of such trades do), these quote for the pound in Frankfurt?
rates will be expressed in either American terms (numbers of U.S.
Percent spread = Ask price - Bid price x 100
dollars per unit of foreign currency) or European terms (number
of foreign-currency units per U.S. dollar). In The wall Street Ask Price
Journal, quotes in both American and European terms are listed
side by side (see Exhibit 2.3), For example, on February 6, 1990,
the American quote for the Swiss franc was SFr I = $0.6766, and
30
INTERNATIONAL FINANCE MANAGEMENT
Exhibit 3: Key Currency Cross Rates
Key currency cross rates : Late New York Trading Feb. 6.1990
Dollar Pound SFranc Guilder Yen Lira D-Mark FFrance Cinder
Canada 1.1874 2.0227 .80447 .63514 .00817 .00096 .71664 .21048 ..
France 5.6415 9.610 3.8222 3.0177 .03884 .00457 3.4049 4.7511
Germany 1.6569 2.8225 1.1226 .88628 .01141 .00134 Debt 29370 1.3954
Instruments Debt
Instruments Debt
Instruments Debt
Instruments
Italy 1234.3 2102.5 836.21 660.20 8.497 .. 744.92 218.78 1039.5
Japan 145.25 247.43 98.408 77.695 .11768 87.664 25.747 122.33
Netherlands 1.8695 3.1847 1.2666 .01287 .00151 1.1283 .33138 15744
Switzerland 1.4760 2.5144 .78952 .01016 .00120 .89082 .26163 1.231
U.K .58703 .39771 .31400 .00404 .00048 .35429 .10406 .49438
U.S. . 1.7035 .67751 .53490 .00688 .00081 .60354 .17726 .84218
Solution: The bid rate for the pound in Frankfurt can be found equivalent dollar amount at the agreed exchange rate and (2) the
by realizing that selling pounds for OM is equivalent to French suppliers account that is to be credited by FF 1 million.
combining two transactions: (I) selling pounds for dollars at Upon completion of the verbal agreement, the trader will
the rate of $1.7019 and (2) converting those dollars into OM forward a dealing slip containing the relevant information to the
1.7019/0.6267 = OM 2.7157 per pound at the ask rate of settlement section of his bank. That same day, a contract note-
$0.6267. Similarly, the OM cost of buying one pound (the ask that includes the amount of the foreign currency, the dollar
rate) can be found by first buying $1.7036 (the ask rate for 1) equivalent at the agreed rate, and confirmation of the payment
with OM and then using those dollars to buy one pound. instructions-will be sent to the importer. The settlement section
Because buying dollars for OM is equivalent to selling OM for will then cable the banks correspondent (or branch) in Paris,
dollars (at the bid rate of $0.6250), it will take OM 1.7036/ requesting transfer of FF 1 million from its nostro account-that
0.6250 = OM 2.7258 to acquire the $1.7036 necessary to buy one is, working balances maintained with the correspondent to
pound. Thus, the direct quotes for the pound in Frankfurt are facilitate delivery and receipt of currencies-to the account
OM 2.7157-7258. specified by the importer. On the value date, the U.S. bank will
For example, with pound sterling quoted at $1.7019 36, the debit the importers account, and the exporter will have his
percentage spread equals 0.1%: account credited by the French correspondent.
1.7036 1.7019 At the time of the initial agreement, the trader provides a clerk
Percent spread = = 0.1% with the pertinent details of the transaction. The clerk, in turn,
constantly updates a position sheet that shows the banks position
1.7036
by currency (as well as by maturities of forward contracts). A
For widely traded currencies, such as the pound, DM and yen, number of the major international banks have fully computer-
the spread might be in the order of 0.1 0.5%. Less heavily ized this process to ensure accurate and instanta-neous
traded currencies have higher spreads. These spreads have information on individual transactions and on the banks
widened appreciably for most currencies since the general switch cumulative currency expo-sure at any time. The head trader will
to floating rates in early 1973. monitor this information for evidence of possible fraud or
Cross-Rates: Because most currencies are quoted against the excessive exposure m a given currency.
dollar, it may be necessary to work out the cross-rates for Because spot transactions are normally settled two working days
currencies other than the dollar. For example, if the Deutsche later, a bank is never certain until one or two days after the deal
mark is selling for $0.60 and the buying rate for the French franc is concluded whether the payment due the bank has actually
is $0.15, then the DM (FF cross-rate is DM 1 = FF 4. Exhibit been made. To keep this credit risk in bounds, most banks will
contains cross rates for major currencies on February 6, 1990. transact large amounts only with prime names (other banks or
The Mechanics of Spot Transactions corporate customers).
The simplest way to explain the process of actually settling Exchange Rate Quotations and Arbitrage
transactions in the spot market is to work through an example. An exchange rate between currencies A and B is simply the price
Suppose a U.S. importer requires FF 1 million to pay his French of one in terms of the other. It can be stated either as units of
supplier. After receiving and accepting a verbal quote from the B per unit of A or units of A per unit of B. In stating prices of
trader of a U.S. bank, the importer will be asked to specify two goods and services in terms of money, the most natural format
accounts: (l) the account in a U.S. bank that he wants debited for the is to state them as units of money per unit of the good -rupees
31
per liter (or per gallon or whatever) of milk-rather than as units lira. (The reason is otherwise we will have to deal with very
INTERNATIONAL FINANCE MANAGEMENT
of a good per unit of money. When it is two monies, either small numbers). The notational confusion can get further
way would be equally natural. The choice of a unit is also a compounded when we have to deal with two-way, bid-ask
matter of convenience. (Price of rice is given in rupees per quotes for each exchange rate.
kilogram in the retail market, and rupees per quintal in whole- The inter-bank market uses quotation, conventions adopted by
sale mar-kets). ACI (Association Cambiste International), which we will use in
Before proceeding, let us clarify the way we will designate the this book. These conventions are described below:
various currencies in this book. The International Standards A currency pair is denoted by the 3-letter SWIFT codes for the
Organization has developed three-letter codes for all the two currencies separated by an ob-lique or a hyphen
currencies, which abbreviate the name of the country, as well as
Examples: USD/CHF: US Dollar-Swiss Franc
the currency. These codes are used by the SWIFT network,
which affects inter-bank funds transfers. Depending upon the GBP/JPY: Great Britain Pound-Japanese Yen
context we will either use the full name of a currency such as US The Mechanics of Inter- Bank Trading
dollar, Swiss franc, Pound sterling and so on, or the ISO code. As discussed above, the main actors in the forex markets are the
A complete list of ISO codes is given at the end of this book. primary market makers who trade on their own account, and
Here we will give the codes for selected currencies, which will be make a two-way bid-offer market. They deal actively and
frequently used in the various examples. continuously with each other, and with their clients, central
USD: US Dollar EUR: Euro banks, and sometimes with currency brokers. In the process of
GBP: British Pound IEP: Irish Pound (Punt) dealing, they shift around their quotes, actively take positions,
offset positions taken earlier or roll them forward. Their
JPY: Japanese Yen CHF: Swiss Franc
performance is evaluated on the basis of the amount of profit
CAD: Canadian Dollar AUD: Australian Dollar their activities yield, and whether they are operating within the
DEM: Deutschemark SEK: Swedish Kroner risk parameters established by the management. It is a high-
NLG: Dutch Guilder BEF: Belgian Franc tension business, which requires an alert mind, quick reflexes,
and the ability to keep ones cool under pressure
FRF: French Franc DKK: Danish Kroner
ESP: Spanish Peseta ITL: Italian Lira
Inter-bank Dealing
We have said that primary dealers quote two-way prices and are
INR: Indian Rupee SAR: Saudi Riyal willing to deal on either side, that is, buy or sell the base currency
Further, unless otherwise stated, Dollar will always mean the up to conventional amount at those prices. However, inter-bank
US dollar; pound or sterling will always denote the British markets; this is a matter of mutual accommodation. A dealer will
pound sterling and rupee will invariably mean the Indian be shown a two-way quote only If he or she extends that
rupee. We will fre-quently use just the symbols $, and privilege to fellow dealers when they call for a quote.
to designate the USD, the GBP and the JPY respectively. These days in the interbank market deals are mostly done with
Spot Rate Quotations computerized dealing systems such as Reuters. Real time
In foreign exchange literature, one comes across a variety of information on exchange rates is provided by a number of
terminology, which can occasionally lead unnecessary confusion information services including Reuters, bridge, and Bloomberg.
about simple matters. You will hear about quotations in Sample screens from Reuters forex page and bridge informa-
European Terms and quo-tations in American Terms. The former tion system are shown below
are quotes given as number of units of a currency per US dollar. A sample screen from Reuters FoXE: USD/ INR
Thus, EUR 1.0275 per USD, CHF 1.4500 per USD, INR 46.75
per USD are quotes in European terms. Quotes in American
Last update onn25/09/2000 at 7.45:00 PM (IST)
terms are given as number of US dollars per unit of a currency.
Spot Bid: 45,9500 Spot Ask: 46.1500
Thus USD 0.4575 per CHF, USD 1.3542 per GBP is quotes in
Forward rates Forward rates Swap %
American terms. The prevalence of this terminology is due to
the common practice mentioned above of quoting all exchange (annualized)
rates against the dollar. Period Value Date Bid Ask Bid Ask Bid Ask
month
You will occasionally come across terminology such as direct
quotes and indirect quotes. (The latter are also called reciprocal or 1 27/10/2000 46.1250 46.3450 17.50 19.50 4.63 5.14
inverse quotes). In a country, direct quotes are those that give month
units of the currency of that country per unit of a foreign 2month 27/11/2000 46.3300 46.5500 38.00 40.00 4.95 5.19
currency. Thus INR 46.00 per USD is a direct quote in India and 3 27/12/2000 46.5350 46.7550 58.50 60.50 5.11 5.26
USD 0.9810 per EUR is a direct quote in the US. Indirect or month
reciprocal quotes are stated as number of units of a foreign 6 27/03/2001 47.0650 47.2850 111.50 113.50 4.89 4.96
currency per unit of the home currency. Thus USD 2.2560 per month
INR 100 is an indirect quote in India.4 Notice here that the 12 27/09/2001 48.1250 48.3450 217.50 219.50 4.73 4.76
unit for rupees is 1O0s. Similarly, for currencies like Japanese month
yen, Italian Lira, quotations may be in terms of 100 yen or 1000
32
A sample screen from return FoXE: EUR/ INR
33
INTERNATIONAL FINANCE MANAGEMENT
Learning objective: market, and the rates may have moved against the bank in the
To expose you to the mechanics of the functioning of the meanwhile. This is known as reverse exchange rate risk.) If
intermediary and derivative instruments such as forward the firm has a credit line with the bank, the amount of the
quotations, option forwards, swaps; short date contracts are credit line will be usually reduced by the amount involved in the
effectively used in the foreign exchange market to gain forward contract. The forward desk must obtain the approval
leverage. of the banks credit department before entering into a forward
contract with a party that is not the banks usual client. Some-
Forward Quotations times the bank may decline a customers request for a forward
Outright Forwards contract if it can-not satisfactorily verity the customers credit
Quotations for outright forward transactions are given in the status. Sometimes, the bank may ask the firm for collateral in
same manner as spot quotations. Thus a quote that like: the form of a deposit equal to a certain percentage of the value
USD/SEK 3-Month Forward: 9.1570/9.1595 means, as in the of the contract. The deposit earns interest so there is no explicit
case of a similar spot quote, that the bank will give SEK 9.1570 cash cost. It is only a performance bond.
to buy a USD and require SEK9.1595 to sell a dollar, delivery 3 Swaps in Foreign Exchange Markets:
months from the corresponding spot value date.
Swap Margins and Quotations
Calculate of inverse rates and the notion of two-point arbitrage Recall that a swap transaction between currencies A and B con-
also carries over from the corresponding spot rates. Given the sists of a spot purchase (sale) of A coupled with a forward sale
above USD/SEK 3-month forward quotation, (purchase) of A both against B. The amount of one of the
SEK/USD 3-month forward = (1/4.4595)/(1/1.4570) = currencies is identical in the spot and forward. Since usually there
0.2242/0.2244 will be a forward discount or premium on a vis--vis B, the rate
Similarly, calculations of synthetic cross rates and relation applicable to the forward leg of the swap will differ from that
between synthetic and direct quotes to pre-vent three-point appli-cable to the spot leg. The difference between the two is the
arbitrage are also same as in case of spot rates. Given swap margin, which corresponds to the forward premium or
discount. It is stated as a pair of swaps points to be added to or
USDIINR I-month forward: 47.6955/47.6965
subtracted from the spot rate to arrive at the implied outright
USD/CHF I-month forward: 1.4550/1.4555 forward rate. We will clarify this in detail shortly.
The synthetic CHF/INR I-month forward quote is: While banks quote and do outright forward deals with their
CHF/INR I-month forward = (47.6955/1.4555)/(47.6865/ non-bank customers, in the inter-bank mar-ket forwards are
1.4550) = 32.7691/32.7811 done in the form of swaps. Thus, suppose a bank buys
We will see below that in the interbank market, forward quotes pounds one month forward against dollars from a customer, it
are given not in this manner but as a pair of swap points, to has created a long position in pounds (short in dollars) one-
be added to or subtracted from the spot quotation. month forward. If it wants to square this in the inter-bank
market it will do it as follows:
Option Forwards
A swap in which it buys pounds spot and sells one month
A standard forward contract calls for delivery on a specific day,
forward, thus creating an offsetting short pound position
the settlement date for the contract. In inter-bank market, banks
one month forward
offer what are known as optional forward contracts or option
forwards. Here the contract is entered into at some time to, with Coupled with a spot sale of pounds to offset the long
the rate and quantities being fixed at this time, but the buyer pound position in spot created in the above swap.
has the option to take or make delivery on any day between t1 The reason for this is that it is very difficult to find counter parties
and t2 with t2> t1 > to. with matching opposite needs to cover the original position by
Margin Requirement an opposite outright forward, whereas swap position can be
When a forward contract is between two banks, nothing more easily offset by dealing in the Euro deposit markets.
than a telephonic agreement on the price and amount is As mentioned above, in the interbank market outright forward
involved. However, when a bank enters into a forward deal with quotes for a given maturity are derived from the spot quote and
a non-bank corporation, it will want to protect itself against the a pair of swap margins applicable to that maturity.
possibility that the firm may default on its commitment.
Forward - Forward Swaps
(Remember that the bank will have squared its position by
The swaps we have looked at so far are spot-forward swaps it is
entering into an opposite forward contract with another party.
possible to do a swap between two forward dates. For instance,
If the firm defaults, the bank must fulfill its commitment to
purchase (sale) of currency a 3-months forward and simulta-
that party possibly by buying the relevant cur-rency in the spot
34
neous sale (purchase) of currency a 6-months forward, both rata to get 10 days points as (10/30) X 75 = 25, which are
35
INTERNATIONAL FINANCE MANAGEMENT
36
swaps, mainly for Ads to adjust their positions in various market do not necessarily determine the structure of forward
37
UNIT 2
INTERNATIONAL BANKING AND
FINANCIAL MARKET
INTERNATIONAL TRADE IN
CHAPTER 6: INTERNATIONAL BANKING
BANKING SERVICES
SYSTEMS
INTERNATIONAL FINANCE MANAGEMENT
The primary role of banks is direct intermediation between the borrower and the lends, though most banks in the national level
are engaged in other financial activities, including feebased services, offbalance sheet business and general risk management. In
this chapter you will be exposed to the theory and practices of international banking, because of its critical importance in the
modern banking frame and direct bearing on international trade. In this chapter you will learn the definition of an international
bank, international trade in banking services, the multinational banks, international payment systems, interbank market and the
problems faced by the developing countries in international banking through following sections in International trade in banking
services:
(i) Multinational banking operations
(ii)Structuring international trade transaction
38
diversification and/or credit evaluation services on a global basis risks of international transactions, just as it does in the purely
39
Obligations on other payment or clearing systems can be Notes
INTERNATIONAL FINANCE MANAGEMENT
40
INTERNATIONAL FINANCE MANAGEMENT
MULTINATIONAL BANKING OPERATIONS
41
As the globalization of banking increases, consumer surplus The role foreign banks are allowed to play is an important
INTERNATIONAL FINANCE MANAGEMENT
should rise, for several reasons. First, international banking differentiating characteristic of banking systems in developing
should increase the efficiency of the international flow of countries. In many of the very small lesser developing countries
capital. Prior to recent developments, the transfer of capital was (LDCs) (for example, the Bahamas, Barbados, Fiji, the
achieved primarily through foreign direct investment and aid- Maldives, St Lucia, Seychelles, the Solomon Islands, and
related finance. The Eurocurrency markets have enhanced the Western Samoa) the banking system is dominated by branches
efficient flow of capital by bringing together international or subsidiaries of foreign, commercial banks. By contrast, in
lenders and borrowers. For sample, the absence of regulation some of the large developing countries such as Thailand,
on the Euro market has Permitted marginal pricing on loans foreign banks are prohibited from operating, or are restricted in
and deposits-the unconstrained LIBOR* rates have eliminated their activities to certain types of business in specified parts of
credit squeezes, which tend to arise under an administered rate. the country.
New capital movements will be observed if, prior to the There are a number of problems related to banking structure,
emergence of the system, interest rates varied across counties. which are com-mon to all developing countries. Hanson and
As was observed earlier there is no doubt the Euro markets Rocha (1986) found high oper-ating costs in developing
enhanced the transfer of new capital between countries. countries, with high inflation rates and little or no, competition.
MNBs will increase the number of banks present in the Financial repression, which rises with inflation, raises bank cost
country; thereby increasing competitive pressure by eroding the ratios because it reduces the real size of the banking system and
traditional oligopolies of the domestic banking system. Greater encourages non-price competition. Take, for example, the case
competition among the international banks should, reduce the of Turkey. Fry (1988) looked at operating costs of the Turkish
price of international bank products. Domestic banking system banks as a percentage of total assets. It was 6.6% in 1977 and by
will also be under greater competitive pressure if some of the 1980 had risen to 9.5%. The causes of high operating costs
countrys consumers are able to purchase international bank were interest rate ceilings, an oligopolistic and cartelised bank-
products and by-pass higher prices in the domestic market. As a ing sector, accelerating inflation, and high and rising reserve
result, there should be more competitive pricing in domestic requirements.
markets, for those customers who have the option of going Inflation, if unanticipated, is likely to be profitable for banks.
offshore (mainly corporate). The banks will hold deposits, which decline, in real value on a
International banking activities can also be responsible for a daily or even hourly basis. They also lend to government at high
number of welfare costs. First revenue for central government short-term interest rates. The outcome is high windfall profits,
may be reduced. If a central bank imposes reserve requirements which, if prolonged, will mask inefficiencies in the banking
on deposits in the banking system, the introduction of system.
international banking facilities will lead to the flow of funds out Reserve requirements tend to be higher in developing nations,
of the domestic banking system and into the international which also raises bank-operating costs. A reserve ratio is the
system where deposit rates are higher. A reserve ratio require- percentage of total deposits a bank must place at the central
ment is a form of taxation on the banking system because it bank. No interest is earned, so reserves are a tax.
requires idle funds to be held at the central bank. The reduced
In many developing countries economic regulation (for
volume of domestic deposits as they move offshore will reduce
example, interest rate control) has led to the growth of an
government revenues accruing from this source. These will be
unregulated curb market, which is an important source of
reduced still further if the competition forces the central bank to
funds for both households and businesses. It becomes active
abandon the reserve ratio requirement, or eliminate controls on
under conditions of a heavily regulated market with interest
deposit rates. To make good the loss from the implicit tax on
rates that are held below market levels. In the republic of Korea,
bank reserves, the government may impose a new type of
it was estimated that in 1964 obligations in the curb market
distortionary taxation.
were about 70% of the volume of loans outstanding by
Impact of Multinational Banks commercial banks. By 1972 this ratio had fallen to about 30%
on Developing Countries largely as a result of interest rate reforms in the mid 1960s. In
The evolution of financial systems in developing countries and the late 1970 the market grew very rapidly after intervention by
emerging markets reflects diverse political and economic the monetary authorities. Recently, the market has declined, as
histories. While some emerging markets, particularly in Asia, business shifted from the curb market to non-banked financial
exhibit a relatively high degree of financial stability, others in institutions that are allowed to offer substantially higher
Latin America and some former Soviet states experience returns. In Iran, there are moneylenders in the bazaar, where the
frequent bouts of instability. interest rate changed on a loan runs between 30% and 50%. In
Argentina, the curb market grew after interest rate controls were
Commercial banks are normally the first financial institutions to
re-imposed. About 70 80% of small to medium-sized firm
emerge in the process of economic development, providing the
credit obtained from the curb market is extended without
most basic intermediary and payment functions. Thailand is a
collateral, but most are reputed to use a sophisticated credit-
good example. It is highly concentrated, with the Bangkok Bank
rating system. The average annual interest rate on curb loans can
holding about 40% of bank assets. The five largest commercial
be two to three times higher than the official rate on financial
banks hold about four-fifths of total assets.
42
intermediation because the higher the reserve ratio, the lower
43
INTERNATIONAL FINANCE MANAGEMENT
44
basis. Together, they afford the exporter protection in sell-ing country (LDC) or in an Eastern European nation. It is the
45
UNIT 2
INTERNATIONAL BANKING AND
FINANCIAL MARKET
FUNDAMENTAL EQUIVALENCE CHAPTER 7: DETERMINATIONS OF
RELATIONSHIP EXCHANGE RATES
INTERNATIONAL FINANCE MANAGEMENT
An exchange rate is the relative price of one currency in terms of another. However, unlike say the price of potatoes or comput-
ers, it is an extremely important relative price. It influences trade and capital flows cross national boundaries, relative profitability
of various industries, real wages of workers and, in the final analysis, allocation of resources with in and across countries.
Theoretical investigations of determinants of exchange rates have had a long history in international economics. During the
Bretton Woods era of fixed exchange rates, the economics profession was preoccupied with analyzing the effects of discrete,
policy-induced changes in levels of exchange rates. It was also an era of segmented capital markets and moderate international
capital flows. Effects of exchange rate changes - devaluations and revaluationswere investigated mostly form the point of view
of their impact on trade flows and hence on balance of payments. Exchange rate was treated as an exogenous variable, and
current account balance as an endogenous variable.
With the advent of floating rates in 1973 attention once again shifted to determinants of exchange rates themes selves. Since
then, economists and finance theorists have produced a prodigious output of theoretical studies and mountains of (often
conflicting and confusing) empirical evidence. New theories continue to be formulated, old ones re examined and more and
more sophisticated statistical techniques continue to be employed in empirical investigations. The net result has been more
sophisticated statistical techniques continue to be employed in empirical investigations. The net result has been more a sense of
frustration and general dissatisfaction with the state of exchange rate economics than a clearer understanding of exchange rate
behavior. We now seem to understand, individually, several separate dimensions of the problem of exchange rate determination
role of current account balance, relative monetary growth, inflation differentials, capitals flows and assets, composition,
expectations, news, and so on but not how they all tie together.
The corporate finance manager need not necessary undertake the task of forecasting exchange rates himself or herself. Exchange
rate forecasts can be purchased from professional forecasting services provided, usually, by commercial banks, however, the
manager must have sufficient familiarity with the basics of exchange rate economics to be able to evaluate the forecasts provided
by the professionals.
This chapter attempts to equip you with such an understanding for facilitating a clean understanding about the different facets of
exchange rate determination especially in relation to fundamental theories as well as various models established including the
roles of the central bank in determining and forecasting the viable exchange rates etc the chapter is broadly divided into following
three segments:
46
Now it is no more true that
47
(1 + niA ) / (1 + niB ) = Fn (B/A) / S (B/A)
INTERNATIONAL FINANCE MANAGEMENT
48
INTERNATIONAL FINANCE MANAGEMENT
STRUCTURAL MODELS FOR
FOREIGN EXCHANGE AND EXPOSURE RATE
Learning Objectives
To discuss with you at some length some of conventional as B S D S
well as newly developed and structured models of exchange Exchange Exchange
Rate EUR/$ Rate EUR/$
rate determination.
E E
To guide you to use these models for exchange rate
forecasting.
S D S D
Exchange rate theory has occupied some of the best minds in
No. Of Dollars No. Of Dollars
the economics profession during the last couple of decades. At
one end of the spectrum there are relatively simple flow models Fig 2 Fig 3
49
development in the home country has no effect on the price portfolio risk depends upon the covariance of its return with
INTERNATIONAL FINANCE MANAGEMENT
level in the foreign country. the portfolio return. Hence the proportion of total wealth
In each country there is a stable demand - for - money invested in a particular risky asset depends upon its expected
function. This means that demand for real money balances return and its covariance with portfolio return. The technical
depends upon a few variables like real income and nominal details of the mean-vari-ance approach can be found in the
interest rate and the parameters of this relationship do not appendix to this chapter. As the supply of an asset changes, its
fluctuate over time. Foreign real income and interest rate are expected return is altered as investors reshuffle their portfolios.
exogenous. This leads to changes in demands for individual assets and,
given their supplies, changes in their prices.
Fully flexible exchange rates keep balance of payment in
continuous equilibrium. Consequently there is no change in Expectation Model
foreign exchange reserves. Nominal money supply is Although currency values are affected by current events and
therefore determined entirely by domestic credit creation, current supply and demand flows in the foreign exchange market.
which is totally under the control of monetary authorities. They also depend on expectations about future exchange rate
movements. And exchange rate expectations are influenced by
Capital Account Monetary Model
every conceiv-able economic, political, and social factor.
The assumption of PPP even in the short run as the
counterintuitive prediction about the effect of interest rate The role of expectations in determining exchange rates depends
changes on exchange on exchange rate have often been carried as on the fact that currencies are financial assets and that an exchange
serious weakness of the current account monetary model. rate is simply the relative price of two, financial assets-one
Extensions of the monetary model allow for short run countrys currency in teams of anothers. Thus, currency prices are
departures from PPP and attempt to distinguish between those determined in the same manner that the prices of assets such as
changes in interest rate, which only compensative for changes stocks, bonds, gold, or real estate are determined. Unlike the
UN inflationary expectations, and those, which are due to prices of services or products with short storage lives, asset prices
changes in monetary tightness. The short -run stickiness of are influenced comparatively little by current events. Rather, they
goods prices can produce what is known as overshooting of are determined by peoples willingness to hold the existing
exhaust rate beyond its long-run equilibrium value. quantities of assets, which in turn depends on their expectations
of the future worth of these assets. Thus, for example, frost in
We will describe here a model along these lines due to Frankel (1979)
Florida can bump up the price of oranges, but it should have
PPP holds in the long-run little impact on the price of the citrus groves producing the
There is a stable demand for money function in each country. oranges; instead, longer-term expectations of the demand and
Uncovered interest parity and the Fisher open conditions supply of oranges governs the values of these groves.
hold. Similarly, the value today of a given currency, say, the dollar,
Expected change in the exchange rate in the short run depends on whether or not-and how strongly-people still want
depends upon perceived departures from long run the amount of dollars and dollar-denominated assets they held
equilibrium exchange rate and expected inflation differentials. yesterday. According to this view-known as the asset market model
of exchange rate determination-the exchange rate between two
Portfolio Balance Models currencies represents the price that just balances the relative
The monetary approach ignores all other assets except money supplies of and demands for, assets denominated in those
it is implicitly assumed that markets for domestic and foreign currencies. Consequently, shifts in preferences can lead to
bonds always clear. The assumption of UIP implies that massive shifts in currency values.
domestic and foreign bonds are regarded as perfect substitutes
by the investors in both the countries. In contrast, portfolio The Nature of Money and Currency
balance models recognize first, that asset choice must be Values
modeled as portfolio diversification problem, that is, given total To understand the factors that affect currency values, it helps to
wealth, investors divide it between various assetsdomestic examine the special character of money. To begin, money has
and foreign money, domestic-and foreign bonds-based on their value because people are willing to accept it in exchange for
expected returns and, second, that assets denominate in goods and services. The value of money, therefore, depends on
different currencies are not perfect substitutes. A non-zero risk its purchasing power. Money also provides liquidity that is you
premium will generally exist in favour of (or against a currency) can readily exchange it for goods or other assets, thereby
so that DIP does not hold full blown versions of the portfolio facilitating economic transactions. Thus, money represents both
balance model also take account of the link between current a store of Glue and a store of liquidity. The demand for money
account balance and asset demands. therefore depends on moneys ability to maintain its value and
on the level, of economic activity. Hence, the lower the expected
The various versions of the portfolio balance theories of
inflation rate, the more money people with demand. Similarly,
exchange rate utilize the well-known mean- variance portfolio
higher economic growth means more transactions and a greater
selection framework. Risk-averse investors diversify their
demand for money to pay bills.
portfolios across the available assets so that risk-adjusted return
is equalized between different assets. The key is to recognize The demand for money is also affected by the demand for assets
that in -a well diversified portfolio, an assets contribution- to denominated in that currency. The higher the expected real
return and the lower the riskiness of a countrys assets, the
50
greater is the demand for its currency to buy those assets. In
51
INTERNATIONAL FINANCE MANAGEMENT
52
joys and sorrows of both a strong and a weak; currency in less staggering $772 billion of foreign currencies influence exchange
53
Notes
INTERNATIONAL FINANCE MANAGEMENT
Money supply
Prices
Time
54
UNIT 2
INTERNATIONAL BANKING AND
ISSUES IN THE INTERNATIONALIZATION FINANCIAL MARKETS
PROCESS OF FOREIGN INVESTMENT CHAPTER 8: INTERNATIONAL AND
AND INTERNATIONAL BUSINESS FOREIGN DIRECT INVESTMENTS
55
In the internationalization process there is a clear need to Another advantage is that the foreign investment contract in the
INTERNATIONAL FINANCE MANAGEMENT
provide congenial business environment giving certainty to context of bilateral investment treaties could have the effect of
international financial transactions and protections to foreign forming assets protected by the bilateral investment treaties.
investments. This will also include licenses and other advantages obtained
International trade and finance, because of its global nature, from the government during the course of the foreign invest-
necessarily involves many areas, which may give rise to uncer- ment. Whereas without the bilateral investment treaty these
tainty as to the applicability of the contract under which certain licences and advantages may have been without protection
trade and financing arrangements are made. These areas range under general international law, they new receive protection as a
from political issues and political stability to sovereign interven- result of the wide definition of property in the bilateral
tion of the economy, certainty of applicable laws as well as investment treaty. Whether the host country did intend that its
independence of the judiciary. administrative decisions be subjected to international review as a
result of the treaty, will remain a moot point. But, it would lead
Foreign direct investment constitutes an important interna-
to a possible result if only the treaties are honored.
tional investment portfolio operation in the
internationalization process. Another aspect of international trade is the availability of
acceptable dispute resolution form. Globalization of trade
As much as there is competition among countries to attract
obviously involves greater potential for generating international
foreign investment, there is competition among multinational
trade disputes. The international business community looks for
corporations to enter host countries. Whereas previously the
prompt, economical and fair conflict resolution mechanisms.
market was dominated by large multinationals, now, there are
Negotiation, conciliation, litigation, and arbitration are well-
small and medium enterprises, which can transfer more
known conflict resolution devices. Direct negotiations and
appropriate technology and bring sufficient assets for invest-
conciliation may resolve a conflict. However, when parties fail to
ment.
solve the controversy through direct negotiations, they have two
This open door policy towards foreign investment in choices: litigation or arbitration.
developing countries is typically achieved through careful
Within the context of the GATS, there is an express provision
screening of entry by administrative agencies, which have been
for trade settlement dispute where countries nave disputes in
established for the purpose, and regulation of the process of
relation to commitments made under the agreement. The WTO
foreign investment after entry has been made. After entry, there
have provided for procedures in relation to a dispute settlement
is continued surveillance of the foreign investment to ensure
process. The dispute settlement procedure is considered to be
that the foreign investment keeps to the conditions upon which
the WTOs most individual contribution to the stability of the
entry was permitted. In this regard, attitudes to foreign
global economy. The WTOs procedure underscores the rule of
investment protection and dispute resolution will be affected by
law, and it makes the trading system more secure and predict-
the new strategies adopted towards foreign investment.
able. It is clearly structured, with flexible time-tables set for
In the context of the new strategies, which have been developed completing a case. First rulings are made by a panel appeal based
by controlling entry and the later surveillance of operations of on points of law are possible and all final rulings or decisions
foreign investment, the foreign investment has ceased to be a are made by the WTOs full membership. No single country can
contract based matter and had become a process initiated by a block a decision.
contract - no doubt, but controlled at every point through the
public law machinery of the state. The old notions of foreign Chapter Orientation
investment protection, which concentrated on the making of Given the conceptual framework for the internationalization
the contract and the contract as the basis of all rights of the process relating to foreign investment and foreign trade in the
foreign investor, would inevitably become obsolete. This context of liberalized global economy, the following sections are
transformation, which has taken place, is crucial to the devising designed to be included in the chapter for the benefit of
of effective methods of foreign investment protection. The students:
subject matter of the protection has also changed in that not Issues involved in the internationalization process of foreign
only physical assets of the foreign investor but also his investments and international business
intangible assets, which include intellectual property rights as
Corporate strategy of Foreign Direct Investment
well as public law right to license and privileges, have become
the subject of protection.
Bilateral investment treaties are obviously regarded as important
by both capital exporting and capital importing states. But,
these treaties are not uniform and they do not have the ability
to create any uniform law on foreign investment protection. But
their existence adds to investor confidence and creates an
expectation of investor protection. The importance of these
treaties lies in the several results they achieve. The first is a
signaling function about the national policy towards foreign
investment.
56
In the light of the conceptual framework spelt- out for the There are laws that relate to international trade -both at the
Geographical strategies in internationalization process From a political point of view, foreign investors need to be
concerned about the impact of their investment on the local
Marketing in internationalization process environment and have to figure out how to work with local
Evolution of Strategy in the country-level government officials and agencies. In more
traditional societies, where democracy is not firmly entrenched,
Internationalization Process
they need to be more aware of the importance of contacts and
When one thinks of multinational enterprises, one often thinks
influence and the possibility that they will be asked to behave in
of giant companies like IBM or Nestle, which have sales and
ways inconsistent with the way they behave in their own polit-
production facilities in scores of countries, but companies do
ical and legal context or in ways that might even be illegal.
not start out giant entities, and few think globally at their
inception. Therefore, as we discuss strategies throughout this Thus, as the degree of internationalization increases, the nature,
text, we shall note that companies are at different levels of complexity, and breadth of the companys political and legal
internationalization and that their current status affects the interactions also increases.
optimal strategic alternatives available to them. Although there International Business Strategy in the
are variations in how international operations evolve, some Internationalization Process
overall patterns have been noted. Most of these patterns relate As companies increase their commitments to international
to risk minimization behavior. In other words most companies business operation it is not clear-cut that their strategies toward
view foreign operations as being riskier than domestic ones governmental trade policies change as their levels of commit-
because they must operate in environments, which are less ment change. Rather, companies attitudes toward trade policies
familiar to them. Thus, they initially undertake international differ, depending on how well they think they compete for each
activities reluctantly and follow practices to minimize their risks. product f from each of their production locations-with or
But as they learn more about foreign operations and experiences without trade restrictions. Certainly, company operating in many
success with them, they move to deeper foreign commitments countries must deal with a more complex set of trade relation-
that now seem less risky to them. ships (and potential governmental trade policies) than one
Cultural Needs in the operating only domestically or in a few countries For example, a
Internationalization Process company with operation in many different countries may push
Not all-companies need to have the same degree of cultural for the opening of markets in one but for protection in
awareness. Nor must a particular company have a consistent another. However, regardless of companies levels of interna-
degree of awareness during the course of its operations. tional commitment, changes in governmental actions may
Companies usually increase foreign opera-tions over time. They substantially alter the competitiveness of facilities in given
may expand their knowledge of cultural factors in tandem with countries, thus creating uncertainties about which the must
their expansion of foreign operations. In other words, they may make decisions. These decisions affect companies that are facing
increase their cultural knowledge as they move from limited to import competition as well as those whose exports are facing
multiple foreign functions, from one to many foreign locations, protectionist sentiment. Further, as companys capabilities
from similar to dissimilar foreign environments, and from change, these decisions may affect them differently.
external to internal handling of their international operations. The Strategy of Direct Investment in the
Thus, for example, a small company that is new to international Internationalization Process
business may have to gain only a minimal level of cultural Exporting to a locale usually precedes foreign direct investment
awareness, but a highly involved company needs a high level. there when the output is intended to be sold primarily in the
Evolution of Legal and Political same country where the investment is made. This is partly
Strategies in the Internationalization because of the wish to use domestic capacity before creating new
Process capacity abroad. But there are other factors as well. One is that
Companies deal with political and legal issues at different levels complies want a better indication that they can sell a sufficient
as they become more international. If a company selects amount in the foreign country before committing resources for
exporting as the mode of entry, manage-ment is not as production there. Another is that foreign locations are perceived
concerned with the political process or with the variety of legal to be riskier than domestic ones for operations because
issues as would be the case with a foreign direct investment. management is not as familiar with foreign environments,
57
where they must undertake multifunctional activities such as operations; however, if their sales do not meet expecta-tions,
INTERNATIONAL FINANCE MANAGEMENT
production and marketing. They feel that they must have some they are apt to analyze the legal, cultural, and economic factors
monopolistic advantage to overcome this environmental that constrain their market penetration. If sales expectations
obstacle, so the export experience provides information on justify the costs of product alter-ations, they will then move to
whether they actually have sufficient product advantages and a customer or strategic marketing orientation.
enables them to learn more about the foreign operating Companies may also limit early commitments to given foreign
environment. Once they have experience in foreign production, countries by attempting to sell regionally before moving
they may shorten the export-experience time before they nationally, many products and markets lend themselves to this
produce abroad in location. sort of gradual development. In many cases, geographic bar-
When the motive for foreign investment is to acquire resources, riers divide countries into very distinct markets. For example,
there is little or no opportunity to export in order to learn Colombia is divided by mountain ranges and Australia by a
about the foreign environment. However, one may question desert. In other countries, such as Zimbabwe and Zaire, very
why a company chooses to invest abroad rather than buy from a little wealth or few potential sales may lie outside the large
local company within the foreign market. Simply, there may local metropolitan areas. In still others, advertising and distribution
company with the capabilities to produce and export. Rather may be handled effectively on a regional basis. For example,
than transfer capabilities to a foreign company (thus risking the most multinational consumer goods companies -have moved
development of competitor through appropriability or risking into China - one region at a time.
the higher costs to incur through the transfer), the company
Notes
may engage in internalization. The lack of being able to gain
experience in the foreign country before investing there is not
necessarily a greater obstacle to operational abroad successfully;
there is a narrower need for environmental knowledge because
the foreign operation is only resource (production) oriented,
rather than resource and sales oriented, Thus, operating activities
for resource-seek-ing investments cover fewer functions. In the
case of sales-oriented investments, the export experience serves
only to gain market knowledge, so neither sales nor resource-
oriented investors can learn much about foreign production
nuances by exporting. Resource-oriented investors, therefore,
usually skip the export stage in the internationalization process.
Geographic Strategy in the
Internationalization Process
Fords pattern of international expansion in the opening case is
typical of many companies. In the early stages, companies may
lack the experience and expertise to devise strategies for sequenc-
ing countries in the most advantageous way. Instead, they
respond to opportunities that become apparent to them, and
many of these turn out to be highly advantageous. As they
gain, more international experience, however, they actively decide
which locations to emphasize for sales and production
Further, as in the Ford case, many companies begin selling in an
area very passively. A company may appoint an intermediary to
promote sales for it or a license to produce on its behalf. If
there is a demonstrated increase in sales, the company may
consider investing more of its own resources. Exporting is the
most common mode of initiating foreign sales. The generation
of exports to a given country indicates that sales may be made
from production located in that country however, there is little
to motivate a company to shift production abroad as long as
the company has production capacity to fulfill export orders,
makes sufficient profits on the export sales, and perceives no
threat to continue exporting.
Marketing in the Internationalization
Process
The product policy is apt to evolve as companies increase their
commitments to international operations. For example, they are
apt to begin with a production or sales orientation for foreign
58
INTERNATIONAL FINANCE MANAGEMENT
CORPORATE STRATEGY FOR FOREIGN DIRECT INVESTMENT
59
foreign investors (who must bear). For example, the costs of systematic evaluation of investment opportunities. For one
INTERNATIONAL FINANCE MANAGEMENT
operating in an unfamiliar, and possibly hostile, environment, thing, it would suggest undertaking those projects that are
multinationals can succeed abroad only if the production or most compatible with a firms international expansion. This
marketing edge that they possess cannot be purchased or ranking is useful because time and money constraints limit the
duplicated by local competitors. Eventually, though, barriers to investment alternatives that a firm is likely to consider. More
entry erode, and the firm must find new sources of competitive importantly, a good understanding of multinational strategies
advantage or be driven back to its home country. Thus, to should help to uncover new and potentially profitable projects;
survive as multinational enterprises, one must create and only in theory is a firm fortunate enough to be presented, with
preserve effective barriers to direct competition in product and no effort or expense on its part, with every available investment
factor markets worldwide. opportunity. This creative use of knowledge about global
corporate strategies is as important an element of rational
Financial Market Imperfections
investment decision-making as is the quantitative analysis of
An alternative, though not necessarily competing, hypothesis
existing project possibilities.
for explaining direct investment relies on the existence of
financial market imperfections. Some MNCs rely on product innovation, others on product
differentiation, and still others on cartels and collusion to
An even more important financial motivation for foreign direct
protect themselves from competitive threats. We will now
investment is likely to the desire to reduce risks through
examine three broad categories of multinationals and their
international diversification. This motivation may be somewhat
associated strategies.
surprising because the inherent riskiness of the multinational
corporation usually taken for granted. Exchange rate changes, Innovation-Based Multinationals
currency controls, expropriation, and other forms of govern- Firms such as IBM (United States), N.V. Philips (Netherlands),
ment intervention are some of the risks that are rarely, if ever, and Sony (Japan) create barriers to entry by continually introduc-
encountered by purely domestic firms. Thus, the greater a firms ing new products and differentiating existing ones, both
international investment, the riskier its operations should be. domestically and internationally. Firms in this category spend
Yet, there is good reason to believe that being multinational large amounts of money on R&D and have a high ratio of
may actually reduce the riskiness of a firm. Much of the technical to factory personnel. Their products are typically
systematic or general market risk affecting a company is related designed to fill a need perceived locally that often exists abroad
to the cyclical nature of the national economy in which the as well.
company is domiciled. Hence, the diversification effect due to But technological leads have a habit of eroding. In addition,
operating in a number of countries whose economic cycles are even the innovative multinationals retain a substantial propor-
not perfectly in phase should reduce the variability of MNC tion of standardized product lines. As the industry matures
earnings. Several studies indicate that this result, in fact, is the other factors must replace technology as a barrier to entry;
case1. Thus, since foreign cash- flows are generally not perfectly otherwise local competitors may succeed in replacing foreign
correlated with those of domestic investments, the greater multinationals in their domestic markets.
riskiness of individual projects overseas can well be offset by
Foreign Direct Investment and Survival
beneficial portfolio effects. Furthermore, because most of the
Thus far we have seen how firms are capable of becoming and
economic and political risks, specific to the multinational
remaining multinationals. However, for many of these firms,
corporation are unsystematic, they can be eliminated through
becoming multinational is not a matter of choice but, rather,
diversifica-tion.
one of survival.
The ability of multinationals to supply an indirect means of
international diversification should be advantageous to
Cost Reduction
It is apparent, of course, that if competitors gain access to
investors. But this corporate intentional diversification will prove
lower-cost sources of production abroad, following them
beneficial to shareholders only if there are barriers to direct
overseas may be a prerequisite for domestic survival. One
international portfolio invest-ment by individual investors.
strategy that is often followed by firms for which cost is the key
Our present state of knowledge does not allow us to make consideration is to develop a global-scanning capability to seek
definite statements about the relative importance of financial out lower-cost production sites or production technologies
and non-financial market imperfections in stimulating foreign worldwide. In fact, Firms in competitive industries have usually
direct investment. Most researchers who have studied this issue, seized new nonproprietary cost reduction opportunities, not to
however, would probably agree that the latter market imperfec- earn excess returns, but to make normal profits and survive.
tions are much more important than the former ones. In the
remainder of this chapter, therefore, we will concentrate on the Economies of Scale
effects of nonfinancial market imperfections on overseas A somewhat less-obvious factor motivating foreign invest-
investment. ment is the effect of economies of scale. In a competitive
market, prices will be forced close to marginal costs of produc-
The Strategy of Multinational tion. Hence, firms in industries characterized by high fixed costs
Enterprises relative to variable costs must engage in volume selling just to
An understanding of the strategies followed by MNCs in break- even. A new term describes the size that is required in
defending and exploiting those barriers to entry created by certain industries to compete effectively in the global Market-
product and factor market imperfections is crucial to any
60
place: world-scale. These large volumes may be forthcoming only Companies often prefer to control foreign production
61
market entry overseas may be judged according to its ability to Matsushita and Sony, strengthened their competitive
INTERNATIONAL FINANCE MANAGEMENT
deter a foreign competitor from launching a market-share battle position in the U.S. market by investing throughout the
by posing a credible retaliatory threat to the competitors profit 1970s to build strong brand franchises and distribution
base. By reducing the likelihood of a competitive intrusion, capabilities. The new-product positioning was facilitated by
foreign market entry may lead to higher future profits in the large-scale investments in R&D. By the 1980s, the Japanese
home market. competitive advantage in TVs and other consumer
In designing and valuing a strategic investment program, a firm electronics had switched from being cost based to one based
must be careful to consider the ways in which the investments on quality, features, strong brand names, and distribution
interact. For example, where scale economies exist, investment systems.
in large-scale manufacturing facilities may only be justified if the 4. A systematic investment analysis requires the use of
firm has made supporting investments in foreign distribution appropriate evaluation criteria. Nevertheless, despite the
and brand awareness. Investments in a global distribution complex interactions between investments or corporate
system and a global brand franchise, in turn, are often economi- policies and the difficulties in evaluating proposals (or
cal only if the firm has a range of products (and facilities to perhaps because of them), most firms still use simple rules
supply them) that can exploit the same distribution system and of thumb in selecting projects to undertake. Analytical
brand name. techniques are used only as a rough screening device or as a
Developing a broad product line usually requires facilitates (by final check off before project approval. While simple rules of
enhancing economies of scope) for investment in critical thumb are obviously easier and cheaper to implement, there
technologies that cut across products and businesses. Invest- is a danger of obsolescence and consequent misuse as the
ments in R&D also yield a steady stream of new products that fundamental assumptions underlying their applicability
raises the return on the investment in distribution. At the same change. On the other hand, the use of the theoretically
time a global distribution capability may be critical in exploiting sound and recommended present value analysis is anything
new technology. but straightforward. The strategic rationale underlying many
investment proposals can be translated into traditional
The return to an investment in R&D is largely determined by
capital budgeting criteria, but it is necessary to look beyond
the size of the market in which the firm can exploit its innova-
the returns associated with the project itself to determine its
tion and the durability of its technological advantage. As the
true impact on corporate cash flows and riskiness. For
technology imitation lag shortens a companys ability to fully
example, an investment made to save a market threatened by
exploit a technological advantage may depend on its being able
competition or trade barriers must be judged on the basis of
to quickly push products embodying that technology through
the sales that would otherwise have been lost.
distribution networks in each of the worlds critical national
markets. 5. The firm must estimate the longevity of its particular form
of competitive advantage if this advantage is easily replicated,
Individually or in pairs, investments in large-scale production
both local and foreign competitors will not take long to
facilities, worldwide distribution, a global brand franchise and
apply the same concept, process, or organizational structure
new technology are likely to be negative net present value
to their operations. The resulting competition will erode
projects. Together, however they may yield a high1y positive
profits to a point where the MNC can no longer justify its
NPV by forming a mutually supportive framework for
existence in the market. For this reason, the firms
achieving global competitive advantage.
competitive advantage should be constantly monitored and
2. This global approach to investment planning necessitates a maintained to ensure the existence of an effective barrier to
systematic evaluation of individual entry strategies in foreign entry into the market. Should these entry barriers break
markets, a comparison of the alternatives, and selection of down, the firm must be able to react quickly and either
the optimal mode of entry. For example, in the absence of reconstruct them or build new ones. But no barrier to entry
strong brand names or distribution capabilities but with a can be maintained indefinitely; to remain multinational,
labour-cost advantage, Japanese television manufacturers firms must continually invest in developing new competitive
entered the U.S. market by selling low-cost, private-label, advantages that are transferable overseas and that are not
black-and-white TVs. easily replicated by the competition.
3. A key element is a continual audit of the effectiveness of
Illstration: The Japanese Strategy For
current entry modes, bearing in mind that a markets sales
Global Expansion
potential is at least partially a function of the entry strategy.
In 1945, Japan was a bombed-out wreck of a nation, humili-
As knowledge about a foreign market increases or sales
ated and forced into unconditional surrender. All through the
potential grows, the optimal market penetration strategy will
1950s, Japanese exports were hampered by a low-quality image.
likely to change. By the late 1960s, for example, the Japanese
Yet less than 20 years later, Japanese companies such as Sony,
television manufacturers had built a large volume base by
Hitachi, Seiko, Canon, and Toyota had established worldwide
selling private-label TVs. Using this volume base; they
reputations equal to those of Zenith, Kodak, Ford, Philips,
invested in new process and product technologies, from
and General Electric.
which came the advantages of scale and quality. Recognizing
the transient nature of a competitive advantage built on Here are some lessons about international strategy to be learned
labor and scale advantages, Japanese companies, such as from the Japanese, who arguably are the most successful global
62
expansionists in history. To begin with, it should be pointed dealers could service them; (3) using commodity components
63
UNIT -3
F
CHAPTER 9: MANAGEMENT OF FOREIGN
CLASSIFICATION OF FOREIGN EXCHANGE AND EXPOSURE RISK
EXCHANGE AND EXPOSURE RISKS
Since the advent of floating exchange rates in 1973, firms We must distinguish a spot exchange rate from a forward
INTERNATIONAL FINANCE MANAGEMENT
around the world have become acutely aware of the fact that exchange rate. Forward transactions involve an agreement today
fluctuations in exchange rates expose their revenues, costs for settlement in the future. It might be the delivery of 1,000
operating cash- flows and hence their market value to substan- British pound 90 days hence, where the settlement rate is 1.59
tial fluctuations. Firms which have cross border transactions U.S dollars per pound. The forward exchange rate usually differs
exports and imports of goods and services, foreign borrow- form the spot exchange rate for reasons we will explain shortly.
ing and lending, foreign portfolio, and direct investment and so With these definitions in mind there are following three types
on are directly exposed; but even purely domestic firms of exchange rate risk exposure with which we are concerned:
which have absolutely no cross border transactions are also
Translation exposure
exposed because their customers, suppliers, and competitors are
exposed. Considerable effort has since been devoted to Transactions exposure
identifying and categorizing currency exposure and developing Economic exposure
more and more sophisticated methods to qualify it. The first translation exposure is the change in accounting
Figure 1 presents a schematic picture of currency exposure. In the income and balance sheet statements caused by changes in
short- term, the firm is faced with two kinds of exposures. It has exchange rates. Transactions exposure has to do with setting a
certain contractually fixed payments and receipts in foreign currency particular transaction, like a credit sale, at one exchange rate when
such as export receivables, import payables interest payable on the obligation was originally recorded at another. Finally,
foreign currency loans and so forth. Most of these items are economic exposure involves changes in expected future cash
expected to be settled within the upcoming financial year. flows, and hence economic value, caused by a change in
CURRENCY EXPOSURE exchange rates. For example, if we budget 1.3 million British
pound () to build an extension to out London plant and the
exchange rate is now .615 per U.S. dollar, this corresponds to
1.3 million/.625 = $2,080,000. When we pay for materials and
labour, the British pound might strengthen; say to . 615 per
ACCOUNTING OPERATING dollar. The plant now has a dollar cost of 1.3 million/. 615 =
EXPOSURE EXPOSURE $2,113,821. The difference, $2,113,821 - $2,080,000 = $33,821,
represents an economic loss.
TRANSACTION Chapter Orientation:
TRANSLATION Having briefly defined these three exchange-rate risk exposures,
we investigate them in detail. This will be followed by a
COMPETITIVE
CONTINGENT
discussion of how exchange-rate risk exposure can be managed
with the above cited scenario, and for the purpose let us divide
FIG 1. The Taxonomy of Currency Exposure
the chapter into following two segments to cope with and
The company with foreign operations is at risk in various ways. manage the foreign exchange and exposure risks.
Apart from political danger, risk fundamentally emanates from
1. Classification of Foreign Exchange and Exposure Risks
changes in exchange rates. In this regard, the spot exchange rate
represents the number of units of one currency that can be 2. Management of Exchange Rate Risk Exposure
exchanged for another. Put differently, it is the price of one
currency relative to another. The currencies of the major
countries are traded in active markets, where rates are deter-
mined by the forces of supply and demand. Quotations can be in
terms of the domestic currency or in terms of the foreign
currency. If the U.S. dollar is the domestic currency and the British
pound the foreign currency, a quotation might be .625 pounds
per dollar or $1.60 per pound. The result is the same, for one is
the reciprocal of the other (1/.625 = 1.60, while 1/1.60 = .625).
Currency risk can be thought of as the volatility of the exchange
rate of one currency for another.
64
Learning Objectives: Table 1.
65
payment worth 680/. 58 = $1,172.41. With his illustration in the closing rate while other items are translated at historical
INTERNATIONAL FINANCE MANAGEMENT
66
INTERNATIONAL FINANCE MANAGEMENT
EXCHANGE RATE RISK EXPOSURE MANAGEMENT OF
EXCHANGE RATE RISK EXPOSURE
67
contrast, it should try to obtain extended terms on its accounts tional company. The interest rate on loans is based on the
INTERNATIONAL FINANCE MANAGEMENT
payable. It may also want to borrow in the local currency to Eurodollar deposit rate and bears only an indirect relationship
replace any advances made by the U.S. parent. The last step will to the U.S. prime rate. Typically, rates on loans are quoted in
depend on relative interest rates. If the currency were going to terms of the London inter-bank offered rate (LIBOR). The
appreciate in value, opposite steps should be undertaken. greater the risk, the greater the spread above LIBOR. A prime
Without knowledge of the future direction of currency value borrower will pay about one-half percent over LIBOR for an
movements, aggressive policies in either direction are inappro- intermediate term loan. One should realize that LIBOR is more
priate. Under most circumstances we are unable to predict the volatile than the U.s. prime rate, owing to the sensitive nature
future, so the best policy may be one of balancing monetary of supply and demand for Eurodollar deposits.
assets against monetary liabilities to neutralize the effect of We should point out that the Eurodollar market is part of a
exchange-rate fluctuations. larger Eurocurrency market where deposit and lending rates are
International Financing Hedges quoted on the stronger currencies of the world. The principles
If a company is exposed in one countrys currency and is hurt involved in this market are the same as for the Eurodollar
when that currency weakens in value, it can borrow in that market, so we do not repeat them. The development of the
country to offset the exposure. In the context of the framework Eurocurrency market has greatly facilitated international
presented earlier, asset-sensitive exposure would be balanced borrowing and financial intermediation (he flow of funds
with borrowings. A wide variety of sources of external through intermediaries like banks and insurance companies to
financing are available to the for-eign affiliate. These range from ultimate borrowers).
commercial bank loans within the host country to loans from International Bond Financing
international lending agencies. In this section we consider the The Eurocurrency market must be distinguished from the
chief sources of external financing. Eurobond market. The latter market is a more traditional one,
Commercial Bank Loans and Trade Bills with under writers placing securities. Though a bond issue is
Foreign commercial banks are one of the major sources of denominated in a single currency, it is placed in multiple
financing abroad. They perform essentially the same financing countries. Once issued, it is traded over the counter in multiple
func-tion as domestic commercial banks. One subtle difference is countries and by a number of security dealers. A Eurobond is
that banking practices in Europe allows longer-term loans than different from a foreign bond, which is a bond issued by a
are available in the United States. Another difference is that loans foreign government or corporation in a local market. A foreign
tend to be on an overdraft basis. That is, a company writes a bond is sold in a single country and falls under the security
check that overdraws its account and is charged interest on the regulations of that country. Foreign bonds have colourful
overdraft. Many of these lending banks are known as merchant nicknames. For example, non-Americans in the U.S. market
banks, whose supply means that they offer a full menu of issue Yankee bonds, and Samurai bonds are issued by non-
financial services to business firms. Corresponding to the growth Japanese in the Japanese market. Eurobonds foreign bonds, and
in multi-national companies, international banking operations of domestic bond of different countries differ in terminology, in the
U.S. banks have grown accordingly. All the principal commercial way interest is computed, and in features. We do not address
cities of the world have branches or offices of U.S. banks. these differences, because that would require a separate book.
In-addition to Commercial bank loans, discounting trade Many debt issues in the international arena are floating-rate
bills is a common method of short-term financing. Although notes (FRNs). These instruments have a variety of features,
this method of financing is not used extensively in the United often involving multiple currencies. Some instruments are
States, it is widely used in Europe to finance both domestic and indexed to price levels or to commodity prices. Others are linked
international trade. to an interest rate, such as LIBOR. The reset interval may be
annual, semi annual quarterly or even more frequent. Still other
Eurodollar Financing instruments have option features.
Eurodollars are bank deposits denominated in U.S. dollars but
not subject to U.S. banking regulations. Since the late 1950s an Currency-Options and Multiple-Currency
active market has developed for these deposits. Foreign banks Bonds
and foreign branches of U.S. banks, mostly in Europe, actively Certain bonds provide the holder with the right to choose the
bid for Eurodollar deposits, paying interest rates that fluc-tuate currency, in which payment is received, usually prior to each
in keeping with supply and demand. The deposits are in large coupon or principal payment. Typically, this option is confined
denominations, frequently $100,000 or more, and the banks use to two currencies, although it can be more. For example, a
them to make dollar loans to quality borrowers. The loans are company might issue $-1, OOO-par value bonds with an 8
made at a rate in excess of the deposit rate. The rate differential percent coupon rate. Each bond might carry the option to
varies according to the relative risk of the borrower. Essentially, receive payment in either U.S. dollars or in British pounds. The
borrowing and lending Eurodollars is a wholesale operation, exchange rate between the currencies is fixed at the time of
with far fewer costs than are usually associated with banking. bond issue.
The market itself is unregulated, so supply and demand forces Bonds are sometimes issued with principal and interest
have free rein. payments being a weighted average, or basket, of multiple
The Eurodollar market is a major source of short-term currencies. Known as currency cocktail bonds, these securities
financing for the working capital requirements of the multina-
68
provide a degree of exchange-rate stability not found in any one Currency swaps typically are arranged through an intermediary,
69
and forward spot exchange-rate differentials are offsetting. How
INTERNATIONAL FINANCE MANAGEMENT
70
INTERNATIONAL FINANCE MANAGEMENT
COMPONENTS OF BALANCE OF PAYMENTS
71
to the ROW should be recorded as debits and the I. Merchandise In principle, merchandise trade should cover all
corresponding payments as credits. transactions relating to movable goods, with a few exceptions,
Note carefully the obvious corollary of this rule; a payment where the ownership of goods changes from residents to non-
received from the ROW increases the coun-try foreign assets- residents (ex-ports), and from non-residents to residents
either the payment will be credited to a bank account held (imports). The valuation should be on f.o.b. basis so that inter-
abroad by a resident entity. Or a claim is acquired on a foreign national freight and insurance are treated as district services and
entity. Thus an increase in foreign assets (or a decrease in foreign not merged with the value of the goods themselves.
Liabilities) must appear as a debit entry. Conversely, a payment Box 1
to the ROW reduces the countrys foreign assets or increases its
Structure the Current Account in Indias
liabilities owed to foreigners; a reduction in foreign assets or an
BOP Statement
increase in foreign liabilities must therefore appear as a credit
entry. This may appear somewhat paradoxical but the second A. CURRENT ACCOUNT
rule of thumb below will make it clear. Credit Debits Net
(b) A transaction which result in an increase in demand for I. Merchandise
foreign exchange is to be recorded as a debit entry while a II. Invisibles (a+b+c)
transaction, which results in an increase in the supply of a.) Services
foreign exchange, is to be recorded as a credit entry.
1. Travel
Thus an increase in foreign assets or reduction in foreign
2. Transportation
liabilities because it uses up foreign exchange now, is a debit
entry, while a reduction in foreign assets or an increase in foreign 3. Insurance
liabilities, because it is a source of foreign exchange now, is a 4. Government not else where Classified
credit entry. Capital outflow-such as when a resident purchases 5. Miscellaneous
foreign securities or pays off a foreign bank loan-is thus a debit
b.) Transfers
entry while a capital inflow, such as a disbursement of a World
Bank loan-is a credit entry. 6. Official
7. Private
Components of Balance of Payments
The BOP is a collection of accounts conventionally grouped C. Income
into three main categories with subdivisions in each. The three i) Investment income
main categories are: ii) Compensation to Employees
(a) The Current Account: Under this are included imports and
exports of goods and services and uni-lateral transfers of
goods and services. Total Cuttent Account - A (I+II)
Export valued on f.o.b. basis, are credit entries. Data for these
(b) The Capital Account: Under this are grouped transactions
items are obtained from the various forms exporters have to fill
leading to changes in foreign financial assets and liabilities of
in and submit to designated authorities.
the country.
Imports valued at c.i.f. are the debit entries. Three categories of
(c) The Reserve Account: In principle this is no different from
imports are distinguished according to the mode of payment
the capital account in as much as it also relates to financial
and financing. Valuation at c.i.f., though inappropriate, is a
assets and liabilities. However, in this category only reserve
forced choice due to data inadequacies.
assets are included.
The difference between the total of credits and debits appears in
These are the assets which the monetary authority of the
the Net column. This is the Balance on Merchandise Trade
country uses to settle the deficits and sur-pluses that arise on
Account, a deficit if negative and a surplus if positive.
the other two categories take together.
II. Invisibles Conventionally, trade in physical goods is
In what follows we will examine in some detail each of the
distinguished from trade in services. The invisibles account
above main categories and their sub-divisions. Our aim is to
includes services such as transportation and insurance, income
understand the overall structure of the BOP account and the
payments, and receipts for factor services-labour and capital-and
nature of relationships between the different sub groups. We
unilateral transfers.
will not be concerned with details of the valuation methodol-
ogy, data sources and the various statistical compromises that Credits under invisibles consist of services rendered by
have to be made to overcome data inadequacy. We draw residents to non-residents, income earned by residents from
extensively on the Reserve Bank of India monograph Balance of their ownership of foreign financial assets (interest, dividends),
Payments Compilation Manual. [RBI] (1987)]. income earned from the use, by non-residents, of non-financial
assets such as patents and copyrights owned by residents and
The Current Account the offset entries to the cash and gifts received in-kind by
The structure of the current account in Indias BOP statement is residents from non-residents. Debits consist of same items
shown in Box. with the roles of residents and non-residents reversed. A few
We will briefly discuss each of the above heads and subheads. examples will be useful:
1.. Receipts in foreign exchange, reported by authorized dealers Box 2
in foreign exchange, remitted to them by organizers of
Structure of the Capital Account
foreign tourist parties located abroad for meeting hotel and
other local expenses of the tourists. This will be a credit B. CAPITAL ACCOUNT (l to 5) credit
under travel. Debit Net
2. Freight charges paid to non-resident steamship or airline 1. Foreign Investment (a + b)
companies directly when imports arc in-voiced on f.o.b. basis a) In India
by the foreign exporter will appear as debits under i. Direct
transportation.
ii. Portfolio
3. Premiums on all kinds of insurance and re-insurance
b) Abroad
provided by Indian insurance companies to non--resident
clients are a credit entry under insurance. 2. Loans (a + b - c)
4. Profits remitted by the foreign branch of an Indian company a) External Assistance
to the parent represent a receipt of in vestment i. By India
income. It will be recorded as a credit under investment ii. To India
income. Interest paid by a resi-dent entity on a foreign
b) Commercial Borrowings (MT and LT)
borrowing will appear as a debit.
i. By India
5. Funds received from a foreign government for the
maintenance of their embassy, consulates and so on in India ii. To India
will constitute a credit entry under government not included b) Short-term to India
elsewhere. 3. Banking Capital (a + b)
6. Payment to a foreign resident employed by an Indian a) Commercial Banks
company will appear as a debit under com-pensation to
i. Assets
employees.
ii. Liabilities
7. Revenue contributions by the Government of India to
international institutions such as the UN, or a gift of iii. Non-resident Deposits
commodities by the Government of India to non-residents b) Others
will constitute a debit entry under official transfers. Cash 4. Rupee debt Service
remittances for family maintenance from Indian nationals
5. Other capital
residing abroad will be a credit entry under private
transfers. Total Capital Account (1 to 5)
The net balance between the credit end debit entries under the The total capital account consists of these three major groups
heads merchandise, non-monetary gold movements, and and two other minor items shown under rupee debt service
invisibles taken together is the Current Account Balance. The net and other capital.
balance is taken as deficit if negative (debits exceed credits), a The Other Accounts
surplus if positive (credits exceed debits). The remaining accounts in Indias BOP are set out in Box 3.
The Capital Account The IMF account contains, as mentioned above, purchases
The capital account in Indias BOP is laid out in Box.2. The (credits) and repurchases (debits)! Tom the IMF. The Foreign
capital account consists of three major subgroups. The first Exchange Reserves account records increases (debits), and
relates to foreign equity investments in India either in the form decreases (credits) in reserve assets. Reserve assets consist of
of direct investments-for instance, Ford Motor Co. starting a car RBIs holdings of gold and foreign exchange (in the form of
plant in India- or portfolio investments such as purchase of balances
Indian companies stock by foreign institutional investors, or BOX 3
subscriptions by non-resident investors to GDR and ADR Credit Debits Net
issues by Indian companies. The next group is loans- Under C. Errors and Omissions
this are included concessional loans received by the government
or public sector bodies, long- and medium-term borrowings D. Overall Balance (Total of Capital and Current Accounts and
from the commercial capital market in the form of loans, bond Errors and Omissions)
issues and so forth, and short-term credits such as trade related E. Monetary Movements
credits. Disbursements received by Indian resident enti-ties are i) IMF
credit items while repayments and loans made by Indians are
debits. The third group separates out the changes in foreign ii) Foreign Exchange Reserves (Increase-/Decrease+)
assets and liabilities of the banking sector. An increase (decrease) With foreign central banks and investments in foreign govern-
in assets is debits (credits) while increase (decrease) in liabilities ment securities) and holdings of SDRs. SDRs-Special Drawing
are credits (debits). Non-resident deposits with In-dian banks Rights-are a reserve asset created by the IMF and allocated from
are shown separately. time to time to member countries. Within certain limitations it
INTERNATIONAL FINANCE MANAGEMENT
74
INTERNATIONAL FINANCE MANAGEMENT
COLLECTION REPORTING AND PRESENTATION OF BOP STATISTICS
Learning Objectives is because they are based upon the principle of double-entry
To provide you with basic information on the IMFs bookkeeping. Each transaction be-tween a domestic and foreign
Guidelines for Collection, compilation, reporting and resident has two sides to it, a receipt and a payment, and both
presentation of BOP statistics these sides are recorded in the balance-of-payments statistics.
Each receipt of currency from residents of the rest of the world
To create a general awareness and exposure to BOP
is recorded as a credit item (a plus in the accounts) while each
accounting and recording of transaction in the Balance of
payment to residents of the rest of the world is recorded as a
Payments
debit item (a minus in the accounts). Before considering some
Collection, Reporting and Presentation examples of how different types of economic transactions
of the Balance-o-Payments Statistics between domestic and foreign residents get re-corded in the
The balance-of-payments statistics record all of the transactions balance of payments, we need to consider the various sub
between domestic and foreign residents, be they purchases or accounts that make up the balance of payments. Traditionally,
sales of goods, services or of financial assets such as bonds, the statistics are divided into two main sections - the current
equities and banking transactions. Reported figures are normally account and the capital account, with each part being further
in the domestic currency of the reporting country. Obviously, sub-divided. The explanation for division into these two main
collecting statistics on every transaction between domestic and parts is that the current account items refer to income flows,
foreign residents is an impossible task. The authorities collect while the capital account records changes in assets and liabilities.
their information from the customs authorities, surveys of A simplified example of the annual balance-of-payments
tourist numbers and expenditures, and data on capital inflows accounts for Europe is presented in Table l.
and outflows is obtained from banks, pension funds, multina- Table 1. The balance of payments of Euro land
tionals and investment houses. Information on government Current Account
expenditures and receipts with foreign residents is obtained
from local authorities and central government agencies. The 1) Exports of goods +150
statistics are based on reliable sampling techni-ques, but 2) Imports of goods -200
nevertheless given the variety of sources the figures provide 3) Trade Balance -50 rows (1) + (2)
only an estimate of the actual transactions. The responses from 4) Exports of services +120
the various sources are compiled by government statistical 5) Imports of services -160
agencies. In the United States, the statistics are compiled by the
US Department of Commerce and in the United Kingdom by 6) Interest, profits and dividends +20 received
the Department of Trade and Industry. 7) Interest, profits and dividends -10 paid
There is no unique method governing the presentation of 8) Unilateral receipts +30
balance-of payments statistics and there can be considerable 9) Unilateral payments -20
variations in the: presentations of different national authorities.
10) Current account balance -70 sum rows (3) ( 9)
However, the International Monetary Fund provides a set of
inclusive
guidelines for the compilation of such statistics published in its
Balance of Payments Manual. In addition, the Fund publishes the Capital Account
balance-of-payments statistics of all its member countries in a 11) Investment Abroad -30
standardized format facilitating inter-country comparisons. These 12) Short term landing -60
are presented in two publications - the Balance of Payments Statistics
13) Medium and long term lending -80
Yearbook and the International Financial Statistics.
14) Repayment of borrowing form ROW -70
In the US, the value of exports and imports is compiled on a
monthly basis and likewise in the UK. The monthly figures are 15) Inward foreign investment +170
subject to later revision and two sets of statistics are published; the 16) Short term borrowing +40
seasonally adjusted figure and the unadjusted figure. The 17) Medium and long term borrowing +30
seasonally adjusted figures correct the balance-of-payments figures
18) Repayments on loans received form ROW +50
for the effect of seasonal factors to reveal underlying trends.
19) Capital account balance +50 sum (11) (18)
Balance-of-Payments Accounting and
20) Statistical error+5 zero minus [(10) +(19) +(24)]
Accounts
An important point about a countrys balance-of-payments 21) Official settlements balance-15 (10) +(19) +(20)
statistics is that in an accounting sense they always balance. This 22) Change in reserves rise (-), fall (+) +10
75
23) IMF borrowing form (+) repayments to (-) +5 Capital Account Capital
INTERNATIONAL FINANCE MANAGEMENT
76
INTERNATIONAL FINANCE MANAGEMENT
THE INTERNATIONAL FLOW OF GOODS, SERVICES AND CAPITAL
Learning Objectives foreign investment. Net foreign investment equals the nations
To provide you a pragmatic, operational and analytical frame- net public and private capital outflows plus the increase in
work that links the international flow of goods and capital official reserves. The net private and public capital outflows
to respond to domestic economic behavior. equal the capital-account deficit if the outflow is positive
To help you develop an understanding on domestic savings (A capital-account surplus if outflow is negative), while the net
vis a vis investment taking into account current and increase in official reserves equals the balance on official reserves
capital accounts, government budget deficits and current account. In a freely floating exchange rate system-that is, no
accounts deficits government intervention and no official reserve transactions-
excess savings will equal the capital-account deficit. Alternatively,
This section provides an analytical framework that links the
a national savings deficit will equal the capital account surplus
international flows of goods and capital to domestic economic
(net borrowing from abroad); this borrowing finances the
behavior. The framework consists of a set of basic macroeconomic
excess of national spending over national income.
accounting identities that links domestic spending and production
to savings, consumption, and investment behavior, and thence Here is the bottom line: A nation that produces more than it
to the capital-account and current-account balances. By manipu- spends will save more than it invests domestically and will have
lating these equations, we will identify the nature of the links a net capital outflow. This capital outflow will appear as some
between the U.S. and world economies and assess the effects on combination of a capital-account deficit and an increase in
the domestic economy of international economic policies, and official reserves. Conversely, a nation that spends more than it
vice versa. As we shall see in the next section, ignoring these produces will invest domestically more than it saves and have a
links leads to political solutions to international economic prob- net capital inflow. This capital inflow will appear as some
lems-such as the trade deficit-that create greater problems. At combination of a capital-account surplus and a reduction in
the same time, authors of domestic policy changes are often official reserves.
unaware of the effect these changes can have on the countrys The Link Between the Current and Capital Accounts
international economic affairs. Beginning again with national product, we can subtract from it
Domestic Savings and Investment and spending on domestic goods and services. The remaining
the Capital Account goods and services must equal exports. Similarly, if we subtract
The national income and product accounts provide an account- spending on domestic goods and services from total expendi-
ing framework for recording our national product and showing tures, the remaining spending must be on imports. Combining
how its components are affected by international transactions. these two identities leads to another national income identity:
This framework begins with the observation that national National income National spending = Exports imports
income, which is the same as national product, is either spent on Equation above says that a current-account surplus arises when
consumption or saved: national output exceeds domestic expenditures; similarly, a
National product = Consumption + Savings current-account deficit is due to domestic expenditures exceed-
Similarly, national expenditure, the total amount that the nation ing domestic output. Exhibit illustrates this latter point for the
spends on goods and services, can be divided into spending on United States.
consumption and spending on domestic real investment. Real More over when last two equations are combined
investment refers to plant and equipment, R&D, and other Savings - Investment = Exports - Imports
expenditures designed to increase the nations productive
According to above Equation, if a nations savings exceed its
capacity. This equation provides the second national accounting
investment, then that nation
identity:
National spending = Consumption + Investment will run a current-account surplus. This equation explains the
Japanese current-account surplus: The Japanese have an
Subtracting the latter Equation from the previous Equation extremely high savings rate, both in absolute terms and relative
yield a new identity: to their investment rate. Conversely, a nation such as the United
National - National = Savings - Investment States that saves less than it invests must run a current-account
Income. Spending deficit. Noting that savings minus investment equals net
This identity says if a nations income exceeds its spending, foreign investment, we have the following identity:
then savings will exceed domestic investment, yielding surplus Net foreign investment = Exports - Imports
capital. The surplus capital must be invested overseas (if it were Equation above says that the balance on the current account
invested domestically there wouldnt be a capital surplus). In must equal the net capital outflow; that is, any foreign exchange
other words, savings equals domestic investment plus net earned by selling abroad must either be spent on imports or
77
exchanged for claims against foreigners. The net amount of it produces will invest more than it saves, import more than it
INTERNATIONAL FINANCE MANAGEMENT
these IOUs equals the nations capital outflow. If the current exports, and wind up with a capital inflow.
account is in surplus, then the country must be a net exporter Conditions: (1) Raise national product relative to national
of capital; a current-account deficit indicates that the nation is a spending, and (2) increase savings relative to domestic invest-
net capital importer. This equation explains why Japan, with its ment. A proposal to improve the current-account balance by
large current-account surpluses, is a major capital exporter, while reducing imports (say, via higher tariffs) that doesnt affect
the United States, with its large current-account deficits, is a national output/spending and national savings/investment
major capital importer. Bearing in mind that trade is goods plus leaves the trade deficit the same; and the proposal cannot
services, to say that the United States has a trade deficit with achieve its objective without violating fundamental accounting
Japan is simply to say that the United States is buying more identities.
goods and services from Japan than Japan is buying from the
Government Budget Deficits and Current-Account Deficits
United States, and that Japan is investing more in the United
up to now, government spending and taxation have been
States than the United States is investing in Japan. Between the
included in aggregate domestic spending and income figures- by
United States and Japan, any deficit in the current account is
differentiating between the government and private sectors; we
exactly equal to the surplus in the capital account Otherwise;
can see the effect of a government deficit on the current-account
there would be an imbalance in the foreign. Exchange market,
deficit.
and the exchange rate would change.
National spending can be divided into household spending
Another interpretation of Equation 6.6 is that the excess of
plus private investment plus government spending. Household
goods and services bought over goods and services produced
spending, in turn, equals national income less the sum of
domestically must be acquired through foreign trade and must
private savings and taxes- combining these terms yields the
be financed by an equal amount of borrowing from abroad (the
following identity:
capital-account surplus and/or official reserves deficit). Thus, in
a freely floating exchange rate system, the current -account
balance and the capital account balance must exactly offset each National Household Private Government
Spending = spending + investment + spending
other. With government intervention in the foreign exchange
market, the sum of the current-account balance plus the capital = National Private Private Private Government
account balance plus the balance on official reserves account Income - savings - Taxes + investment + spending
must be zero. These relations are shown in Exhibit 6.5.
Rearranging Equation above yields a new expression for excess spending:
These identities are useful because they allow us to assess the
efficacy of proposed H solutions for improving the current-
account balance. It is clear that a nation cannot reduce its National National Private Private Government
Spending - income = investment - savings + budget deficit
current-account deficit nor increase its current-account surplus
unless it meets two
EXHIBIT 1 The Trade Balance Falls as Spending Rises Relative
to GNP
Our national product (Y) - Our total spending (E)
= Minus our spending for consumption
EXHIBIT 3. U.S. National Income Accounts and the Current-Account Deficit.
Minus our spending for consumption 1973 1990 (Percent of GNP)
Our national savings (S) - Our investment in new real assets (Id)
= Net foreign investment, or the net increase in claims on Gross Gross Savings Total Current-
foreigners and official reserve assets, Year Private Private Less Government Account
Savings Investment Investment Deficit Balance*
e.g., gold (If)
Our national product (Y) - Our total spending (E) 1973-79 18.0 16.8 1.2 -0.9 0.1
minus our spending on our own goods minus our spending (Average)
on our own goods and 1980 17.5 16.0 1.5 -1.3 0.5
1981 18.0 16.9 2.9 -1.0 0.3
And services services 1982 18.3 14.7 3.6 -3.6 0.0
1983 17.4 14.7 2.7 -3.8 -1.0
Our exports of goods and services (X) Our imports of 1984 17.9 17.6 0.3 -2.7 -2.4
goods and services (M) 1985 17.2 16.5 0.7 -3.4 -2.9
1986 16.2 16.3 -0.I -3.4 -3.4
Balance on current account 1987 14.7 15.7 -0.8 -2.3 -3.5
= - (Balance on capital and official reserves accounts) 1988 15.1 15.4 -0.3 -2.0 -2.5
1989 15.0 14.8 0.2 -1.7 -1.9
Y -E = S- Id=X -M= If 1990* * 14.3 13.6 0.7 -2.3 -1.7
78
* The sum of the savings-investment balance and the govern-
79
INTERNATIONAL FINANCE MANAGEMENT
80
Alternative Concepts of Surplus and payments. However, the UK investor could very easily sell the
81
the home currency. On the other hand, under floating exchange Finally, BOP accounts are intimately connected with the overall
INTERNATIONAL FINANCE MANAGEMENT
rates and no intervention the official settlements balance saving-investment balance in a countrys national accounts;
automatically tends to zero as the authorities do not buy or sell Continuing deficits or surpluses may lead to fiscal and monetary
the home currency since it is left to appreciate or depreciate. actions designed
Even in a fixed exchange rate regime the settlements concept Notes
ignores the fact that the authorities have other instruments
available with which to defend the exchange rate, such as capital
controls and interest rates. Also, it does not reveal the real threat
to the domestic currency and official reserves represented by the
liquid liabilities held by foreign residents who might switch
suddenly out of the currency.
Although in 1973 the major industrialized countries switched
from a fixed to floating exchange-rate system, many developing
countries con-tinue to peg their exchange rate to the US dollar
and consequently attach much significance to the settlements
balance. Indeed, to the extent that industrialized countries
continue to intervene in the foreign exchange market to
influence the value of their currencies, the settlements balance
retains some significance and news about changes in the
reserves of the authorities is of interest to foreign exchange
dealers as a guide to the amount of official intervention in the
foreign exchange market.
Why are Bop Statistics Important ?
Balance of Payments statistics (at least estimates of major
items) are regularly compiled, published and are continuously
monitored by companies, banks, and government agencies.
Often we find a news headline like announcement of provi-
sional US balance of payment figures sends the dollar tumbling
down. Ob-viously, the BOP statement contains useful
information for financial decision matters.
In the short-run, BOP deficits or surpluses may have an
immediate impact on the exchange rate. Basi-cally, BOP records
all transactions that create demand for and supply of a currency.
When exchange rates are market determined, BOP figures
indicate excess demand or supply for the currency and the
possible impact on the exchange rate. Taken in conjunction with
recent past data, they may confirm or indicate a reversal of
perceived trends. Further, as we will see later, they may signal a
policy shift on the part of the monetary authorities of the
country, unilaterally or in concert with its trading partners. For
instance, a country facing a current account deficit may raise
interest rates to attract short-term capital inflow to pre-vent
depreciation of its currency. Or it may otherwise tighten credit
and money supply to make it difficult for domestic banks and
firms to borrow the home currency to make investments
abroad. It may force ex-porters to realize their export earnings
quickly, and bring the foreign currency home. Movements in a
coun-trys reserves have implications for the stock of money
and credit circulating in the economy. Central banks purchases
of foreign exchange in the market will add to the money supply
and vice versa unless the central bank sterilizes the impact by
compensatory actions such as open market sales or purchases.
Coun-tries suffering from chronic deficits may find their credit
ratings being downgraded because the markets interpret the
data as evidence that the country may have difficulties in
servicing its debt.
82
UNIT 3
INTERNATIONAL BANKING AND
FINANCIAL MARKETS
CURRENCY AND INTEREST CHAPTER 11: SPECIAL FINANCING VEHICLES :
RATE FUTURES FUTURES, OPTIONS AND FINANCIAL SWAPS
Chapter Organization:
Learning Objectives specified price. The principal features of the contract are as
What are futures contract and forward contracts follows:
To let you know how futures trading process take place Organised Exchanges: Unlike forward contracts, which are
traded in an over-the-counter market, futures are traded on
To let you know about futures and forward pricing system
organised futures exchanges either with a designated physical
To help you learn the hedging procedure for futures location where trading takes place or screen based trading. This
Futures contract is an agreement between two parties to buy or provides a ready liquid market in which futures can be bought
sell an asset at a certain time in the features for a certain price. and sold at any time like in a stock market. Only members of
Unlike forward contract, futures contracts can be traded on an the exchange can trade on the exchange. Others must trade
exchange. To make trading possible, the exchange specifies through the members who act as brokers. They are known as
certain standardized features of the contract. Futures Commission Mer-chants (FCMs).
The largest exchanges on which futures contracts are Standardisation: As we saw in the case of forward currency
traded are Chicago Board of Trade (CBOT) and the Chicago contracts, the amount of the commodity to be delivered and
mercantile Exchange (CME). On these and other exchange a the maturity date are negotiated between the buyer and the seller
very wide variety commodities of commodities and financial and can be custom-ised to buyers requirements. In a futures
assets from the underlying assets in the various contracts are contract both these are standardised by the exchange on which
included. The commodities include: pork, cattle, sugar, wool, the contract is traded. Thus for instance, one futures contract in
lumber, copper, aluminum, gold etc. The financial assets include pound sterling on the International Mon-etary Market (IMM), a
stock indices, currencies, treasury bills and treasury bonds etc. financial futures exchange in the US, (part of the Chicago
Futures Contracts, Markets and the Mercantile Exchange or CME), calls for delivery of 62,500 and
Trading Process contracts are always traded in whole numbers. Similarly, for each
In order to fully understand the nature and uses of futures, it is contract, the exchange specifies a set of delivery months and
necessary to acquire familiarity with the major features of specific delivery days within those months. A three-month
futures contracts, organization of the markets, and the mechan- sterling time deposit contract on the London International
ics of futures trading. At this stage, we want to keep the Financial Futures Exchange (LIFFE) has March, June, Septem-
discussion fairly general. Also, we will concentrate on the ber, December delivery cycle. The exchange also specifies the
essential charac-teristics of futures and not the institutional minimum size of price movement (this is known as a tick)
details. The discussion will serve to bring out the crucial differ- and, in some cases, may also impose a Ceiling on the maximum
ences between forwards and futures. price change within a day. Thus, for a GBP contract on CME,
the minimum price movement is $0.0002 per GBP, which, for a
Major Features of Futures Contracts contract size of GBP 62,500, translates into $12.50 per contract.
As mentioned above, a futures contract is an agreement for
Clearing House: The clearinghouse is the key institution in a
future delivery of a specified quantity of a commodity at a
futures market. It may be a part of the exchange in which case a
83
subset of the exchange members are clearing members, or an Futures contracts are traded by a system of open outcry on the
INTERNATIONAL FINANCE MANAGEMENT
independent institution which provides clearing services to trading floor (also called the trading pit) of a centralized and
many exchanges. They perform several functions. Among them regulated exchange. Increasingly, trading with electronic screens
are recording and matching trades, calculating net open posi- is becoming the pre-ferred mode in many exchanges around the
tions of clearing members, collecting margins and, most world. All traders represent exchange members. Those who
important, assuring financial integrity of the market by trade for their own account are called floor traders while those
guaranteeing obligations among clearing members. who trade on behalf of others are floor brokers. Some do both
On the trading floor a futures contract is agreed between two and are called dual traders.
parties A and B who are members of the change trading on The variables to be negotiated in any deal are the price and the
their own behalf or acting as brokers for their public clients. number of contracts. A buyer of futures acquires a long position
When it is reported to and registered with the clearing house, while the seller acquires a short position. As we have seen above,
the contract between A and B is immediately replaced by two when two trad-es agree on a deal, it is entered as a short and a
con-tracts, one between A and the clearing house and another long both vis--vis the clearinghouse.
between B and the clearing house.3 Thus the clearing house When a position is opened, the trader (both the long and the
interposes itself in every deal, being buyer to every seller and short) must post an initial margin. As prices change, the contract
seller to every buyer. This eliminates the need for A and B (and is marked to market with gains credited to the margin account and
their clients) to investigate each others creditworthiness and losses debited to the account. These are called variation margins. If,
guaran-tees the financial integrity of the market. The clearing as a result of losses, the amount in the margin ac-count falls below
house guarantees performance for contracts held till maturity, a certain level known as maintenance margin the trader receives a margin
that is, it ensures that the buyer will get delivery of the underly- call and must make up the amount to the level of the initial margin
ing asset provided he pays the appropriate price and, conversely, in a specified time. This is called paying the varia-tion margin. If
seller will get paid provided he delivers the underlying asset. It the trader fails to do so, his or her position is liquidated immedi-
protects itself by imposing margin requirements on traders and ately. Thus daily marking to market coupled with margins, limit the
a system known as marking to market described below. Exhibit loss the clearing house or a broker may have to incur to at most a
fit. 1 illustrates operation of a clearinghouse. couple of days price change.
Exhibit 1. Clearing House Operations There are various kinds of orders given to floor traders and
Initial Margins: Only members of an exchange can trade in brokers. A client may ask his or her broker to buy or sell a
futures contracts on the exchange. The general public uses the certain number of contracts at the best available price (Market
members services as brokers to trade on their behalf (Of course an Orders), or may specify upper price limit for buy orders and
exchange mem-ber can also trade on its own account.). A subset of lower limit for sell orders (Limit Orders). An order can become a
exchange members are clearing members, that is members the market order if a specified price limit is touched though it may
clearing house when the clearinghouse s a subsidiary of the not get executed at the limit price or better (Market If Touched or
exchange. A non-clearing member must clear all its transactions MIT orders). A trader with a long (short) position may wish to
through a clearing member. Every transaction is thus between limit his losses by instructing his broker to liquidate the
member and the exchange clearing house. The exchange requires position if the price falls (rises) to or below (above), a specified
that a performance bond m the form of a margin must be level below (above) the current market price (stop-loss orders).
deposited with the clearing house by a clearing member who enters Stop orders can be combined with limit orders by stating that
into a futures commitment an his own behalf or on behalf of his execution is restricted to the specified limit price or better (stop
broker client whose transactions he is clearing or a public customer. limit orders). Some traders may wish their orders to be executed
during specified intervals of time-for instance, first half an hour
The Futures Trading Process of trading (time of day orders).
For every contract, the exchange specifies a last trading day.
Clearing Association
Those who have not liquidated their con-tracts at the end of
this day are obliged to make or accept delivery as the case may
be. For some contracts, there is no physical delivery of the
Clearing Member A Clearing Member B Clearing Member C Clearing Member D Underlying asset but only a cash settlement from losers to the
gainers. Where physical delivery is involved, the exchange
specifies the mechanism of delivery.
Non-clearing
Customer Some Typical Currency Futures
member
Contract Specifications
Customer
Exchange: Chicago Mercantile Exchange CME
Non-clearing
member X
Customer British Pound Futures Contract Specifications
Size of Contract: 62,500 Pounds
Expiry Months: January, March, April, June, July, September,
Customer
Customer October, December, & Spot Month.
Non-clearing
member
84
Minimum Price Fluctuation (Tick): $ 0002 per Pound (2 pt) an asset e.g. a receivable in a currency A that it would like to hedge,
85
Market (a part of Chicago Mercantile Exchange) has futures
INTERNATIONAL FINANCE MANAGEMENT
86
INTERNATIONAL FINANCE MANAGEMENT
CURRENCY OPTIONS
Options are unique financial instruments that confer upon the spot foreign exchange gives the option buyer the right to buy or
holder the right to do something without the -obligation to do sell a currency at a stated price (in terms of another currency). If
so. More specifically, an option is a financial contract in which the the option is exercised, the option seller must deliver or take
buyer of the option has the right to buy or sell an asset, at a pre delivery of a currency.
specified price, on or up to a specified date if he chooses to do An option on currency futures gives the option buyer the right
so; however, there is no obligation for him to do so. In other words, to establish a long or a short position in a currency futures
the option buyer can simply let his right lapse by not exercising contract at a specified price. If the option is exercised, the seller
his option. The seller of the option has an obligation to take the must take the opposite position in the relevant futures contract.
other side of the transaction if the buyer wishes to exercise his For instance, suppose you hold an option to buy a December
option. Obviously, the option buyer has to pay the option seller CHF contracts on the IMM at a price of$0.58/CHF. You
a fee for receiving such a privilege. exercise the option when December futures are trading at
Options are available on a large variety of underlying assets 0.5895. You can close out your position at this price and take a
including common stock, currencies, debt instruments, and profit of $0.0095 per CHF or, meet futures margin require-
commodities. Options on stock indices and futures contracts ments and carry the long position with $0.0095 per CHF being
(the underlying asset is a futures contract) and futures-style immediately credited to your margin account. The option seller
options are also traded on organised options exchanges. While automatically gets a short position in December futures.
over-the- counter option trading has had a long and chequered Futures-style options are a little bit more complicated. Like
history, option trading on organised options exchanges is futures contracts, they represent a bet on a price. The price being
relatively recent. Options have proved to be a very versatile and betted on is the price of an option on spot foreign exchange. Recall
flexible tool for risk management in a variety of situa-tions that the buyer of an option has to pay a fee to the seller. This
arising corporate finance, stock portfolio risk management, fee is the price of the option. In a futures-style option you are
interest risk management, and hedging of commodity price betting on changes in this price, which in turn, depends on
risk. By themselves and in combination with other financial several factors including the spot exchange rate of the currency
instruments, options per-mit creation of tailor-made risk involved. We will describe the mechanics of futures-style
management strategies. options after explaining some standard terminology associated
Options also provide a way by which individual investors with with options.
moderate amounts of capital can spec-late on the movements Options on spot exchange are traded III the over-the-counter
of stock prices, exchange rates, commodity prices and so forth. markets as well as a number of organized exchange including
The limited loss feature of options is particularly advantageous the United Currency Options Market (UCOM) of the Philadelphia
in this context. Stock Exchange (PHLX), the London Stock Exchange (LSE), and
Options on stocks were first traded on an organized exchange in the Chicago Board Options Exchange (CBOE). Exchange-traded
1973. Since then there has been a phenomenal growth in options options can be both standardised as to amounts of underlying
market. Optional are now traded in many exchange market currency and maturity dates as, well as customised. For instance,
throughout the world. Huge volumes of options are also traded PHLX trades both standardised and customised options. Over the
over the counter by the banks and other financial institutions. counter options are customised by banks.
The underlying assets include stocks, stock indices, foreign Options on currency futures are traded at the Chicago Mercantile
currencies, debit instruments, commodities and future contracts. Exchange (CME) among others. Futures styles options are
Learning Objectives traded at the LIFFE.
To familiarize you with different types of options. Most of our discussion will be centered around options on
spot exchange.
To help you learn pricing mechanism of options
To let you know the hedging procedure with currency Options Terminology
options Before we proceed to discuss option pricing and applications,
we must understand the market terminology associated with
To let you know about recent innovations in options trading
options. While our context is that of options on spot foreign
Options On Spot, Options On Futures currencies, the terms describe below carry over to other types of
And Futures-style Options options as well.
As mentioned above, the asset underlying an option contract The two parties to an option contract are the option buyer and the
can be a spot commodity or a futures contract on the commod- option seller also called option writer. For exchange-traded options,
ity. Still another variety is the futures-style option. An option on as in the case of futures, once an agreement is reached between
two traders, the exchange (the clearinghouse), interposes itself
87
between the two parties, becoming buyer to every seller and when the spot rate is $0.600. Its market value would exceed its
INTERNATIONAL FINANCE MANAGEMENT
seller to every buyer. The clearinghouse guarantees performance intrinsic value of $0.0 14 because before the option expires,
on the part of every seller. CHF may appreciate further increasing the gain to the option
Call Option: A call option gives the option buyer the right to holder. The difference between the value of an option at any
purchase a currency Y against a currency X at a stated price YIX, time t and its intrinsic value at the time is called the time value
on or before a stated date. For exchange-traded options, one of the option. For European options, this argument does not
contract represents a standard amount of the currency Y. The hold. A European call on a foreign currency can at times have a
writer of a call option must deliver the currency Y if the option value less than (S-X2) assuming that this is positive] and a
buyer chooses to exercise his option. European put on a foreign currency can have a value less than
(X-S). The lower bound on European option values is zero.
Put Option: A put option gives the option buyer the right to
sell a currency Y against a currency X at a specified price, on or Hedging with Currency Options
before a specified date. The writer of a put option must take Currency options provide the corporate treasurer another tool for
delivery if the option is exercised. hedging foreign exchange risks arising. Out of the firms opera-
Strike Price (also called Exercise Price): The price specified in the tions. Unlike forward contracts, options allow the hedger to gain
option contract at which the option buyer can purchase the from favourable exchange rate movements while being protected
currency (call), or sell the currency (put) Y against X. Note against unfavourable movements. However, forward con-tracts are
carefully that this is not the price of the option; it is the rate of costless while options involve up-front premium costs.
exchange between X and Y that applies to the transaction if the Here we will illustrate hedging applications of exchange-traded
option buyer decides to exercise his option. and OTC options with some examples. The figures assumed for
Thus a call (put) option on GBP at a strike price of USD 1.4500 brokerage and other transaction costs are hypothetical.
gives the option buyer the right to buy (sell) GBP at a price of Hedging a Foreign Currency Payable With Calls: In late February,
USD 1.4500 if and when he exercises his option. an American importer- anticipates a yen payment of JPY 100
Maturity Date: The date on which the option contract expires. million to a Japanese supplier sometime in late May. The current
Exchange traded options have standardized maturity dates. USD / JPY spot rate is 129.220 (which implies a IPYIUSD rate
of 0.007739). A June yen call option on the PHLX, with a strike
American Option: An option, call or put that can be exercised
price of $0.0078 per yen, is available for a premium of 0.0108
by the buyer on any business day from initiation to maturity.
cents per yen or $0.000108 per yen. Each yen contract is for IPY
European Option: An option that can be exercised only on the 6.25. Million. Premium per contract is therefore
maturity date.
$(0.000108 x 6250000) = $675
Option Premium (Option Price, Option Value): The fee that
The firm decides to purchase 16 calls for a total premium of
the option buyer must pay the option writer up-front, that is,
$10800. In addition, there is a brokerage fee of$20 per contract.
at the time the contract is initiated. This fee is like an insurance
Thus total expense in buying the options is $11,120. The firm
premium; it is non-refundable whether the option is exercised
has in effect ensured that its buying rate for yen will not exceed:
or not.
$0.0078 + $(111201100,000,000) = $0.0078112 per yen
Intrinsic Value of the Option: Given its throwaway feature, the The price the firm will actually end up paying for yen depends
value of an option can never fall below zero. Consider an upon the spot rate at the time of pay-ment. We will consider two
American call option on CHF with a strike price of $0.5865. If
scenarios:
the current spot rate CHF/$ is 0.6005, the holder of such an
option can realise an immediate gain of $(0.6005-0.5865) or 1. Yen depreciates to $0.0075 per yen ($/ = 133.33) in late May
$0.014 by exercising the call and selling the currency in the spot when the payment becomes due. The firm will not exercise its
market. This is the intrinsic value of the call option. There- option. It can sell 16 calls in the market, provided the resale
fore the market value or the premium demanded by the seller value exceeds the brokerage commission it will have to pay.
of the call must be at least equal to this. The intrinsic value of (Recall that June calls will still command some positive
an option is the gain to the holder on immediate exercise. For a premium). It buys yen in the spot market. In this case, the price
call option, it is defined as max [(S-X), O] where S is the current per yen it will have paid is
spot rate and X is the strike price. If S > X, the call has a $0.0075 + $0.0000112 - $ (Sale value of options - 320
positive intrinsic value. If S >X, intrinsic value is zero. Similarly (100,000,000)
for a put option, intrinsic value is max [(X-S), O]. For Euro-
If the resale value of options is less than $320, it will simply let
pean options, the concept of intrinsic value is only notional
the option lapse. In this case the effective rate will be $0.0075112
since they cannot be prematurely exercised. Their intrinsic value
per yen. Or I33. 13 per dollar. It would have been better to
is meaningful only on the expiry date.
leave the payable uncovered. A forward purchase at $0.0078
Time Value of the Option: The value of an American option at would have fixed the rate at that value and would be worse than
any time prior the option.
To expiration must be at least equal to its intrinsic value. In 2. Yen appreciates to $0.80.
general, it will be larger. This is because there is some probability
Now the firm can exercise the option and procure yen at the
that the spot price will move further in favour of the option
strike price of $0.0078. In addition, there will be transaction
holder. Take the call option on CHF at a strike price of $0.5865
88
costs associated with exercise. Alternatively, it can sell the contract. For instance, the IMM currency futures options expire
89
INTERNATIONAL FINANCE MANAGEMENT
FINANCIAL SWAPS
90
Floating Rate
91
INTERNATIONAL FINANCE MANAGEMENT
Foundation. In particular, it is a basic precept of price theory that the amount that individuals desire to hold. In order to reduce their
as the supply of one-commodity increases relative to supplies of excess holdings of money individuals increase their spending on
all other commodities, the price of the first commodity must goods, services and securities, causing U.S. prices to rise.
decline relative to the prices of other commodities. Thus, for
A further link in the chain relating money supply growth,
example, a bumper crop of commodities should cause corns
inflation, interest rates and exchange rates is the notion that
value in exchange-its exchange rate-to decline. Similarly, as the
money is neutral That is, money should have no impact on real
supply of money increases relative to the supply of goods and
variables. Thus, for example, a 10% increase in the supply of
services the purchasing power of money-the exchange rate
money relative to the demand for money should cause prices to
between money and goods-must decline.
rise by 10%. This view has important implications for interna-
The mechanism that brings this adjustment about is simple and tional finance. Specifically, although a change in the quantity of
direct. Suppose for example, that the supply of U.S. dollars exceeds
92
money will affect prices and exchange rates, this change should exchange rates at the end of World War I that would allow for
93
Nominal exchange rate that is, the actual exchange rate-may pressure on its prices, while its costs-primarily labor and raw
INTERNATIONAL FINANCE MANAGEMENT
be of little significance in determining the true effects of materials from local sources-rose apace with British inflation.
Currency changes on a firm and a nation. In terms of Currency The result was a decline in sales and greatly reduced profit
changes affecting relative competitiveness, therefore, the focus margins. Wedgwoods competitive position improved with
must be not on nominal exchange rate changes but instead on pound devaluation in the early 1980s.
changes in the real purchasing power of one currency relative to
another. Here we consider the concept of the real exchange rate. Expected Inflation and Exchange Rate
Changes
The Real Exchange Rate As we will see in the next section,
Changes in expected, as well as actual, inflation will cause
although purchasing power parity is a fairly accurate description
exchange rate changes. An increase in a currencys expected rate
of long-run behavior, deviations from PPP do occur. These
of inflation, all other things equal, makes that currency more
deviations give rise to changes in the real exchange rate. As
expensive to hold over time (because its value is being eroded at
defined in Chapter 4, the real exchange rate is the nominal
a faster rate) and less in demand at the same price. Conse-
exchange rate adjusted for changes in the relative purchasing
quently, the value of higher-inflation currencies will tend to be
power of each currency since some base period. Specifically, the
depressed relative to the value of lower-inflation currencies,
real exchange rate at time t, et, is designated as
other things being equal.
et = et (1 + if )t / (1+ih )t
Empirical Evidence
where the various parameters are the same as those defined previously. The strictest version of purchasing power parity-that all goods
If purchasing power parity holds exactly, that is, and financial assets obey the law of one price-is demonstrably
et = e0 (1 + ih )t / (1+if )t false. The risks and costs of shipping goods internationally, as
well as government-erected barriers to trade and capital flows,
then et equals e0. In other words, if changes in the nominal
are at times high enough to cause exchange-adjusted prices to
exchange rate are fully offset by changes in the relative price levels
systematically differ between countries. On the other hand, there
between the two countries, then the real exchange rate remains
is clearly a relationship between relative inflation rates and
unchanged. Alternatively, a change in the real exchange rate is
changes in exchange rates. This relationship is shown in Exhibit
equivalent to a deviation from PPP.
/43, which compares the relative change in the purchasing
Illusration power of 47 currencies (as measured by their relative inflation
Calculating Real Exchange Rates for the Pound and DM rates) with the relative change in the exchange rates for those
Between June 1979 and June 1980, the U.S. rate of inflation was currencies for the period 1982 through 1988. As expected, those
13.6%, and the German rate of inflation was 7.7%. In line with currencies with the largest relative decline (gain) in purchasing
the relatively higher rate of inflation in the United States, the power saw the sharpest erosion (appreciation) in their foreign
West German Deutsche mark revalued from $0.54 in June 1979 exchange values.
to $0.57 in June 1980. Based on the above definition, the real The general conclusion from empirical studies of PPP is that
rate of exchange in June 1980 equaled $0.57(1.077)/1.136 = the theory holds up well in the long run, but not as well over
$0.54. In other words, the real (inflation-adjusted) dollar / shorter time periods.3 A common explanation for the failure of
Deutsche mark exchange rate held constant at $0.54. During this PPP to hold is that goods prices are sticky, leading to short-term
same time period, England experienced a 17.6% rate of violations of the law of one price. Adjustment to PPP eventu-
inflation, and the pound sterling revalued from $2.09 to $2. I 7. ally occurs, but it does so with a lag. An alternative explanation
Thus, the real value of the pound in June 1980 (relative to June for the failure of most tests to support PPP in the short run is
1979) was 2.17(1.176)/1.136 = $2.25. Hence, the real exchange that these tests ignore the problems caused by the combination
rate increased between June 1979 and June 1980 from $2.09 to of differently constructed price indices, relative price changes,
$2.25, a real appreciation of? .6% in the value of the pound. and non traded goods and services.
The distinction between the nominal exchange rate and the real One problem arises because the price indices used to measure
exchange rate has important implications for foreign exchange inflation vary substan-tially between countries as to the goods
risk measurement and management. The real exchange rate and services included in the market basket and the weighting
remains constant (I.e., if purchasing power parity hold currency formula used. Thus, changes in the relative prices of various
gains or losses from nominal exchange rate changes will goods and services will cause differently constructed indices to
generally be off set over time by the effects of differences in deviate from each other, falsely signaling deviations from PPP.
relative rates of inflation, thereby reducing the net impact of Careful empirical work by Kravis and others demonstrates
nominal devaluations and revaluations. Deviations from Exhibit 3. Purchasing Power Parity: Empirical Data. 1982-1988
purchasing power parity, however, wiII lead to real exchange
that measured deviations from PPP are far smaller when using
gains and losses.
the same weights than when using different weights in
For example, the U.K. s Wedgwood Ltd. was significantly hurt calculating the U.S. and foreign price indices.4
by the real appreciation of the British pound described above.
In addition, relative price changes could lead to changes in the
The strong pound made Wedgwoods china exports more
equilibrium exchange rate, even in the absence of changes in the
expensive, costing it foreign sales and putting downward
general level of prices. For example, an increase in the relative
price of oil will lead to an increase in the exchange rates of oil-
94
behind this result is that $1 next year will have the purchasing
95
differential of 3% versus an interest differential of only 2%), The key to understanding the impact of relative changes in
INTERNATIONAL FINANCE MANAGEMENT
funds should flow from the foreign country to the home nominal interest rates among countries on the foreign exchange
country to take advantage of the real differential. This flow will value of a nations currency is to recall the implications of PPP
continue until expected real returns are again equal. and the generalized Fisher effect. PPP implies that exchange
Exhibit 4. The Fisher Effect rates will move to offset changes in inflation rate differentials.
Thus, a rise in the U.S. inflation rate relative to those of other
Empirical Evidence countries will be associated with a fall in the dollars value. It will
Exhibit 5 illustrates the relationship between interest rates and also be associated with a rise in the U.S. interest rate relative to
subsequent inflation rates for 43 countries during the period foreign interest rates. Combine these two conditions and the
1982 through 1988. It is evident from the graph that nations result is the international Fisher effect:
with higher inflation rates generally have higher interest rates.
(1 + rh)t / (1 + rf )t = et / e0
Thus, the empirical evidence is consistent with the hypothesis
that most of the variation in nominal interest rates across where et is the expected exchange rate in period t. The single
countries can be attributed to differences in inflationary period analogue to above Equation is
expectations. (1 + rh) / (1 + rf ) = e1 / e0
Note the relation here to interest rate parity. If the forward rate
is an unbiased predictor of the future spot rate-that is,fl = e1-
then Equation becomes the interest rate parity condition:
(1 + rh) / (1 + rf ) = f1 / e0
According to both Equations the expected return from
investing at home, I + rh, should equal the expected HC return
from investing abroad, (1 + rf)eI / eo or (1 + rf) f1 / e0 As
discussed in the previous section, however, despite the intuitive
appeal of equal expected returns, domestic and foreign expected
returns might not equilibrate if the element of cwrency risk
restrained the process of international arbitrage.
Illustration
Using the IFE to Forecast U.S.$ and SFr Rates. In July, the one-
year interest rate is 4% on Swiss francs and 13% on U.S. dollars.
a. If the current exchange rate is SFr 1 = $0.63, what is the
expected future exchange rate in one year?
Solution. According to the international Fisher effect, the spot
exchange rate expected in one year equals 0.63 x 1.13/1.04 = $0.6845.
Exhibit 5. Fisher Effect: Empirical Data, 1982-1998
b. If a change in expectations regarding future U.S. inflation
The proposition that expected real returns are equal between causes the expected future spot rate to rise to $0.70, what
countries cannot be tested directly. However, many observers should happen to the U.S. interest rate?
believe it unlikely that significant real interest differen-tials could
long survive in the increasingly internationalized capital markets. Solution. If r us is the unknown U.S. interest rate, and the Swiss
interest rate stayed at 4% (because there has been no change in
Most market participants agree that arbitrage, via the huge pool
of liquid capital that operates in international markets these expectations of Swiss inflation), then according to the interna-
days, is forcing pretax real interest rates to converge across all the tional Fisher effect, 0.70/0.63 = (1 +rus)/1.04, or r us = 15.56%.
major nations.
The International Fisher Effect
96
INTERNATIONAL FINANCE MANAGEMENT
INFLATION RISK AND CURRENCY FORECASTING
Learning Objectives Therefore, lender and borrower will decide under some circum-
To explain how inflation risk impact the financial market stances to shun fixed-rate debt contracts altogether.
To explain the strategies to be adopted to cope with inflation Inflation and Bond Price Fluctuations
risk The effect of inflation on bond prices is comparable to that of
To spell out the requirements for successful currency interest rate changes because both affect the real value of cash
forecasting along with forecasting of controlled exchange rates flows to be received in the future. For example, the real or
inflation-adjusted value of a dollar to be received in one year
Inflation Risk and Its Impact on when inflation is 5% per annum equals l/1.05 or $0.9524. That
Financial Markets same dollar to be received two years hence has a real value of 1/
We have seen from the Fisher effect that both borrowers and (1.05) 2 = $0.9070. An increase in the inflation rate to 8% per
lenders factor expected inflation into the nominal interest rate. annum will change the real values of the dollars received in the
The problem, of course, is that actual inflation could turn out first and second years to $0.9259 and $0.8573, respectively. The
to be higher or lower than expected. This possibility introduces 3% increase in the rate of inflation reduces the real value of the
the element of inflation risk, by which is meant the divergence dollar received in year I by $0.0265, while the real value of the
between actual and expected inflation. dollar received in year 2 drops by $0.0497.
It is easy to see why inflation risk can have such a devastating This example illustrates a more general phenomenon: The
impact on bond prices. Bonds promise investors fixed cash longer the maturity of a bond, the greater the impact on the
payments until maturity. Even if those payments are guaran- present value of that bond associated with a given change in the
teed, as in the case of default-free U.S. Treasury bonds, investors rate of inflation. In effect, a change in the inflation rate is
face the risk of random changes in the dollars purchasing equivalent to a change in the rate at which future cash flows are
power. If actual inflation could vary between 5% and 15% discounted back to the present. Thus, inflation risk is most
annually, then the real interest rate associated with a 13% devastating on long-term, fixed-rate bonds.
nominal rate could vary between 8% (13 - 5) and -2% (13 - 15). Responses to Inflation Risk
Since what matters to people is the real value not the quantity- Since the problem of inflation risk increases with the maturity of a
of the money they will receive, a high and variable rate of bond, the presence of volatile inflation will make corporate
inflation will result in lenders demanding a premium to bear borrowers less willing to issue, and investors less willing to buy,
inflation risk. long-term, fixed-rate debt. The result will be a decline in the use of
Borrowers also face inflation risk, assume a firm issues a 200 long-term, fixed-rate financing and an increased reliance on debt
year bond prices to yield 15% if this nominal rate is based on a with shorter maturities, floating-rate bonds, and indexed bonds.
12% expected rate on inflation then the firms expected real cost Shorter Maturities: With shorter maturities, investors and
of debt will be about 3%. But suppose the rate of inflation borrowers lock them-selves in for shorter periods of time. They
averages 2% over the next 20 years. Instead of a 3% real cost of reduce their exposure to inflation risk because the divergence
debt, the firm must pay a real interest rate of 13%. Thus, between actual and expected inflation decreases as the period of
borrowers will also demand to be compensated for bearing time over which inflation is measured decreases. When the
inflation risk. Of course, if inflation turns out to be higher than security matures, the loan can be rolled over or borrowed
expected, the borrower will gain by having a lower real cost of again at a new rate that reflects revised expectations of inflation.
funds than anticipated. Since inflation is a zero-sum game, the
Floating-Rate Bonds: The problem with short maturities for
lender will lose exactly what the borrower gains. When inflation
the corporate borrower, however, is that there is no guarantee
is lower than expected, however, the lender will profit at the
that additional funds will be available at maturity. A floating-
borrowers expense. Thus, the presence of uncertain inflation
rate bond solves this problem. The funds are automatically
introduces an element of risk into financial contracts even when,
rolled over every three to six months, or so, at an adjusted
as with government debt, default risk is absent. Under condi-
interest rate. The new rate is typically set at a fixed margin above
tions of high and variable inflation, therefore, we would expect
a mutually agreed-upon interest rate index such as the
to fmd an inflation risk premium, p, added to the basic Fisher
London interbank offer rate (LIBOR) for Eurodollar deposits
equation. The modified
the corresponding Treasury bill rate, or the prime rate. For
Fisher equation would then be example, if the floating rate is set at prime plus 2, then a prime
r = a + i + ai + p rate of 8.5% will yield a loan rate of 10.5%.
Yet a basic problem remains. Although inflation risk on a financial Indexed Bonds: The real interest rate on a floating-rate bond can
contract stated in nominal terms affects both borrower and lender, still change if real interest rates in the market change. Issuing
both cannot be compensated simultaneously for bearing this risk.
97
indexed bonds that pay interest tied to the inflation rate can clearly political. During the Bretton Woods system, for example,
INTERNATIONAL FINANCE MANAGEMENT
alleviate this problem. For example, the British government has many speculators did quite well by stepping into the shoes of
sold several billion pounds of indexed bonds since 1981. The the key decision makers to forecast their likely behavior. The
way indexation works is that the interest rate is set equal to, say, basic forecasting methodology in a fixed-rate system, therefore,
3% plus an adjustment for the amount of inflation during the involves first ascertaining the pressure on a currency to devalue
past year. If inflation was 17%, the interest rate will be 3 + 17 = or revalue and then determining how long the nations political
20%. In this way, although the nominal rate of interest will leaders can, and will, persist with this particular level of
fluctuate with inflation, the real rate of interest will be fixed at disequilibrium.
3%. Both borrower and lender are protected against inflation risk.
Market-Based Forecasts
The international evidence clearly supports these conjectures. In So far, we have identified several equilibrium relationships that
highly inflationary countries-such as Argentina, Brazil, Israel, should exist between exchange rates and interest rates. The
and Mexico-Iong-term fixed-rate financing is no longer empirical evidence on these relationships implies that, in
available. Instead, long-term financing is done with floating-rate general, the financial markets of developed countries efficiently
bonds or indexed debt. Similarly, in the United States during incorporate expected currency changes in the cost of money and
the late 1970s and early 1980s, when inflation risk was at its forward exchange. This means that currency forecasts can be
peak, 3D-year conventional fixed-rate mortgages were largely obtained by extracting the predictions already embodied in
replaced with so-called adjustable-rate mortgages. The interest interest and forward rates.
rate on this type of mortgage is adjusted every month or so in
Forward Rates: Market-based forecasts of exchange rate changes
line with the changing short-term cost of funds. To the extent
can be derived most simply from current forward rates.
that short-term interest rates track actual inflation rates closely a
Specifically, II-the forward rate for one period from now-will
reasonable assumption according to the available evidence-an
usually suffices for an unbiased estimate of the spot rate as of
adjustable rate mortgage protects both borrower and lender
that date. In other words, f1 should equal e1 where e1 is the
from inflation risk.
expected future spot rate.
Currency Forecasting Interest Rates: Although forward rates provide simple and easy
Forecasting exchange rates has become an occupational hazard to use currency forecasts, their forecasting horizon is limited to
for financial executives of multinational corporations. The about one year because of the general absence of longer-term
potential for periodic-and unpredictable-government interven- forward contracts. Interest rate differentials can be used to
tion makes currency forecasting all the more difficult. But this supply exchange rate predictions beyond one year. For example,
has not dampened the enthusiasm for currency forecasts, or the suppose five-year interest rates on dollars and Deutsche marks
willingness of economists and others to supply them. Unfortu- are 12% and 8%, respectively. If the current spot rate for the
nately, though, enthusiasm and willingness are not sufficient DM is $0.40 and the (unknown) value of the DM in five years
conditions for success. is e5, then $1.00 invested today in Deutsche marks will be worth
Requirements for Successful Currency Forecasting (1.08) se5/0A dollars at the end of five years; if invested in the
Currency forecasting can lead to consistent profits only if the dollar security, it will be worth (1.12) in five years.
forecaster meets at least one of the following four criteria: 10 He Model-Based Forecasts
or she The two principal model-based approaches to currency predic-
Has exclusive use of a superior forecasting model tion are known as funda-mental analysis and technical analysis.
Has consistent access to information before other investors Each approach has its advocates and detractors.
Exploits Small, temporary deviations from equilibrium Fundamental Analysis. Fundamental analysis is the most
common approach to forecasting future exchange rates. It relies
Can predict the nature of government intervention in the
on painstaking examination of the macroeconomic variables
foreign exchange market
and policies that are likely to influence a currencys prospects.
The first two conditions are self-correcting. Successful forecast- The variables examined include relative inflation and interest
ing breeds imitators, while the second situation is unlikely to rates, national income growth, and changes in money supplies.
last long in the highly informed world of interna-tional finance. The interpretation of these variables and their implications for
The third situation describes how foreign exchange traders future exchange rates depend on the analysts model of
actually earn their living and also why deviations from equilib- exchange rate determination. The simplest form of fundamen-
rium are not likely to last long. The fourth situation is the one tal analysis involves the use of PPP. We have previously seen the
worth searching out. Countries that insist on managing their value of PPP in explaining exchange rate changes. Its application
exchange rates, and are willing to take losses to achieve there in currency forecasting is straightforward.
target rates, present speculators with potentially profitable
Most analysts use more complicated forecasting models whose
opportunities. Simply put, consistently profitable predictions
analysis usually centers on how the different macroeconomic
are possible in the long run only if it is not necessary to
variables are likely to affect the demand and supply for a given
outguess the market to win.
foreign currency. The currencys future value is then determined
As a general rule, when forecasting in a fixed-rate system, the by estimating the exchange rate at which supply just equals
focus must be on the governmental decision-making structure demand-when any current -account imbalance is just matched
because the decision to devalue or revalue at a given time is by a net capital flow.
98
Technical Analysis Notes
99
UNIT - 4
INTERNATIONAL CAPITAL BUDGETING
CHAPTER 13: INTERNATIONAL CAPITAL
BASICS OF CAPITAL BUDGETING BUDGETING FOR THE MULTINATIONAL
CORPORATION
Chapter Organization
INTERNATIONAL FINANCE MANAGEMENT
The motivation to invest capital in a foreign operation is, of course, to provide a return in excess of that required. There may
be gaps in foreign markets where excess returns can be earned. Domestically, competitive pressures may be such that only a
normal rate of return can be earned. Although expansion into foreign markets is the reason for most investment abroad, there
are other reasons. Some firms invest in order to produce more efficiently. Another country may offer lower labor and other
costs, and a company will choose to locate, production facilities there in the quest for lower operating costs. The electronics
industry for instances has moved towards foreign production facilities for this saving. Some companies invest abroad to secure
neces-sary raw materials. Oil companies and mining companies in particular invest abroad for this reason. All of these
pursuits-markets, production facilities, and raw materi-als-are in keeping with an objective of securing a higher rate of return
than are possi-ble through domestic operations alone.
Multinational corporations evaluating foreign investments find their analyses compli-cated by a variety of problems that are
rarely, if ever, encountered by domestic firms. This chapter examines several such problems, including differences between project
and parent company cash flows, foreign tax regulations, expropriation, blocked funds, exchange rate changes and inflation,
project-specific financing, and differences between the basic business risks of foreign and domestic projects. The purpose of this
chapter is to develop a framework that allows measuring, and reducing to a common denominator, the consequences of these
complex factors on the desirability of the foreign investment opportunities under review. In this way, projects can be compared
and evaluated on a uniform basis, The major principle behind methods proposed to cope with these complications is to
maximize the use of available information while reducing arbitrary cash flow and cost of capital adjustments.
Based on the above approaches, it has been planned to divide the chapter into 3 broad segments:
Basics of Capital Budgeting
Issues in Financial Investments Analysis
International Project Appraisal System
Lesson Objective n
To help you develop an understanding, the relevance and NPV = - I0 + Xt / (1 + K)t
criticality of NPV and APV in Capital Budgeting as a Basic t=1
Principle
Where I0 = the initial cash investment
Once a firm has compiled a list of prospective investments, it
Xt = the net cash flow in period t
must then select from among them that combination of
projects that maximizes the companys value to its shareholders. k = the projects cost of capital
This selection requires a set of rules and decision criteria that n = the investment horizon
enables managers e to determine, given an investment oppor- To illustrate the NPV method, consider a plant expansion
tunity, whether to accept or reject it. It is generally agreed that the project with the following stream of cash flows and their
criterion of net present value is the most appropriate one to use present values:
since its consistent application will lead the company to select
Assuming a 10% cost of capital, the project is acceptable.
the same investments the shareholders would make them-
selves, if they had the opportunity. The most desirable property of the NPV criterion is that it
evaluates investments in the same way the companys share-
Net Present Value holders do; the NPV method properly focuses on cash rather
The net present value (NPV) is defined as the present value of
future cash flows discounted at an appropriate rate minus the
Present
initial net cash outlay for the project. Projects with a positive Value Cumulative
NPV should be accepted; negative NPV projects should be Factor Present Present Value
Year Cash Flow x =
rejected. If two projects are mutually exclusive, the one with the (10%) Value
higher NPV should be accepted. The discount rate, known as -
0 -$4,000,000 1.0000 -$4,000,000
the cost of capital, is the expected rate of return on projects of $4,000,000
similar risk. For now, we take its value as given. 1 1,200,000 0.9091 1,091,000 - 2,909,000
2 2,700,000 0.8264 2,231,000 - 678,000
In mathematical terms, the formula for net present value is 3 2,700,000 0.7513 2,029,000 1,351,000
100
than on accounting profits and emphasizes the opportunity changes. Thus even in a purely domestic context, the standard
101
In both cases, an investment either created or was expected to In general, incremental cash flows associated with an investment
INTERNATIONAL FINANCE MANAGEMENT
create additional sales for existing products. Thus, sales creation is can be found only by subtracting worldwide corporate cash
the opposite of cannibalization. In calculating the projects cash flows without the investment from post investment corporate
flows, the additional sales and associated incremental cash flows cash flows. In performing this incremental analysis, the key
should be attributed to the project. question that managers must ask is, what will happen if we
dont make this investment? Failure to heed this question led
Opportunity Cost
General Motors during the 1970s to slight investment in small
Suppose IBM decides to build a new office building in Sao
cars despite the Japanese challenge; small cars looked less
Paulo on some land it bought ten years ago. IBM must include
profitable than GMs then-current mix of cars. As a result,
the cost of the land in calculating the value of undertaking the
Toyota, Nissan, and the other Japanese automakers were able to
project. Also, this cost must be based on the current market
expand and eventually threaten GMs base business. Similarly,
value of the land, not the price it paid ten years ago.
many U.S. companies that thought overseas expan-sion too
This example demonstrates a more general rule. Project costs risky today find their worldwide competitive positions eroding.
must include the true economic cost of any resource required They didnt adequately consider the consequences of not
for the project, regardless of whether the firm already owns the building a strong global position.
resource or has to go out and acquire it. This true cost is the
opportunity cost, the cash the asset could generate for the firm Illustration
should it be sold or put to some other productive use. It Investing in Memory Chips. Since 1984, the intense competi-
would be foolish for a firm that acquired oil at $3/barrel and tion from Japanese firms has caused most U.S. semiconductor
converted it into petrochemicals to sell those petrochemicals manufacturers to lose money in the memory chip business.
based on $3/barrel oil if the price of oil has risen to $30/barrel. The only profitable part of the chip business for them is in
So, too, it would be foolish to value an asset used in a project at making microprocessors and other specialized chips. Why do
other than its opportunity cost, regardless of how much cash they continue investing in facilities to produce memory chips
changes hands. despite their losses in this business?
Transfer Pricing U.S. companies care so much about memory chips because of
By raising the price at which a proposed Ford plant in their importance in fine-tuning the manufacturing process.
Dearborn will sell engines to its English subsidiary. Ford can Memory chips are manufactured in huge quantities and are fairly
increase the apparent profitability of the new plant, but at the simple to test for defects, which make them ideal vehicles for
expense of its English affiliate. Similarly, if Matsushita lowers refining new production processes. Having worked out the bugs
the price at which its Panasonic division buys microprocessors by making memories, chip companies apply an improved process
from its microelectronics division, the latters new semiconduc- to hundreds of more complex products. Without manufacturing
tor plant will show a decline in profitability. some sort of memory chip, most chipmakers believe, it is very
difficult to keep production technology competitive. Thus,
It is evident from these examples that the transfer prices at
making profitable investments elsewhere in the chip business
which goods and services are traded internally can significantly
may be contingent on producing memory chips.
distort the profitability of a proposed investment. Where
possible, the prices used to evaluate project inputs or outputs Clearly, although the principle of incremental analysis is a simple
should be market prices. If no market exists for the product, one to state, its rigorous application is a tortuous undertaking.
then the firm must evaluate the project based on the cost However, this rule at least points executives responsible for
savings or additional profits to the corporation of going ahead estimating cash flows in the right direction. Moreover, when
with the project. For example, when Atari decided to switch estimation shortcuts or simplifications are made, it provides
most of its production to Asia, its decision was based solely on those responsible with some idea of what they are doing and
the cost savings it expected to realize. This approach was the how far they are straying from a thorough analysis.
correct one to use because the stated revenues generated by the
project were meaningless, an artifact of the transfer prices used
in selling its output back to Atari in the United States.
Fees and Royalties
Often companies will charge projects for various items such as
legal counsel, power, lighting, heat, rent, research and develop-
ment, headquarters staff, management costs, and the like. These
charges appear in the form of fees and royalties. They are costs
to the project, but are a benefit from the standpoint of the
parent firm. From an economic standpoint, the project should
be charged only for the additional expenditures that are
attributable to the project; those overhead expenses that are
unaffected by the project should not be included when estimat-
ing project cash flows.
102
INTERNATIONAL FINANCE MANAGEMENT
ISSUES IN FOREIGN INVESTMENT ANALYSIS
The analysis of a foreign project raises two additional issues Estimating Incremental Project Cash-
other than those dealing with the interaction between the Flows
investment and financing decisions. These two issues are as Essentially, the company must esti-mate a projects true
follows, which you must be familiarized with: profitability. True profitability is an amorphous concept, but
1. Should cash flows be measured from the viewpoint of the basically it involves determining the marginal revenue and
project or the parent? marginal costs associated with the project. In general, as
2. Should the additional economic and political risks that are mentioned earlier, incremental cash flows to the parent can be
uniquely foreign be reflected in cash flow or discount rate found only by subtracting worldwide parent company cash
adjustments? flows (without the investment) from post investment parent
company cash flows. This estimating entails the following:
Accordingly, the following are the learning objectives:
1. Adjust for the effects of transfer pricing and fees and
Learning Objectives royalties.
To explain you about the significance of parent vs. project Use market costs/prices for goods, services, and capital
cash flows for understanding the interaction between transferred internally
investment and financing decisions Add back fees and royalties to project cash flows since
To help you understand the rationale for political and they are benefits to the parent
economic risk analysis as a pre- requisite for foreign investment Remove the fixed portions of such costs as corporate
Parent Versus Project Cash-Flows overhead
A substantial difference can exist between the cash flow of a 2. Adjust for global costs benefits that are not reflected in the
project and the amount that is remitted to the parent firm projects financial state-ments. These costs benefits include
because of tax regulations and exchange controls. In, addition, Cannibalization of sales of other units
project expenses such as management fees and royalties are
Creation of incremental sales by other units
returns to the parent company. Further more, the incremental
revenue contributed to the parent MNC by a project can differ Additional taxes owed when repatriating profits
from total project revenues if, for example, the project involves Foreign tax credits usable elsewhere
substituting local production for parent company exports or if Diversification of production facilities
transfer price adjustments shift profits elsewhere in the system. Market diversification
Given the differences that are likely to exist between parents and Provision of a key link in a global service network
project cash flows, the question arises as to the relevant cash flows The second set of adjustments involves incorporating the
to use in project evaluation. Economic theory has the answer to projects strategic purpose and its impact on other units.
this question. According to economic theory, the value of a
Although the principle of valuing and adjusting incremental
project is determined by the net present value of future cash
cash flows is itself simple, it can be complicated to apply. Its
flows back to the investor. Thus, the parent MNC should value
application is illustrated in the case of taxes.
only those cash flows that are, or can be, repatriated net of any
transfer costs (such as taxes) because only accessible funds can be Tax Factors
used for the payment of dividends and interest, for amortization Because only after-tax cash flows are relevant, it is necessary to
of the firms debt, and for reinvestment. determine when and what taxes must be paid on foreign-source
profits. To illustrate the calculation of the incremental tax owed
A Three-Stage Approach
on foreign-source earning, suppose an affiliate will remit after-
To simplify project evaluation, a three-stage analysis is recom-
tax earnings of $150,000 to its U.S. parent in the form of a
mended. In the first stage, project cash flows are computed
dividend. Assume the foreign tax rate is 25%, the withholding
from the subsidiarys standpoint, exactly as if the subsidiary
tax on dividends is 4%, and excess foreign tax credits are
were a separate national corporation. The perspective then shifts
unavailable. The marginal rate of additional taxation is found
to the parent company. This second stage of analysis requires
by adding the withholding tax that must be paid locally to the
specific forecasts concerning the amounts, timing, and form of
U.S. tax owed on the dividend. Withholding tax equals $6,000
transfers to headquarters, as well as information about what
(150,000 x 0.04), while U.S. tax owed equals $12,000. This latter
taxes and other expenses will be incurred in the transfer process.
tax is calculated as follows. With a before-tax local income of
Finally, the firm must take into account the indirect benefits and
$200,000 (200,000 x 0.75 = 150,000), the U.S. tax owed would
costs that this investment confers on the rest of the system,
equal $200,000 x 0.34. or $68,000. The firm then receives foreign
such as an increase or decrease in export sales by another affiliate.
tax credits equal to $56,000-the $50,000 in local tax paid and the
$6.000 dividend withholding tax leaving a net of $12,000 owed
103
the IRS. This calculation yields a marginal tax rate of 12% on that shareholders are risk- neutral, it does assume either that
INTERNATIONAL FINANCE MANAGEMENT
remitted profits as follows: risks such as expropriation currency controls, inflation and
6,000 + 12,000 = 0.12 exchange rate changes are unsystematic or that foreign invest-
ments tend to lower a firms systematic risk. In the latter case,
150,000
adjusting only the expected values of future cash flows will yield
If excess foreign tax credits are available, then the marginal tax rate a lower bound on the value of the investment to the firm.
on remittances is just the dividend withholding tax rate of 4%.
Although the suggestion that cash flows from politically risky
Political and Economic Risk Analysis areas should be dis-counted at a rate that ignores those risks is
All else being equal, firms prefer to invest in countries with contrary to current practice, the difference is more apparent than
stable currencies, healthy economies, and minimal political risks, real: Most firms evaluating foreign investments discount most
such as expropriation. But all else is usually not equal, so firms likely (modal) rather than expected (mean) cash flows at a risk-
must assess the consequences of various political and economic adjusted rate. If an expropriation or currency blockage is
risks for the viability of potential investments. anticipated, then the mean value of the probability distribution
The three main methods for incorporating the additional of future cash flows will be significantly below its mode. From
political and economic risks, such as the risks of currency a theoretical standpoint, of course, cash flows should always be
fluctuation and expropriation, into foreign investment analysis adjusted to reflect the change in expected values caused by a
are (1) shortening the minimum payback period, (2) raising the particular risk; however, only if the risk is systematic should
required rate of return of the investment, and (3) adjusting cash these cash flows be further discounted.
flows to reflect the specific impact of a given risk.
Exchange Rate Changes and Inflation
Adjusting the Discount Rate or Payback The present value of future cash flows from a foreign project
Period can be calculated using a two-stage procedure: (1) Convert
The additional risk confronted abroad are usually described in nominal foreign currency cash flows into nominal home
general term instead of being related to their impact on specific currency terms, and (2) discount those nominal cash flows at
investments This rather vague view of risk probably explain in the nominal domestic required rate of return. Let C, be the
the prevalence among multinationals of two unsystematic view nominal expected foreign currency cash flow in year t, et the
probably explains the prevalence among economic risks of nominal exchange rate in t, and k* is the nominal required rate
overseas approaches to account for the added political and of return. Then Ctet is the nominal HC value of this cash flow
overseas operations One IS to use a higher discount rate for in year t and Ctet / (I + k*)t is its present value.
foreign operations; another, to require a shorter payback period, In order to properly assess the effect of exchange rate changes
for instance if exchange restrictions are anticipated, a normal on expected cash flows from a foreign project, one must first
required return of 15% might be raised to 20%, or a five-year remove the effect of offsetting inflation and exchange rate
payback period may be shortened to three years. changes. It is worthwhile to analyze each effect separately
Neither of the aforementioned approaches, however, lends because different cash flows may be differentially affected by
itself to a careful evaluation of the actual impact of a particular inflation. For example, the depreciation tax shield will not rise
risk on investment returns. Thorough risk analysis requires an with inflation, while revenues and variable costs are likely to rise
assessment of the magnitude and timing of risks and their in line with inflation.
implications for the projected cash flows. For example, an Or local price controls may not permit internal price adjust-
expropriation five years hence is likely to be much less threaten- ments. In practice, correcting for these effects means first
ing than one expected next year, even though the probability of adjusting the foreign currency cash flows for inflation and then
it occurring later may be higher. Thus, using a uniformly higher converting the projected cash flows back into HC using the
discount rate just distorts the meaning of the present value of a forecast exchange rate.
project by penalizing future cash flows relatively more heavily
than current ones, without obviating the necessity for a careful Illustration
risk evaluation. Furthermore, the choice of a risk premium is an Factoring in Currency Depreciation and Inflation. Suppose that
arbitrary one, whether it is 2% or 10%. Instead, adjusting cash with no inflation the cash flow in year 2 of a new project in
flows makes it possible to fully incorporate all available France is expected to be FF I million, and the exchange rate is
information about the impact of a specific risk on the future expected to remain at its current value of FF I = $0.20. Con-
returns from an investment. verted into dollars, the FF I million cash flow yields a projected
cash flow of $200,000. Now suppose that French inflation is
Adjusting Expected Values expected to be 6% annually, but project cash flows are expected
The recommended approach is to adjust the cash flows of a to rise only 4% annually because the depreciation tax shield will
project to reflect the specific impact of a given risk primarily remain constant. At the same time, because of purchasing
because there is normally more and better information on the power parity, the franc is expected to devalue at the rate of 6%
specific impact of a given risk on a projects cash flows than on annually -giving rise to forecast exchange rate in year 2 of 0.20 x
its required return. The cash-flow adjustments presented in this (1 - 0.06) 2 = $0.1767. Then the forecast cash flow in year 2
chapter employ only expected values; that is, the analysis reflects becomes FF 1,000,000 x 1.042 = FF 1,081,600, with a forecast
only the first moment of the probability distribution of the dollar value of$191,119 (0.1767 x 1,081,600).
impact of a given risk. While this procedure does not assume
104
INTERNATIONAL FINANCE MANAGEMENT
INTERNATIONAL PROJECT APPRAISAL SYSTEMS
105
The parent will charge IDC-U.K. licensing and overhead Of the $50 million in net plant and equipment costs, $10
INTERNATIONAL FINANCE MANAGEMENT
allocation fees equal to 7% of sales in pounds sterling. In million will be financed by NEBs loan of 5 million at 8%.
addition, IDC-U.S. will sell its English affiliate valves, piston The remaining $40 million will be supplied by the parent, $20
rings, and other components that account for approximately million as equity and $20 million as debt. The debt carries a fair
30% of the total amount of materials used in the manufactur- market rate of 12%, and the principal is repayable in ten equal
ing process. IDC-U.K. will be billed in dollars at the current installments, commencing at the end of the first year.
market price for this material. The remainder will be purchased Working-capital requirementscomprising cash, accounts
10caIJy. IDC-U.S. estimates that its all-equity nominal required receivable, and inventory -are estimated at 30% of sales, but this
rate of return for the project will equal 15%, based on an amount will be partially offset by accounts payable to local
estimated 8% U.S. rate of inflation and the business risks firms, which are expected to average 10% of sales. Therefore,
associated with this venture. The debt capacity of such a project net investment in working capital will equal approximately 20%
is judged to be about 20%-that is a debt/equity ratio for this of sales. The transfer price on the material sold to IDC-U.K. by
project of about 1:4 is considered reasonable. its parent includes a 25% contribution to IDC-U.S.s profit and
To simplify its investment analysis, IDC-U.S. uses a five-year overhead. That is, the variable cost of production equals 75%
capital budgeting horizon and then calculates a terminal value of the transfer price. Lloyds Bank is providing an initial
for the remaining life of the project. If the project has a positive working-capital loan of 1.5 million ($3 million). All future
net present value for the first five years, there is no need to working-capital needs will be financed out of internal cash flow.
engage in costly and uncertain estimates of future cash flows. If Exhibit 1 summarizes the initial investment and exhibit 2
the initial net present value is negative then IDC-U.S. can summarizes initial balance sheet
calculate a break-even terminal value at which the net present
Financing IDC-U.K.
value will just be positive. This break-even value is then used as
Based on the information just provided, IDC-U.K. initial
a benchmark against which to measure projected cash flows
balance sheet, both in pounds and dollars, is presented in
beyond the first five years.
Exhibit 2. The debt ratio for IDC-U.K. is 15/25, or 60%. Note
Estimation of Project Cash Flows that this debt ratio could vary from 20%, if the parents total
A principal cash outflow associated with the project is the initial investment was in the form of equity, to 100%, if the parent
investment outlay, consisting of the plant purchase, equipment provided all of its $40-million investment for plant and
expenditures, and working-capital requirements. Other cash equipment as debt. In other words, an affiliates capital structure
outflows include operating expenses, later additions to working is not independent; rather, it is a function of its parents
capital as sales expand, and taxes paid on its net income. investment policies.
IDC-U.K. has cash inflows from its sales in England and other Exhibit 1: Initial Investment Outlay in IDC-U.K. (1 = $2)
EC countries. It also has cash inflows from three other sources:
(Millions) $(Millions)
The tax shield provided by depreciation and interest charges
Plant purchase and 17.5 35
Interest subsidies retooling expense
The terminal value of its investment, net of any capital gains equipment
liquidation Supplied by parent (used) 2.5 5
Recapture of working capital is not assumed until eventual Purchased in united 5 10
Kingdom working capital
liquidation because this working capital is necessary to maintain
Bank financing
an ongoing operation after the fifth year.
Total initial investment 26.5 $53
Initial Investment Outlay
As discussed in the previous section, the tax shield benefits of
Total plant acquisition, conversion, and equipment costs for
interest write-offs are represented separately. Assume that IDC-
IDC-U.K. were previously estimated at $50 million. Part of this
U.K. contributes $10.6 million to its parents debt capacity (0.2 x
$50 million is accounted for by equipment valued at $15
$53 million), the market rate of interest for IDC-U.K. is 12%,
million, which is required for retooling. Approximately $10
and the U.K. tax rate is 40%. This calculation translates into a
million worth of this equipment will be purchased locally, with
cash flow in the first and subsequent years equal to $10,600,000
the remaining $5 million imported as used equipment from the
x 0.12 x 0040, or $509,000. Discounted at 12%, this cash flow
parent. Although this used equipment has a book value of
provides a benefit equal to $1.8 million over the next five years.
zero, it will be transferred at its market value of $5 million. The
parent will be taxed at a rate of 25% on this gain over book Exhibit: 2. Initial Balance Sheet of IDC U.K. (1 = $2
value. If the equipment were transferred at other than its Interest Subsidies
market value, say at $7 million, the stated value on IDC-U.K. Based on an 11 % anticipated rate of inflation in England and
books ($7 million) would differ from its capital budgeting value on an expected annual 3% depreciation of the pound relative to
($5 million), which is based solely on its opportunity cost the dollar, the market rate on the pound loan to IDC-U.K.
(normally its market value). Both the new and used equipment would equal about 15%. Thus, the 8% interest rate on the loan
will be depreciated on a straight-line basis over a five-year by the National Enterprise Board represents a 7% subsidy to
period, with a zero salvage value. IDC-U.K. The cash value of this subsidy equals 350,000
106
(5,000,000 x 0.07), or approximately $700,000 annually for the Exhibit 3: Sales and Revenue Projections for IDC - UK
107
revenue. This situation is due both to the fixed depreciation
INTERNATIONAL FINANCE MANAGEMENT
Y ear
1 2 3 4 5
Production volum e (units) 30000 66000 73000 80000 88000
Variable costs
1. Labor and m aterial purchased in U.K. 110.0 122.1 135.5 150.4 167.0
a. Unit price ($) 3.3 8.1 9.9 12.0 14.7
b. Total cost (million)
2. Components purchased form IDC U.S 60.0 64.8 70 75.6 81.6
A. Unit price ($) 30.0 33.2 37.0 41.0 45.6
B. Unit price ($) 0.9 2.7 3.3 4.0
C. Total cost (Million)
3. Total variable costs (Bib +B2c) 4.2 10.2 12.6 15.3 18.7
C. License and overhead allocation fees
1. Total revenue (form exhibit 18.3 line C in 7.5 18.4 22.5 27.4 33.4
m illion)
a. License fees at 5% of revenue (m illions) 0.4 0.9 1.1 1.4 1.7
Overhead allocation at 2% of revenue ( 0.2 0.4 0.5 0.6 0.7
m illions)
2. Total licensing and overh ead allocation fees 0.6 1.3 1.6 2.0 2.4
(C1a +C1b in m illions)
D. Overhead expenses ( m illion) 0.6 1.3 1.5 1.7 1.9
E. Depreciation ( m illions) 5.0 5.0 5.0 5.0 5.0
F. Total production costs (B2+C2+D+E in in 10.4 17.9 20.7 24.0 28.0
m illions)
G. Exchange rate (4) 2.00 1.95 1.89 1.84 1.79
H. Total production costs (FXG in $ millions) $20.8 $34.9 $39.1 $44.2 $50.1
Projected Net Income effective tax rate on corporate income faced by IDC-U.K. in
In Exhibit 5, net income for years I through 5 is estimated England is estimated to be 40%. The $5.8 million loss in the
based on the sales and cost projections in Exhibits 3 and 4. The first year is applied against income in years 2, 3, and 4, reducing
corporate taxes owed in these years.
Year
1 2 3 4 5
Revenue (from Exhibit 3 line E) $ 15.0 $ 35.8 $42.5 $50.3 $59.9
Total production costs (from Exhibit 4 line H) 20.8 34.9 39.1 44.2 50.1
Profit before tax $5.8 $0.9 $3.4 $6.1 $9.8
Corporate income taxes paid to England @40% (0.4X C) 0 01 02 1.8 3.9
Net profit after tax (C-D) $5.8 $0.9 $3.4 $4.3 $5.9
One of the major outlays for any new project is the investment necessary investment in working capital will increase by 22%
in working capital. IDC-U.K begins with an initial investment annually, the rate of increase in pound sales revenue. Translated
in working capital of 1.5 million ($3 million). Working-capital into dollars, this means a 19% yearly increase in dollar working
requirements are projected at a constant 20% of sales. Thus, the capital, as shown in Exhibit 6.
108
Exhibit 6: Projected Additions to IDC- UKs Working Exhibit 7: Calculation of Terminal Value for
Year Year
0 1 2 3 4 5 6 7 8 9 10 10+
Revenue (from $0 $15. $35. $42. $50. $59. Net income $11.21 $11.2 $11.2 $11.2 $11.2
exhibit 18.3 0 8 5 3 9 after tax
line E) Required 1.02 1.0 1.1 1.2 1.3
addition to
Working 0 3.0 7.2 8.5 10. 12.0
working capital
capital 1 Recapture of ------- ------ ------ ------ ------ ----
investment at working capital -- ---- --- - -
20% of Total cash flow 10.2 10.2 10.1 10.0 9.9 17.6
revenue (A-B+C)
Present value3 8.9 7.7 6.6 5.7 4.9 8.8
Initial working 3.0 --- --- --- --- --- (DXE)
capital Cumulative $8.9 $16.6 $23.2 $28.9 $33.8 $42.6
investment present value
Required --- 0 4.2 1.3 1.6 1.9
Options Approach to Project Appraisal
addition to The discounted cash flow approaches discussed above-whether
working capital NPV or APV-suffer from a serious drawback. Both ignore the
(line B for year various operational flexibilities built into many projects and
I line B for assume that all operating decisions are made once for all at the
year I 1; 2,5) start of the project. In many situations the project sponsors
have the freedom to alter various features of the project in the
Terminal Value light of developments in input and output markets, competi-
Calculating a tenninal value is a complex undertaking, given the tive pressures and changes in government policies. Among
various possible ways to treat this issue. Three different these flexibilities are:
approaches are pointed out. One approach is to assume the
1. The start of the project may be delayed till more information
investment will be liquidated after the end of the planning
about variables such as demand, costs, exchange rates and so
horizon and to use this value. However, this approach just
on is obtained. For instance starting a foreign plant may be
takes the question one step further. What would a prospective
postponed till the foreign currency stabilizes. Development
buyer be willing to pay for these projects? The second approach
of an oil field may be delayed till oil prices harden. For
is to estimate the market value of the project, assuming that it
instance, consider a project to develop an oil field. The
is the present value of remaining
current oil price is $15 a barrel and the project NPV is $10
Cash flow again through the value of the project to an outside million. In one years time the oil price may rise to $30 or fall
buyer may differ from it s value to the parent firm, due to to $10. The NPV of the project then would be either $18
parent profits on sales to its affiliate, for instance. The third million or-$IO million. By delaying the start of the project
approach is to calculate a break even terminal value at which the the firm can add greater shareholder value avoid getting
project is just acceptable the parent, and then use that as a locked into an unprofitable project.
benchmark against which to judge the likelihood of the present
2. The project may be abandoned if demand or price forecasts
value of future cash flows exceeding that value.
turn out to be over-optimistic or operat-ing costs shoot up.
Most firms try to be quite conservative in estimating terminal It may even be temporarily closed down and re-started again
values. IDC-UK calculates a terminal value based on the assump- when market conditions improve e.g. a copper mine can be
tion that the nominal dollar value of future income remains closed down when copper prices are low and operations re-
constant from years 6 through 10, and equals not income in year started when prices rise. Some exit and re-entry costs may of
5 except for adjustments to depreciation charges. In real terms, course be involved.
dollar income declines by 8% per for adjustments to depreciation
3. The operational scale of the project may be expanded or
charges in real terms, dollar income declines by 8% per year. It is
contracted depending upon whether demand turns out to be
assumed that this decline is due to the higher maintenance
more or less than initially envisioned.
expenditures associated with aging plant and equipment.
Nominal dollar revenue is expected to increase at the yearly rate of 4. The input and output mix may be changed or a different
inflation (i.e., real sales remain constant). To support the higher technology may be employed.
level of sales, nominal working capital needs also increase by 8% The conventional DCF approaches cannot easily incorporate
annually. All working capital is recaptured at the end of tear 10, these features. In recent years the theory of option pricing has
when the project is expected to cease. The calculation of terminal been applied to project appraisal to take account of these
value for IDC UK appears in Exhibit 7 as of the end of year 5, operational flexibilities. For instance, the option to abandon a
the terminal value has a present value of $ 42.6 million. project can be viewed as a put option-the option to sell the
109
project assets-with a strike price equal to the liquidation value 1. A large majority of practitioners employ DCF asset least one
INTERNATIONAL FINANCE MANAGEMENT
of the project. The option to start the project at a later date can of the methods for valuation.
be viewed as a call option on the PV of project cash flows with 2. Most practitioners are de facto multi-factor model adherents.
a strike price equal to the initial investment required for the More segmented the market under consideration greater is
project. Similarly, the option to expand capacity if demand turns the number of additional factors used in valuation. Even
out to be higher than expected can be viewed as a call option on those who claimed to use the single factor CAPM include
the incremental present value, with the strike price being equal more than one risk factor proxies.
to the additional investment required to expand capacity. 3. The use of local market portfolio as the sole risk factor is less
In many cases, these choices can be incorporated and evaluated frequent when the evaluator is dealing with countries, which
using a decision tree approach; in other cases option pricing are not well, integrated into the global capital markets.
models such as the Black-Scholes model and its referents can be However, they then add other risk factors rather than using
the global market portfolio. For integrated markets such as
employed.
the US or the UK, global market portfolio is used more
The Practice of Cross-Border frequently.
Direct Investment Appraisal 4. In the case of less integrated markets like Sri Lanka or
How do practitioners approach the problem of appraising Mexico, exchange risk, political risk (e.g. expropriation),
investment projects in foreign countries? Some survey results sovereign risk (e.g. Government defaulting on its
have been reported which seem to indicate that many participants obligations) and unexpected infla-tion are considered to be
use DCF methods with some Version of asset pricing model to important risk factors in-addition to market risk.
estimate the cost of Capital but make lot of heuristic adjust to 5. Most practitioners adjust for these added risks by adding ad-
the discount rate to account for political and exchange rate risks. hoc risk premia to discount rates de-rived from some asset
In a recent paper Keck, Levengood and Longfield (1998) have pricing model rather than incorporating them in estimates of
reported the results of a survey of prac-titioners pertaining to cash flows. This goes against the spirit of asset pricing model,
the methodologies they employ to estimate cost of capital for which are founded on the premise that only non-- diversifiable
international invest-ments. Their findings can be broadly risks should be incorporated in the discount rate.
summarized as follows: Godfrey and Espinosa (1996) have developed a Practical
1. A large majority of practitioners employ DCF as at least one approach to computing the Cost of equity for investments in
of the methods for valuation. emerging markets. It essentially involves starting with the cost
of equity for similar domestic projects and adding on risk
2. Most practitioners are de facto multi-factor model adherents.
premia to reflect country risk and the total project risk. The
More segmented the market under con-sideration; greater is
former is estimated by looking at the spreads on dollar
the number of additional factors used in valuation. Even
denominated sovereign debt issued by the host country
those who claimed to use the single factor CAPM include
government, and the latter by the volatility of the host-country
more than one risk factor proxies.
stock market relative to the domestic stock market.
3. The use of local market portfolio as the sole risk factor is
A more common form of cross-border investment is joint
less frequent when the evaluator is dealing with countries,
venture and other modes of alliances between a firm in the host
which are not well, integrated into the global capital markets.
country and a foreign firm.
However, they then add other risk factors rather than using
the global market portfolio. For integrated markets such as Over and above the pure economics of the joint venture project,
the US or the UK, global market portfolio is used more the most crucial issue is the sharing of the synergy gains between
frequently. the partners. Two or more partners join in a venture only because
they have strengths that complement each other, in terms of
4. In the case of less integrated markets like Sri Lanka or
technology, distribution, market access, brand equity and so forth.
Mexico, exchange risk, political risk (e.g. expropriation),
The joint venture is expected to yield gains over and above the
sovereign risk (e.g. Government defaulting on its
sum of the gains each partner can obtain on its own.
obligations) and unexpected infla-tion are considered to be
important risk factors in addition to market risk. Game-theoretic models of bargaining suggest that the synergy
gains should be split equally. One way of achieving this is
5. Most practitioners adjust for these added risks by adding ad-
proportional sharing of project cash flows. Thus of the two
hoc risk premia to discount rates de-rived from some asset
partners, A brings in 30% of the investment, and B the remain-
pricing model rather than incorporating them in estimates of
ing 70%, cash flows should be shared in the same proportion.
cash flows. This goes against the spirit of asset pricing
This conclusion however needs modification when the two
models, which are founded on the premise that only non-
diversifiable risks should be incorporated in the discount rate. partners are subject to different tax regimes and tax rates.
Fair sharing of synergy gains can also be achieved by other
Some version of asset pricing model to estimate the cost of
means. Thus, a properly designed license contract wherein the
capital but make lot of heuristic adjustments to the discount
joint venture pays one of the partners a royalty or license fee for
rate to account for political and exchange rate risks.
know-how can achieve the same result as proportional
In a recent year, Keck, Levengood and Longfield (1998) have sharing of cash flows. Alternatively, one of the partners brings
reported the results of a survey of practi-tioners pertaining to in some intangible asset (e.g. a brand name), the value of which
the methodologies they employ to estimate cost of capital for is negotiated between the partners.
international invest-ments. Their findings can be broadly
summarized as follows:
110
UNIT 4
INTERNATIONAL CAPITAL BUDGETING
CHAPTER 14: INTERNATIONAL DEBT
INTERNATIONAL DEBT CRISIS OF 1982: CRISIS AND COUNTRY RISK ANALYSIS
ANALYSIS OF FACTORS
Chapter Orientation
Lesson Objectives: increasing the flow of loans to LDCs to $39 billion in 1980
(from $22 billion in 1978 and $35 billion in 1979) and to $40
Analysis of events that culminated into the international
billion in 1981.
banking crisis of 1982
The catalyst of the crisis was provided by the economic policies
Significant of backer plan and Bradley plan in coping the
pursued by the industrial countries in general, and by the
emerging crisis
United States in particular, in their efforts to deal with rising
Impact study of debt relegations to overcome debt crisis. domestic inflation. The combination of an expansionary fiscal
The International Banking Crisis of 1982 policy and tight monetary policy led to sharply rising real interest
The events that culminated in the international banking crisis of rates in the United States-and in the Euromarkets where the
1982 began to gather force in 1979. Several developments set the banks funded most of their international loans. The variable
stage. One of these was the growing trend in overseas lending rate feature of the loans combined with rising indebtedness
to set interest rates on a floating basis-that is. at a rate that boosted the LDCs net interest payments to banks from $11
would be periodically adjusted based on the rates prevailing in bilIion in 1978 to $44 billion in 1982. Further more, the doIlars
the market. Floating-rate loans made borrowers vulnerable to sharp rise in the early 1980s increased the real cost to the
increases in real interest rates as well as to increases in the real borrowers of meeting their debt payments.
value of the dollar because most of these loans were in dollars. The final element setting the stage for the crisis was the onset
Because of high U.S. inflation and a declining dollar during of a recession in industrial countries. The recession reduced the
most of the 1970s, borrowers were not concerned with these demand for the LDCs products and, thus, the export earnings
possibilities. Borrowers seemed to believe that inflation would needed to service their bank debt. The interest payments/
bail them out by reducing the real cost of loan repayment. export ratio reached 50% for some of these countries in 1982.
(Note the inconsistency of this belief with the Fisher effect.) A This ratio meant that more than half of these countries
second development was the second jump in oil prices, in 1979. exports were needed to maintain up-to-date interest payments,
In the absence of policies that promoted rapid adjustment to leaving less than half of the export earnings to finance essential
this new shock, the LDCs balance-of-payments deficits soared imports and to repay principal on their bank loans. These
to $62 billion in 1980 and $67 bilIion in 1981 and increased the trends made the LDCs highly vulnerable.
LDCs need for external financing; the banks responded by
111
Onset of the Crisis The Brady Plan
INTERNATIONAL FINANCE MANAGEMENT
The first major blow to the international banking system came Faced with the Baker Plan failure to resolve the ongoing debt
in August 1982. When Mexico announced that it was unable to crisis. Nicholas Brady, James Bakers Successor as U.S. Treasury
meet its regularly scheduled payments to international creditors. Secretary, put forth a new plan in 1989 that emphasized debt
Shortly thereafter, Brazil and Argentina-the second- and third- relief through forgiveness instead of new lending. Under the
largest debtor nations-found themselves in a similar situation. Brady Plan banks have a choice: They either could make new loans
By the spring of 1983, about 25 LDCs-accounting for two- or they could write off portions of their existing loans in
thirds of the international banks claims on this group of exchange for new government securities whose interest payments
countries-were unable to meet their debt payments as scheduled were backed with money from the International Monetary Fund.
and had entered into loan-rescheduling negotiations with the The problem with the Brady Plan is that, for it to work, commer-
creditor banks. cial banks will have to do both: make new loans at the same time
Compounding the problems for the international banks was a that they are writing off existing loans. Instead, many banks have
sudden drying up of funds from OPEC. A worldwide used the Brady Plan as an opportunity to exit the LDC debt
recession that reduced the demand for oil put downward market. They added billions to their loan-loss reserves to absorb
pressure on oil prices and on OPECs revenues. In 1980, OPEC the necessary loan write downs, virtually guaranteeing that they
contributed about $42 billion to the loan able funds of the will slash new LDC lending to the bone.
BIS-reporting banks. By 1982, the flow had reversed, as OPEC Illustration
nations became a net drain of $26 billion in funds. At the same Mexico Implements the Brady Plan. Mexicos Brady Plan
time, banks cut back sharply on their lending to LDCs. agreement in February 1990 offered three options to the banks:
The Baker Plan (I) convert their loans into salable bonds with guarantees
In October 1985, U.S. Treasury Secretary (now Secretary of State) attached. But worth only 65% of the face value of the old debt;
James Baker caIled on is principal middle-income debtor LDCs-the (2) convert their debt into new guaranteed bonds whose yield
Baker 15 countries-to undertake growth-oriented structural reforms was just 6.5%; or (3) keep their old loans but provide new
that would be supported by increased financing from the World money worth 25% of their exposures value. Only 10% of the
Bank, continued modest lending from commercial banks, and a banks risked the new money option, while 41 % agreed to debt
pledge by industrial nations to open their markets to LDC exports. reduction and 49% chose a lower interest rate. This agreement
The goal of the Baker Plan was to buttress LDC economic growth, saved Mexico $3.8 billion a year in debt servicing costs, but it is
making these countries more desirable borrowers and restoring unlikely to receive new money in the foreseeable future.
their access to international capital markets. As part of this restructuring, the U.S. government agreed to sell
By 1991, achievement stands far short of these objectives. Most Mexico 30-year, zero-coupon Treasury bonds in a face amount
of the Baker 15 has lagged in delivering on promised policy of $33 billion. Mexico bought the zeros to serve as collateral for
changes and economic performance. This recogni-tion has the bonds it planned to issue as a substitute for the bank loans.
dimmed assessments of the debtors prospects. Instead of When the Mexican deal was struck, 30-year Treasury zeros were
getting their economic house in order, many of the LDCs- selling in the open market to yield 7.75%. But the U.S. Treasury
feeling they had the big banks on the hook-sought to force the priced the zeros it sold to Mexico to yield 8.05%, reflecting the
banks to make more and more lending concessions. The price not of zeros but of conventional 3D-year Treasury bonds.
implied threat was that the banks would otherwise be forced to The Treasury also charged Mexico a service fee of 0.125% per
take large write-offs on their existing loans. annum, as is customary in such special Treasury sales. As a
result, Mexico received an effective annual interest yield of7.925
In May 1987, Citicorps new chairman, John Reed, threw down
% (8.05% - 0.125%).
the gauntlet to big debtor countries by adding $3 billion to the
banks loan-loss reserves. Citicorps action was quickly followed The sale of zero-coupon bonds to Mexico at a cut-rate price
by large additions to loss reserves by most other big U.S. and brought criticism from Congress and Wall Street. Many argued
British banks. The banks that boosted their loan-loss reserves that any U.S. aid to Mexico ought to flow through normal
have become tougher negotiators, arguing against easing further channels, and not be done in a back-door financing scheme.
the terms for developing countries debt settlements. The Without taking sides in this dispute, what is the value of the
decisions of these banks to boost their reserves-plus the subsidy the Treasury provided to Mexico?
announcement by some of their intention, one way or another, Solution: Solution: if the Treasury had priced the zeros to yield
to dispose of a portion of their existing LDC loanshave 7.75% less the 0.125% service fee, of 7.625% the $ 33 billion
precipitated fresh questioning of the LDC debt strategy, in face value of bonds would have cost Mexico
particular of the Baker initiative. The problem, however, is not $33 billion/(1.07625)30 = $3.64 billion
with the Baker initiative, but rather with its implementation. By
By pricing the bonds to yield 7.925%, the Treasury sold the
adding to their loan-loss reserves, Citicorp and the other banks
bonds to Mexico at a price of
that followed suit put themselves in a stronger position to
demand reforms in countries to which they lend-a key feature $33 billion/( 1.07925)30 = $3.35 billion
of the Baker Plan. The result is a savings to Mexico of about $290 million.
The market clearly recognized the deteriorating condition of the
LDC debt held by the large U.S. money-center banks. This
112
recognition is reflected in the bond markets increas-ingly grim their debts without added funding, the LDCs must run a non-
Debt Renegotiations
Since the early I 980s, there has been a seemingly endless series
of debt renegotiations. In order to grow, the LDCs require added
capital formation. But servicing their foreign debts requires the
use of scarce capital, thereby constraining growth. Thus, the
debtor LDCs is determined to reduce their net financial
transfersby limiting interest payments and increasing net Rather than interest payments coming out of consumption,
capital inflows-to levels consistent with desired economic they were financed by a dramatic cut in domestic investment.
growth. In short, they want more money from their banks. That is, the 5.5% turnaround in the non-interest surplus (4.7 +
However, the banks first want to see economic reforms that will 0.8) was matched by a 5.8% drop in net investment (calculated
improve the odds that the LDCs will be able to service their as a percent of GDP).
debts. The principal hindrance to bank willingness to supply
The same story can be told for the Baker 15 in the aggregate. As
more funds is skepticism about the ability and willingness of
shown in Exhibit.3, rather than financing interest payments by
the debtor nations to make sound economic policy.
cutting their deficit-ridden public sectors (Exhibit .3a), the
The predicament facing the LDCs can best be understood by Baker 15 cut capital formation (Exhibit .3b). The low rate of
dividing the current-ac-count surplus into two components: the investment is ominous for the debtors economic growth
non-interest surplus and interest payments. In order to service prospects.
113
One response to this hard arithmetic is seen in Perus unilateral limit
INTERNATIONAL FINANCE MANAGEMENT
114
INTERNATIONAL FINANCE MANAGEMENT
COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING
Learning Objectives their debts. Bank country risk analysis can, therefore, focus
To examine how enforceability of debt contacts and loan largely on ability to repay rather than willingness to repay.
syndications help overcome debt repayment crisis Notice, however, that the threat to cut off credit to borrowers
To explain you how the government at political level can who default is meaningful only so long as the banks have
resolve terms of trade risk barrier sufficient resources to reward with further credit those who do
not default. But if several countries default simultaneously,
To help to understand how debt services measures can
then the banks promise to provide further credit to borrowers
effectively reduce nations debt burden
who repay their debts is no longer credible; the erosion in their
Country Risk Analysis in International capital bases caused by the defaults will force the banks to curtail
Banking their loans. Under these circumstances, even those borrowers
It is worthwhile to note some differences between international who did not default on their loans will suffer a reduction of
loans and domestic loans because these differences have a lot to credit. The lesser penalty for defaulting may induce borrowers to
do with the nature of country risk. Ordinarily banks can control default en masse. The possibility of mass defaults is the real
borrowers by means of loan covenants on their dividend and international debt crisis.
financing decisions. Quite often, however, the borrowers in
Country Risk and the Terms of Trade
international loan agreements are sovereign states, or their
What ultimately determines a nations ability to repay foreign
ability to repay depends on the actions of a sovereign state. The
loans is that nations ability to generate U.S. dollars and other
unique characteristics of a sovereign borrower render irrelevant
hard currencies. This ability, in turn, is based on the nations
many of the loan covenants - such as dividend or merger
terms of trade, the weighted average of the nations export prices
restrictions-normally imposed on borrowers. Moreover,
relative to its import prices-that is, the exchange rate between
sovereign states ordinarily refuse to accept economic or financial
exports and imports. Most economists would agree that these
policy restrictions imposed by foreign banks.
terms of trade are largely independent of the nominal exchange
The key issue posed by international loans, therefore, is how do rate, unless the observed exchange rate has been affected by
banks ensure the enforceability of these debt contracts? What government intervention in the foreign exchange market.
keeps borrowers from incurring debts and then defaulting
In general, if its terms of trade increase, a nation will be a better
voluntarily? In general, seizure of assets is not useful unless the
credit risk. Alternatively, if its terms of trade decrease, a nation
debtor has substantial external assets, as in the case of Iran.
will be a poorer credit risk. This terms-of-trade risk, however, can be
Ordinarily, though, the borrower has few external assets.
exacerbated by political decisions. When a nations terms of trade
One answer to the question of enforceability is that it is difficult improve, foreign goods become relatively less expensive, the
for borrowers that repudiate their debts to reenter private capital nations standard of living rises, and consumers and businesses
markets -That is, banks find it in their best interest, ex- post, to become more dependent on imports. But since there is a large
deny further credit to a borrower that defaults on its bank loans. element of unpredictability to relative price changes, shifts in the
If the bank fails to adhere to its announced policy of denying terms of trade will also be unpredictable. When the nations
credit to its defaulters, some of its other borrowers may now terms of trade decline, as must inevitably happen when prices
decide to default on their debts because they realize that default fluctuate randomly, the government will face political pressure to
carries no penalty. Having a reputation for being a tough bank is maintain the nations standard of living.
a valuable commodity in a hard world that has no love for
A typical response is for the government to fix the exchange rate
moneylenders.
at its former (and now overvalued) level-that is, to subsidize the
The presence of loan syndications-in which several banks share a price of dollars. Loans made when the terms of trade improved
loan-and cross-default clauses-which ensure that a default to one are now doubly risky: first, because the terms of trade have
bank is a default to all banks-means that if the borrower declined and, second, because the government is maintaining an
repudiates its debt to one bank, it must repudiate its debt to all overvalued currency, further reducing the nations net inflow of
the banks. This constraint makes the penalty for repudiation dollars. The deterioration in the trade balance usually results in
much stiffer because a large number of banks will now deny added government borrowing. This was the response of the
credit to the borrower in the future. After a few defaults, the Baker 15 countries to the sharp decline in their terms of trade
borrower will exhaust most of the potential sources of credit in shown in Exhibit 114. Capital flight exacerbates this problem, as
the international financial markets. residents recognize the countrys deteriorating economic situation.
For many borrowers, this penalty is severe enough that they do To summarize, a terms-of-trade risk can be exacerbated if the
not voluntarily default on their bank loans. Thus, countries will government attempts to avoid the necessary drop in the standard
sometimes go to extraordinary lengths to continue servicing of living when the terms of trade decline by maintaining the old
115
and now overvalued exchange rate. In reality, of course, this
INTERNATIONAL FINANCE MANAGEMENT
Ex ante what matters is not just the coverage ratio but also the
element of country risk is a political risk. The government is variability of the difference between export revenues, X, and
attempting by political means to hold off the necessary economic import costs, M, relative to the nations debt-service require-
adjustments to the countrys changed wealth position. ments (i.e., c.v. [(X - M)/D], where c.v. is the coefficient of
A key issue, therefore, in assessing country risk is the speed with variation and D is the debt service requirement). In calculating
which a country adjusts to its new wealth position. In other this measure of risk, it is important to recognize that export
words, how fast will the necessary austerity policy be imple- volume is likely to be positively correlated-and import volume
mented? The speed of adjustment will be determined in part negatively correlated-with price. In addition, import expendi-
by the governments perception of the costs and benefits tures are usually positively related to export revenues.
associated with austerity versus default. Exhibit 5: Debt / Burden Ratios as of Year end 1982
The Governments Cost/Benefit Calculus
The cost of austerity is determined primarily by the nations Country Debt services / Debt service /
external debts relative to its wealth, as measured by its gross
exports GNP
national product (GNP). The lower this ratio, the lower the Mexico 0.70 0.080
relative amount of consumption that must be sacrificed to Brazil 0.56 0.063
meet a nations foreign debts. Argentina 0.41 0.024
The cost of default is the likelihood of being cut off from Chile 0.54 0.099
international credit. This possibility brings with it its own form Venezuela 0.32 0.090
of austerity. Most nations will follow this path only as a last Spain 0.28 ------
resort, preferring to stall for time in the hope that something Philippines 0.25 0.040
will happen in the interim. That something could be a bailout South Korea 0.17 0.063
by the IMF, the Bank for International Settle-ments, the Federal Non OPEC LDCs 0.24 0.056
Reserve, or some other major central bank. The bailout decision OPEC countries 0.11 0.054
is largely a political decision. It depends on the willingness of
citizens of another nation, usually the United States, to tax
Summingup
The end of lets pretend in international banking has led to a
themselves on behalf of the country involved This willingness
new emphasis on country risk analysis. From the banks stand-
is a function of two factors: (1) the nations geopolitical
point, country risk-the credit risk on loans to a nation-is largely
importance to the United States and (2) the probability that the
determined by the real cost of repaying the loan versus the real
necessary economic adjustments will result in unacceptable
wealth that the country has to draw on. These parameters, in
political turmoil.
turn, depend on the variability of the nations terms of trade and
The more a nations terms of trade fluctuate and the less stable the governments willingness to allow the nations standard of
its political system, the greater the odds the government will living to adjust rapidly to changing economic fortunes.
face a situation that will tempt it to hold off on the necessary
The countries at the center of the international debt crisis can
adjustments. Terms-of-trade variability will probably be
only get out if they institute broad systemic reforms. Their
inversely correlated with the degree of product diversification in
problems are caused by governments spending too much
the nations trade flows. With limited diversifica-tion-for
money they dont have to meet promises they should not
example, dependence on the export of one or two primary
make. They create public sector jobs for people to do things
products or on imports heavily weighted toward a few com-
they shouldnt do and subsidize companies to produce high
modities-the nations terms of trade are likely to be highly
priced goods and services. These countries need less govern-
variable. This characterizes the situation facing many Third
ment and fewer bureaucratic rules. Debt forgiveness or further
World countries. It also describes, in part, the situation of those
capital inflows would just tempt these nations to postpone
OECD (Organization for Economic Cooperation and Develop-
economic adjustment further.
ment) nations heavily dependent on oil imports.
Debt Service Measures
Two measures of the risk associated with a nations debt
burden are the debt service/ex-ports and debt service/GNP
ratios, where debt service includes both interest charges and
loan repayments. Exhibit 5 contains 1982 year-end statistics on
these debt service measures for both individual countries and
groupings of OPEC and non-OPEC developing countries. To
put these figures in perspective, most bankers consider a debt
service/exports ratio of 0.25 or higher to be dangerous. In
recent years, however, debt rescheduling has steadied the debt
service/exports ratio for the Baker IS (see Exhibit81.6a).
Moreover, their interest/exports ratio is actually improving (see
Exhibit a6b).
116
UNIT 4
INTERNATIONAL CAPITAL BUDGETING
CHAPTER 15: INTERNATIONAL TAX MAN-
OBJECTIVE OF TAXATION ON AGEMENT
INTERNATIONAL INVESTMENT
Chapter Orientation
117
2. The tax credit for taxes paid to a foreign government is The basic consid-eration here is that all similarly situated
INTERNATIONAL FINANCE MANAGEMENT
limited to the amount of tax that would have been due if taxpayers should help pay the cost of operating a government.
the income had been earned in the United States. There is no The key to the application of this concept lies in the definition
additional credit if the tax rate in the foreign country is of similarly situated. According to the U.S. Department of the
higher than that of the United States. Treasury, the definition encompasses all entities and income of
3. There are special tax incentives for U.S. exports sold through U.S. corporations. Opponents of the position advocate that the
a Foreign Sales Corporation (FSC). definition should limit taxation only to sources within the
United States.
4. The United States defers taxation of income earned in
foreign subsidiaries (except Subpart F income, to be Tax Treaties
discussed in a later section) until it is returned to the United The general tax policies toward the multinational firm outlined
States in the form of a dividend. This deferral becomes here are modified somewhat by a bilateral network of tax
important only if the effective foreign tax is below that of treaties designed to avoid double taxation of income by two
the United States. taxing jurisdictions. Although foreign tax credits help to some
Both the theory and the actual practice give a good indication of extent, the treaties go further in that they allocate certain types
the influence domestic tax neutrality has on U.S. tax policy. This of income to specific countries and also reduce or eliminate
influence, however, is limited with regard to foreign neutrality. withholding taxes.
The theory behind foreign neutrality in taxation is that the tax These tax treaties should be considered when planning foreign
burden placed on the foreign subsidiaries of U.S. firms should operations because under some circumstances, they can provide
equal that imposed on foreign-owned competitors operating in for full exemption from tax in the country in which a minor
the same country. There are basically two types of foreign activity is carried on (one that does not require a permanent
competitors that the U.S. subsidiary faces: the firm owned by establishment in the country). The general pattern of the treaties
residents of the host country and the foreign subsidiary of a is for the two treaty countries to grant reciprocal reductions in
non-U.S. corporation. Since other countries gear their tax systems withholding taxes on dividends, royalties, and interest.
to benefit domestic firms, the United States would have to Scope of Tax Charge
modify its tax system to that of other countries to achieve foreign
Status-situs Nexus (Sections 5 & 6)
neutrality. This modification would mean foregoing taxation of
Residential Status
income from foreign sources. In other words, the corporations
Every country develops its own rules to determine the scope of
foreign affiliate would be impacted by taxes only in the country
income that it can tax. These rules create liability to tax each year
of operation. Foreign neutrality cannot be a principal guide for
by linking the residential status of the income earning entity
tax policy because its achievement would be impossible in light
and the place where the income is earned. In terms of residen-
of present U.S. tax policies and objectives. Certainly it is inconsis-
tial status the Act stipulates that in respect of each previous year
tent with the principle of domestic neutrality.
any person (individual, firm, company etc.) is treated as either
Most major capital exporting countries including the United resident or non-resident in India. An individual who is a
States, Germany, Japan, Sweden, and Great Britain-follow a resident can once again be considered as either ordinarily
mixed policy of foreign and domestic tax neutrality whereby the resident or a not ordinarily resident. In the case of an
home government currently taxes foreign branch profits but individual the residential status depends upon the duration of
defers taxation of foreign subsidiary earnings until those his stay in India during the previous year under consider. A
earnings are repatriated. Host taxes on branch or subsidiary firm or a company is treated as resident or non-resident
earnings may be credited against the home tax; the credit is depending on whether the control and management of its
limited by the home tax or host tax, whichever is lower. affairs is situated wholly in India or outside India respectively
However, this latter provision violates domestic neutrality. during the previous year. An Indian company is always treated
Several home countries including France, Canada, and the as resident. It may be noted that the definition of residential
Netherlands fully or partially exempt foreign subsidiary and/or status under the Act is not entirely in agreement with the
branch earnings from domestic taxation. Other countries such definition given under the Foreign Exchange Management Act.
as Italy, Switzerland, and Belgium exclude a portion of foreign
Place of Earning Income and Tax Liability
income when calculating the domestic tax liability. The policy of
Any person who is a resident and ordinarily resident during a
equity in taxation is also justified on many of the same grounds
previous year is liable to tax in India on the world income:
as neutrality in taxation.
Which is received or deemed to be received in India; or
Tax Equity
Which accrues or arises or is deemed to accrue or arise in
The basis of tax equity is the criterion that all taxpayers in a
India; or
similar situation are subject to the same rules. All U.S. corpora-
tions should be taxed on income, regardless of where it is Which accrues or arises outside India.
earned. Thus, the income of a foreign branch should be taxed Non-residents are liable to tax only in respect of the first two
in the same manner that the income of a domestic branch is categories of income. An individual who is a resident but not
taxed. This form of equity should neutralize the tax consider- ordinarily resident is taxed on the first two categories of income
ation in a decision on foreign location versus domestic location.
118
plus the income that accrues or arises outside India which is derived
119
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120
INTERNATIONAL FINANCE MANAGEMENT
Exhibit 1. US Foreign Tax Credit Calculations
Branch Subsidiary
20 40 50 Foreign tax rates 20 40 50
W ithholding tax 10% dividends
0 % b r a n ch
100 100 100 Pretax profits 100 100 100
(20) (40) L2Q) Foreign co r p o rate tax (20) (40) (50)
80 60 50 N et available for dividends 80 60 50
- - -
W ithholding tax ) )
- -
80 60 50 N et cash to U.S. shareholder 72 54 45
D ividend inco m e-gross 80 60 50
G ross-u p for foreign taxes paid by
subsidiary 20 40 50
100 100 100 U.S. taxable inco m e 100 100 100
34 34 34 U.S. tax @ 34% before foreign tax credit 34 34 34
Less U.S. foreign tax credit:
(20) (40) (50) D irect credit -w ithholding, branch (8) (6) (5)
taxes
Indirect credit (20) (40) (50)
14 (6) (16) Net U.S. tax co s t-all credits used 6 (12) (21)
34 34 34 Total tax co s t-all credits used 34 34 34
34 40 50 Total tax co s t--excess credits not used 34 46 55
121
with an equity investment (using the borrowed funds). The 4. Transfer of intangible property: A cost factor is generally
INTERNATIONAL FINANCE MANAGEMENT
1986 tax act allocates interest expense, no matter where incurred, imputed based on the income received from the use of
on the basis of assets. For example, if interest expense is $ 100 intangible property such as patents, trademarks, formulas, or
and foreign assets account for 30% of total assets, then $30 of licenses by the receiving corporation. Moreover, under the
that interest is allocated against foreign-source income-even if all super royalty provision of the 1986 tax act, the IRS can use
the interest is paid in the United States by the parent-thereby the benefit of hindsight to retroactively adjust the transfer
reducing the FTC limitation. This rule also eliminates the U.S. price on intangibles transferred to foreign affiliates to reflect
tax deduction for that part of interest expense allocated abroad. the income the intangible generateseven though the price
Here, only $70 of the $100 in U.S. interest expense is deductible was arms length when the deal was made. For example, a
in the United States. company licenses its German affiliate at a low fee to produce
a new drug with uncertain uses. But if, three years down the
Research and Development Expenses
road, the drug turns out to be a cure for cancer, the IRS can
Under current tax law, 50% of all U.S.-based R&D expenses are
reset the royalty at a higher level to reflect the higher value of
apportioned to U.S.-source income. The remaining 50% can
the license. The odds are, however, that the German tax
then be apportioned between U.S.-source and foreign-source
authorities will disallow the revalued royalty for tax
income on the basis of either sales or gross income.
purposes.
Expenses Other Than Interest and R&D
5. Sale of inventory: The basis for adjustment is generally the
Expenses not directly allocable to a specific income producing arms-length price charged by the manufacturer (related
activity are to be allocated based on either assets or gross income. corporations) to unrelated customers. The tax regulations
Allocating more expenses incurred in the United States against specifically note that a reduced price to a related corporation
foreign-source income lowers the FTC limitation-the maximum cannot be justified by selling a quantity of the same product
amount of foreign tax credits that can be applied against U.S. at the reduced price to an unrelated customer.
taxes-and, therefore, the deductibility of foreign taxes paid.
Notes
Inter- Company Transactions
In recent years, both amendments to and applications of tax
legislation show a signifi-cant departure from the principle of
juridical domicile. Such departures are particularly prevalent in
the case of inter company transactions-that is, transactions between
members of the same MNC. One example is the authority of
the U.S. Internal Revenue Service to recalculate parent-subsidiary
income and expenses in certain circumstances. Because U.S.
operations have historically been more heavily taxed than
foreign operations, there has been a tendency for the parent firm
to minimize its overall tax bill by assigning deductible costs,
where possible, to itself rather than to its affiliates. As we have
just seen, however, U.S. MNCs now have an incentive to shift
more expenses overseas.
Generally, when transactions between related parties are adjusted
by the IRS, the result is to make these transactions arms length.
As a general principle, the IRS regards the price (or cost) in an
arms-length transaction as that price that would be reached by two
independent firms in normal dealings.
Examples of transactions between related companies that
would usually be adjusted include the following.
1. Non interest-bearing loans: Generally, the Internal Revenue
Service imputes interest at a rate of 6% per annum.
2. Performance of services by one related corporation for another
at no charge or at a charge that would be less than an arms-
length charge: This category would also include an allocation of
cost between a related group of companies for services rendered
by an unrelated company. Generally, the cost is allocated based
on the services received by each related company.
3. Generally, a factor equal to the normal rental charge for such
equipment is imputed as income to the transferor and as
expense to the transferee.
122
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:
TAX INCENTIVES FOR FOREIGN TRADE
123
allowed as a deduction on the ground that this is on capital on scientific research or for com-puting capital gains on sale of
INTERNATIONAL FINANCE MANAGEMENT
account while the loss of stock in trade will be deducted in such asset. It may be noted that but for this provision all
computing the income of the firm. exchange losses and gains of the nature specified above would
The aforesaid general rules are applied in dealing with the have been treated as arising on capital account. Conse-quently
exchange gains and losses also. Thus: the losses would not have been allowed as a deduction in
arriving at the taxable income and the gains would not form
The law may, therefore, now be taken to be well settled that
part of taxable income and hence not taxed. As seen in the
where profit or loss arises to an assesses on account of apprecia-
introduction of this sec-tion, such exchange losses and gains
tion or depreciation in the value of foreign currency held by it,
enter the computation of taxable income by way of either
on conversion into another currency, such profit or loss would
increased depreciation (when exchange losses are added to the
ordinarily be trading profit or loss, if the foreign currency is held
cost of asset) or reduced depreciation (when exchange gains go
by the assesses on revenue account or as a trading asset or as
to reduce the cost of the asset).
part of circulating capital embarked in the business. But if on
the other hand, the foreign currency, is held as a capital, such Tax Incentives For Earnings
profit or loss would be of capital nature. In Foreign Currency
Some of the decided case laws relating to treatment of exchange Taxation has been used by governments of the world including
gain3, which are in conformity with the rule stated by Supreme India as a tool for bringing about social and economic change.
Court as above, are mentioned below by way of amplification. Provisions have been introduced in the Indian tax law for
1. In the case of EID Parry Limited [174 ITR 11], the encouraging varied activities ranging from promoting family
promoters of the company made contribution towards share planning amongst employees of a concern to setting up new
capital in Pound Sterling and this amount was kept in a bank industrial un-dertakings. Though the nominal rates of income
in the UK. After a few months this was repatriated into tax in the Indian context appear to be high, such incen-tives
India and there was an exchange gain on conversion. It was reduce the tax burden resulting in lower effective rates of
held that this was capital in nature and hence not taxable. income tax. Among other things, such incentives have increased
the scope for manipulation by assesses and led to interpreta-
2. In the case of Triveni Engineering Works [156 ITR 202], the
tional problems and complexity in the administration of tax
company converted a loan of Pound Sterling 50,000 into
laws. The Indian government, having realized the negative
equity capital and this resulted in translation gain. It was held
implica-tions of tax incentives, has been progressively disman-
that this gain was on capital account and hence not taxable.
tling these incentive provisions and correspondingly reducing
3. In the case of TELCO [60 ITR 405], the company the nominal rates of taxes. In a setting like this, earnings in
accumulated certain incomes earned and loan repayments in foreign currency by an Indian enter-prise is one area where more
the US with an agent in the US for buying equipment. The and more tax incentives are being introducedObviously with
equipment could not be acquired and hence the money was a view to tackle the problem of balance of payments deficits.
repatriated resulting in exchange gain. This was held to be We will briefly deal with such incentives here.
not taxable being capital in nature.
1. Newly Established Industrial Undertakings in Free Trade
4. In the case of Hindustan Aircraft Limited [49 ITR 471], the Zones [Section 10 A] Newly established industrial
company was doing assembling and ser-vicing of aircraft in undertakings in free trade zones, electronic hardware
the US. There was appreciation in rupee value of the balance technology parks or software technology parks can claim
held in US dollars. It was held taxable being on revenue exemption of 100% of their profits and gains derived nom
account. such exports for a period often years beginning with the
5. Imperial Tobacco Company bought US dollars for buying assessment year relevant to the previous year in which the
tobacco in the US. Due to war, the Indian government did industrial undertaking begins to manufacture or produce
not permit this import and the company surrendered the US articles or things. This section applies to Kandla Free Trade
dollars and made a gain in the process. It was held that this Zone, Santacruz Electronics Export Processing Zone or any
gain is taxable being on revenue account. other free trade zone as prescribed by the Central
After the devaluation of rupee on June 6, 1966, a provision Government by notification in the Official Gazette, or the
[Section 43A] was introduced in the Income Tax Act, 1961 with technology parks set up under a scheme notified by the
effect from April 1, 1967 to deal with certain types of exchange Central Government, for the purposes of this section.
gains and losses relat-ing to acquisition of fixed assets outside 2. Newly Established Hundred Per Cent Export Oriented
India incurring liability in foreign currency. According to this Undertakings [Section 1 0 B] This provision extends the
provision, where an assesses acquires any fixed asset from a same type of benefit as allowed for the industrial
country outside India and incurs any liability in foreign currency undertakings set up in a free trade zone or technology park,
in connection with such acquisition, and there is increase or to newly established undertakings recognized as hundred
decrease in such liability expressed in rupees during any previous percent Export Oriented Undertakings. For the purposes of
year due to change in the rate of exchange, then such gain or this section hundred per cent export oriented under-
loss shall be adjusted to the historical cost of the asset con- takings means an undertaking, which has been approved as
cerned for the purposes of claiming deduction towards
depreciation or claiming 100% deduction as capital expenditure
124
a hundred per cent export oriented undertaking by the PI is arrived at as follows:
125
4. Construction of conference or convention centres; or kind of agreement, the two countries concerned agree that
INTERNATIONAL FINANCE MANAGEMENT
5. Provision of such new facilities, as may be notified, for certain incomes which are likely to be taxed in both countries
growth of Indian tourism. shall be taxed only in one of them or that each of the two
countries should tax only a specified portion of the in- come.
In order to claim the above deduction, the assesses is required
Such arrangements will avoid double taxation of the same
to furnish an audit report in the pre-scribed form (Form No.1 0
income. In the other kind of agreement,
CCAD) along with the return of income.
The income is subjected to tax in both the countries but the
Deduction under Section 80 HHD is being phased out in a
assesses is given a deduction from the tax payable by him in the
gradual manner such that no deduction will be available for the
other country, usually the lower of the two taxes paid. Double
assessment years commencing on 1.4.2005 and subsequent years.
taxation relief treaties entered into between two countries can be
Tax Implications of Activities of Foreign comprehensive covering a host of transactions and activities or
Enterprises in India restricted to air, shipping, or both kinds of trade. India has
Foreign non-resident business entities may have business entered into treaties of both kinds with several countries. Also
activities in India in a variety of ways. In its sim-plest form this there are many countries with which no double taxation relief
can take the form of individual transactions in the nature of agreements exist.
export or import of goods, lend-ing or borrowing of money, Section 90 of the Income fax Act empowers the Central
sale of technical know-how to an Indian enterprise, a foreign Government to enter into an agreement with the Government
air-liner touching an Indian airport and booking cargo or of any country outside India for granting relief when income
passengers, and so on. On the other hand, the activities may tax is paid on the same in-come in both countries and for
vary in intensity ranging from a simple agency office to that of avoidance of double taxation of income. The section also
an independent subsidiary company. Various tax issues arise on empowers the Central Government to enter into agreements
account of such activities. The first is the determination of for enabling the tax authorities to exchange information for the
income, if any, earned by the foreign entity from those transac- prevention of evasion or avoidance of taxes on income or for
tions and operations. This will call for a definition of income investigation of cases involving tax eva-sion or avoidance or for
that is con-sidered to have been earned in India and a method- recovery of taxes in foreign countries on a reciprocal basis. This
ology for quantification of the same. Foreign enterprises having section provides that between the clauses of the double
business transactions in India may not be accessible to Indian taxation relief agreement and the general provisions of the
tax authorities. This raises the next issue of the mechanism to Income Tax Act, the provisions of the Act shall apply only to
collect taxes from foreign enterprises. The government wants to the extent they are beneficial to the assesses. Where a double
encourage foreign enterprises to engage in certain types of taxation relief agreement provides for a particular mode of
business activities in India, which in its opinion is desirable for computation of income, the same is to be followed irrespective
achieving a balanced economic growth. of the provisions in the Income Tax Act. Where there is no
Double Taxation Relief specific provision in. the agreement, it is the basic law, that is,
One of the disadvantages associated with doing business the Income Tax Act that will govern the taxation of income.
outside the home country is the possibility of dou-ble taxation. The treaties entered into with certain countries contain a
Business transactions may be subject to tax both in the country provision that while giving credit for the tax liability in India on
of their origin and of their completion. We had seen in the the doubly taxed income, Indian tax payable shall be deemed
preceding section that tax charge is determined by taking the to include any amount spared under the provisions of the
residential status in conjunction with the situs of accrual, arisal, Indian Income Tax Act. The effect of this provision is that tax
or receipt of the item of income. Accordingly an item of exempted on various types of interest income as discussed
income may be taxed in one country based on residential status under the preceding section would be deemed to have been
and in another country on account of the fact that the income already paid and given credit in the home state. This will result
was earned in that country. For example, an Indian company in the lender saving taxes in his home country. Since this saving
having a foreign branch in France will pay income tax in respect is relatable to the transaction with the business enterprise in
of the income of the foreign branch in India based on its status India, the Indian enterprise can seek a reduction in the rate of
as Resident and in France because the income was earned interest charged on the loan. Suppose an interest income of Rs
there. Since such a state of affairs will impede international 100 is earned by a British bank on the money lent to an Indian
business, each country tries to avoid such double taxation by company, the British rate of tax on this income is 35% and the
either entering into an agreement with the other country to Indian withholding tax is 15%, and this income is exempted
provide relief or by incorporating provisions in their own tax from tax under Section 10(6)(iv), the British bank will save Rs
statutes for avoiding such double taxation. The first scheme is 15 on this transaction by way of tax in Britain as indicated
called Bilateral Relief and the second Unilateral Relief . The below:
features of both kinds of relief s are discussed hereunder:
Gross Interest Income. Rs 100.00
Bilateral Relief Less: Indian withholding tax -
Relief against the burden of double taxation can be worked out
Rs 100.00
on the basis of mutual agreement between the two Sovereign
States concerned. Such agreements may be of two kinds. In one Rs 35.00
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Less: British tax @ 35% on gross world. Transfer pricing has been of great concern to the
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Two entities are also treated as Associated Enterprises based on
INTERNATIONAL FINANCE MANAGEMENT
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